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Ruling

Subject: rental - insurance proceeds - natural disaster - distress relief payment

Questions

1. Are the insurance proceeds you will receive as compensation for lost rent included in your assessable income?

Answer: Yes

2. Will a balancing adjustment amount be included in your assessable income for depreciating assets destroyed in the natural disaster that were not allocated to the low-value pool, where the insurance amount received for the destruction of the asset exceeds its adjustable value?

Answer: Yes, unless you elect to reduce the cost of the replacement assets for depreciation purposes by the balancing adjustment income amounts.

3. Will a balancing adjustment amount be included in your assessable income for depreciating assets destroyed in the natural disaster that were not allocated to the low-value pool, where the insurance amount received for the destruction of the asset does not exceed its adjustable value?

Answer: No, you will be entitled to deduct the difference.

4. Will you have to take into account the insurance amounts you receive for the destruction of depreciating assets in calculating your closing pool balance in the income year that you receive them?

Answer: Yes

5. Are you entitled to claim a deduction for the undeducted construction expenditure of the capital works that were destroyed?

Answer: No

6. Are the insurance proceeds received for capital works destroyed in the natural disaster included in your assessable income?

Answer: No

7. Are you entitled to claim capital works deductions for the replacement capital works based on the construction expenditure incurred to build those replacement works?

Answer: Yes

8. Is the distress relief payment you received included in your assessable income?

Answer: No

This ruling applies for the following period

1 July 2011 to 30 June 2013

The scheme commences on

1 July 2011

Relevant facts and circumstances

You own a rental property jointly with your spouse.

You let the property fully furnished.

The building and contents were destroyed in a natural disaster.

The building and contents were insured against the natural disaster under a current replacement value policy.

You have claimed immediate deductions for depreciating assets costing $300 or less.

You allocate low-cost depreciating assets to a low-value pool.

Depreciating assets that could not be immediately deducted or allocated to the low-value pool are depreciated separately.

You will purchase replacement depreciating assets with the insurance proceeds you receive for depreciating assets destroyed in the natural disaster.

You will use the insurance proceeds you receive for destroyed capital works to build replacement capital works.

The insurance amounts you will receive for the destruction of capital works will exceed the undeducted construction expenditure for those capital works.

You received a distress relief payment in relation to the natural disaster.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 6-10

Income Tax Assessment Act 1997 subsection 6-15(1)

Income Tax Assessment Act 1997 Subdivision 20-A

Income Tax Assessment Act 1997 section 20-20

Income Tax Assessment Act 1997 subsection 20-20(2)

Income Tax Assessment Act 1997 paragraph 20-20(2)(b)

Income Tax Assessment Act 1997 subsection 20-25(2)

Income Tax Assessment Act 1997 subsection 20-25(5)

Income Tax Assessment Act 1997 section 25-10

Income Tax Assessment Act 1997 paragraph 40-85(1)(c)

Income Tax Assessment Act 1997 subsection 40-85(2)

Income Tax Assessment Act 1997 section 40-285

Income Tax Assessment Act 1997 paragraph 40-285(1)(b)

Income Tax Assessment Act 1997 paragraph 40-285(2)(b)

Income Tax Assessment Act 1997 section 40-295

Income Tax Assessment Act 1997 subsection 40-300(2)

Income Tax Assessment Act 1997 section 40-365

Income Tax Assessment Act 1997 subsection 40-365(4)

Income Tax Assessment Act 1997 subdivision 40-E

Income Tax Assessment Act 1997 subsection 40-440(1)

Income Tax Assessment Act 1997 subsection 40-440(2)

Income Tax Assessment Act 1997 section 40-445

Income Tax Assessment Act 1997 section 43-10

Income Tax Assessment Act 1997 section 43-20

Income Tax Assessment Act 1997 section 43-40

Income Tax Assessment Act 1997 section 43-70

Income Tax Assessment Act 1997 subsection 43-75(6)

Income Tax Assessment Act 1997 subsection 43-115(1)

Income Tax Assessment Act 1997 section 43-250

Income Tax Assessment Act 1997 section 43-255

Summary

As you and your spouse own the rental property jointly, the taxation treatment discussed below applies to each of you according to your ownership interest. That is, you are each required to include in your assessable income your share of the insurance amount you receive for lost rent.

Also, you are each required to include in your assessable income your share of the balancing adjustment amounts in relation to the destroyed depreciating assets not allocated to the low-value pool where the insurance amounts received for the destruction of the assets exceeds their adjustable value, unless you make the election to reduce the cost of the replacement assets for depreciation purposes.

Each of you will also be entitled to a deduction for your share of the balancing adjustment amounts for depreciating assets destroyed in the natural disaster that were not allocated to the low-value pool, where the insurance amount received for the destruction of the asset does not exceed its adjustable value.

In respect to assets allocated to your low-value pool, each of you will either be required to include your share of any excess in your assessable income, or will be entitled to your share of the deductible amount, depending on the outcome of your calculations for the low-value pool at the end of the income year.

Both of you will also be entitled to your share of capital works deductions based on the construction expenditure incurred to build replacement capital works.

The distress relief payment you received is not assessable income.

Insurance proceeds and lost rent

Your assessable income includes income according to ordinary concepts, which is called ordinary income (section 6-5 of the ITAA 1997). The legislation, however, does not define the expression income according to ordinary concepts. 

Ordinary income generally includes three categories, namely, income from rendering personal services, income from property, and income from carrying on a business. Other characteristics of income that have evolved from case law include receipts that:

· are earned

· are expected

· are relied upon, and

· have an element of periodicity, recurrence or regularity.

Rental income is ordinary income and is therefore included in assessable income.

Ordinarily, an amount paid to compensate for loss acquires the character of that for which it is substituted (FC of T v. Dixon (1952) 86 CLR 540; (1952) 5 ATR 443; 10 ATD 82).

As such, the insurance proceeds you will receive as compensation for lost rent is included in your assessable income under section 6-5 of the ITAA 1997 in the income year that the compensation is received.

Insurance proceeds and depreciating assets

The insurance proceeds you receive to compensate you for the cost of replacing destroyed depreciating assets, is not income from rendering personal services, income from property or income from carrying on a business. The payment will also be a once and for all payment and therefore will not have an element of recurrence or regularity.

Accordingly, the insurance proceeds you receive as compensation for the destruction of depreciating assets is not assessable income under section 6-5 of the ITAA 1997.

Your assessable income also includes statutory income amounts which are not ordinary income but are included in your assessable income by provisions about assessable income (section 6-10 of the ITAA 1997).

Certain amounts received by way of insurance, indemnity or other recoupment are assessable income if the amounts are not income under ordinary concepts or otherwise assessable (subdivision 20-A of the ITAA 1997).

However, if a balancing adjustment is required for property on which you incurred a loss or outgoing, no part of the termination value of the property is an amount you receive as recoupment of the loss or outgoing (subsection 20-25(5) of the ITAA 1997).

The termination value of a depreciating asset that is lost or destroyed is the amount or value received or receivable under an insurance policy or otherwise for the loss or destruction (item 8 in the table in subsection 40-300(2) of the ITAA 1997).

Therefore, the insurance proceeds you receive for the destruction of your depreciating assets are not an assessable recoupment, as the amount you will receive is the termination value of the destroyed depreciating assets.

Depreciating assets allocated to a low-value pool

Subdivision 40-E of the ITAA 1997 contains a number of provisions that specifically apply to depreciating assets allocated to a low-value pool (pooled assets).

The decline in value of assets in a low-value pool is worked out under subsection 40-440(1) of the ITAA 1997, which provides:

You work out the decline in value of depreciating assets in a low-value pool for an income year in this way:

Step 1: Work out the amount obtained by taking 18 ¾ % of the taxable use percentage of the cost of each low-cost asset you allocated to the pool for that year. Add those amounts.

Step 2: Add to the step 1 amount 18 ¾ % of the taxable use percentage of any amounts included in the second element of the cost for that year of:

(a)     assets allocated to the pool for an earlier income year; and

(b)     low-value assets allocated to the pool for the current year.

Step 3: Add to the step 2 amount 37 ½ % of the sum of:

(a)     the closing pool balance for the previous income year; and

(b)     the taxable use percentage of the opening adjustable values of low-value assets, at the start of the income year, that you allocated to the pool for that year.

Step 4: The result is the decline in value of the depreciating assets in the pool.

The closing pool balance of a low-value pool for an income year is calculated using the formula set out in subsection 40-440(2) of the ITAA 1997, and is the sum of:

(a) the closing pool balance of the pool for the previous income year; and

(b) the taxable use percentage of the costs of low-cost assets you allocated to the pool for that year; and

(c) the taxable use percentage of the opening adjustable values of any low-value assets you allocated to the pool for that year as at the start of that year; and

(d) the taxable use percentage of any amounts included in the second element of the cost for the income year of:

(i) assets allocated to the pool for an earlier income year; and

(ii) low-value assets allocated to the pool for the current year;

less the decline in value of the depreciating assets in the pool worked out under subsection 40-440(1) of the ITAA 1997.

When you stop holding a depreciating asset, such as when it is destroyed, a balancing adjustment event occurs (section 40-295 of the ITAA 1997).

Section 40-445 of the ITAA 1997 provides the simplified balancing adjustment rules for pooled assets under which the closing pool balance is reduced (but not below zero) by the taxable use percentage of the termination value of any asset the taxpayer ceases to hold (such as when it is destroyed).

If the taxable use percentage of the termination value exceeds the closing pool balance, the pool balance is exhausted and any excess is included in your assessable income.

If the taxable use percentage of the termination value does not exceed the closing pool balance, you may continue to deduct the pool balance attributable to the assets on which the balancing adjustment is made even though you no longer hold them.

Depreciating assets not allocated to a low-value pool

For depreciating assets not allocated to a low-value pool, the amount of the balancing adjustment is calculated by comparing the asset's termination value with its adjustable value (section 40-285 of the ITAA 1997).

The termination value of a depreciating asset that is lost or destroyed is the amount or value received or receivable under an insurance policy or otherwise for the loss or destruction (item 8 in the table in subsection 40-300(2) of the ITAA 1997.

The adjustable value of an asset at a particular time is the opening adjustable value for that year plus any second element costs for the year, less its decline in value for the year up to that time (paragraph 40-85(1)(c) of the ITAA 1997).

The opening adjustable value of a depreciating asset for an income year is its adjustable value to you at the end of the previous income year (subsection 40-85(2) of the ITAA 1997).

If the termination value of the depreciating asset is more than its adjustable value, the difference is included in your assessable income in the income year in which the balancing adjustment event occurred (paragraph 40-285(1)(b) of the ITAA 1997).

However, where you stop holding a depreciating asset because it is destroyed you may choose whether or not to include the balancing adjustment amount in your assessable income to the extent that you choose to treat it as a reduction in the cost and/or opening adjustable value of the replacement asset (section 40-365 of the ITAA 1997).

You can only make this choice for a replacement asset if:

· you incur the expenditure on the replacement asset, or you start to hold it:

· no earlier than one year, or within a further period the Commissioner allows, before the balancing adjustment event occurred; and

· no later than one year, or within a further period the Commissioner allows, after the end of the income year in which the balancing adjustment event occurred (section 40-365 of the ITAA 1997), and

· at the end of the income year in which you incurred the expenditure on the asset, or you started to hold it, you used it, or had it installed ready for use, wholly for a taxable purpose and you can deduct an amount for it (subsection 40-365(4) of the ITAA 1997.

If you choose to include a balancing adjustment amount in your assessable income then the cost and/or opening adjustable value of the replacement depreciating assets will be their cost.

If you choose not to include a balancing adjustment amount in your assessable income the cost of the replacement depreciating assets will need to be reduced to the extent that you choose to treat the balancing adjustment amount as a reduction in the cost and/or opening adjustable value of the replacement assets.

If the termination value of the depreciating asset is less than its adjustable value, the difference is deductible in the income year in which the balancing adjustment event occurred (paragraph
40-285(2)(b) of the ITAA 1997).

Insurance proceeds and destroyed capital works

The insurance proceeds you will receive to compensate you for the loss of capital works is not income from rendering personal services, income from property or income from carrying on a business. The payment will also be a once and for all payment and therefore does not have an element of recurrence or regularity.

Additionally, the insurance proceeds you will receive are for the loss of capital works and, therefore, take on the character of those capital works. As such, the payment will be capital in nature.

Accordingly, the insurance proceeds you receive as compensation for the loss of capital works is not assessable income under section 6-5 of the ITAA 1997.

As noted above, your assessable income also includes statutory income amounts which are not ordinary income but are included in assessable income by provisions about assessable income (section 6-10 of the ITAA 1997).

Under paragraph 20-20(2)(b) of the ITAA 1997, recoupment of a loss or outgoing is only an assessable recoupment if the taxpayer can deduct an amount for the loss or outgoing for the current year, or has deducted or is able to deduct an amount for it for an earlier income year, under any provision of the ITAA 1997.

The phrase 'for the loss or outgoing' in paragraph 20-20(2)(b) of the ITAA 1997 requires a connection between the deduction and the loss or outgoing for which the taxpayer had been recouped (paragraph 11 of Taxation Determination TD 2006/31).

In your case, the relevant loss or outgoing which has been recouped is the destruction of the capital works. The 'loss or outgoing' referred to in paragraph 20-20(2)(b) of the ITAA 1997 is not limited to an amount expended or paid by you, it extends to a loss incurred as a result of the destruction of an asset.

Whilst you may have been able to deduct an amount in relation to the original construction of the capital works under section 43-40 of the ITAA 1997, or in relation to the construction of replacement capital works under section 43-10 of the ITAA 1997, these are not deductions for the loss referred to in paragraph 20-20(2)(b) of the ITAA 1997. No deduction is available for the loss of the capital works.

Accordingly, as you cannot deduct an amount for the loss or outgoing for which the insurance proceeds will be received as recoupment, the insurance proceeds for the destruction of the capital works are not an assessable recoupment under section
20-20 of the ITAA 1997.

As the insurance proceeds that will be paid to cover the cost of reconstructing the capital works that were destroyed in the natural disaster are not ordinary or statutory income they are not included in your assessable income under any provision of the ITAA 1997.

No deduction for destroyed capital works

You can deduct an amount (called a balancing deduction), if all, or part of your capital works are destroyed in an income year, and:

· you have been allowed or can claim a capital works deduction for the capital works

· the capital works were used for income producing purposes before they were destroyed, and

· there is an amount of undeducted construction expenditure for the capital works (section 43-40 of the ITAA 1997).

The amount of the balancing deduction is calculated using the formula set out in section 43-250 of the ITAA 1997. Generally, the deduction is equal to the undeducted construction expenditure at the date of the destruction of the capital works less amounts you have received or have the right to receive for the destruction of the capital works, including an amount received under an insurance policy for the destruction of capital works (section 43-255 of the ITAA 1997).

As the insurance amounts you will receive for the destruction of the capital works will exceed the undeducted construction expenditure for those capital works, the amount available as a deduction under section 43-40 of the ITAA 1997 is nil.

Deduction for new capital works

You can deduct an amount for capital works in an income year if:

· the capital works have a 'construction expenditure area'

· there is a 'pool of construction expenditure' for that area, and

· you use 'your area' in the income year to produce assessable income (section 43-10 of the ITAA 1997).

'Construction expenditure' is capital expenditure incurred in respect of the construction of capital works (subsection 43-70 of the ITAA 1997). Construction expenditure is determined on the basis of the actual costs incurred to construct the capital works, but does not include expenditure incurred to demolish existing structures.

Deductions based on 'construction expenditure' apply to capital works such as a building or an extension and structural improvements to the property including a gazebo, carport or fence (section 43-20 of the ITAA 1997).

A separate 'construction expenditure area' is created each time an entity undertakes the construction of capital works (subsection 43-75(6) of the ITAA 1997).

A 'pool of construction expenditure' is so much of the construction expenditure incurred by an entity on capital works as is attributable to the construction expenditure area.

'Your area' is the part of the construction expenditure area that you own (subsection 43-115(1) of the ITAA 1997).

'Your construction expenditure' is the portion of the pool of construction expenditure that is attributable to your area.

As construction expenditure will be incurred to build capital works and you will use those capital works to produce assessable income, you will be entitled to claim capital works deductions based on the total construction expenditure incurred to construct those capital works under section 43-10 of the ITAA 1997.

Distress relief payment

As noted above, your assessable income includes income according to ordinary concepts, which is called ordinary income (section 6-5 of the ITAA 1997), and statutory income (section 6-10 of the ITAA 1997).

Ordinary income generally includes three categories, namely, income from rendering personal services, income from property, and income from carrying on a business. Other characteristics of income that have evolved from case law include receipts that:

· are earned

· are expected

· are relied upon, and

· have an element of periodicity, recurrence or regularity.

The distress relief payment you received was not earned by you as it does not relate to services performed. The payment was also a one off, or non-periodic, payment and so it does not have an element of regularity. Although the payment may be said to be expected and relied upon, this expectation and reliance arises from personal hardship suffered as a result of the natural disaster, rather than from a relationship to services performed. As such, the distress relief payment you received is not ordinary income.

Also, there are no specific provisions which include the distress relief payment in your assessable income, and therefore, the payment is not statutory income.

As the payment is not ordinary or statutory income, it is not assessable income (subsection 6-15(1) of the ITAA 1997).