Depreciation

Sections EE 22, EE 45(8) and EZ 23B to EZ 23G, of the Income Tax Act 2007

Following the February 2011 earthquake in Canterbury, taxpayers have begun to receive insurance or compensation payments, and to re-establish business or income-earning activities. This has highlighted some particular problems, largely relating to the income tax rules for asset depreciation, the taxation of insurance proceeds that are not received or cannot be used in the conventional way, and the repair or abandonment of damaged buildings and other assets.

Many of these problems have arisen because of the scale of earthquake damage to a significant number of capital assets, which has affected the way insurance claims are being processed and paid.

With some exceptions, the focus of the changes contained in the Taxation (Annual Rates, Returns Filing, and Remedial Matters Act) 2012 is to provide temporary, time-limited earthquake relief and assistance, as reflected in the application dates of some of the provisions.

Key features

Changes to the depreciation rules:

• provide optional matching rules to smooth the timing of income and deductions/disposal losses when insurance proceeds have been received for earthquake-damaged depreciable assets;
• align the tax treatment of depreciable assets that are uneconomic to repair with the treatment of depreciable assets that have been "irreparably damaged" or are "useless for earning income" for tax purposes;
• limit the depreciation recovery income that arises under the tax rules when insurance proceeds have been received for a damaged asset that is repairable to the amount of depreciation deductions previously claimed for the asset;
• allow a depreciation deduction in relation to depreciable property when access to the property is temporarily restricted as a result of a Canterbury earthquake; and
• address minor technical issues with the pool depreciation rules.

Detailed analysis

Consideration when depreciable property is irreparably damaged or rendered useless

Section EE 45(8) has been amended to ensure that the amount derived from a depreciable asset that is irreparably damaged or rendered useless for earning income includes any proceeds from its disposal, for example, any scrap value.

Previously, the provision stated that the amount derived from disposal of the asset was the amount of insurance, indemnity or compensation received and did not take into account any disposal proceeds.

Application date

The amendment applies for the 2011-12 and later income years. This includes taxpayers who have been granted an extension of time for filing an income tax return for the 2010-11 income year under the Canterbury Earthquake (Inland Revenue Acts) Order 2011.

Damaged depreciable property that is uneconomic to repair

New section EZ 23C provides for the deemed disposal and reacquisition of assets which are damaged in a Canterbury earthquake and uneconomic to repair.

The tax depreciation rules do not provide an appropriate outcome when an asset has been damaged in a Canterbury earthquake and the insurer considers it to be uneconomic to repair (and requiring replacement), even though the asset may be physically repairable. This is because the current rules make a distinction between assets that are repairable and those that are irreparably damaged or rendered useless for earning income. Assets that are uneconomic to repair are generally included in the former category.

The consequence is that a taxpayer may face a significant unexpected tax liability when an insurance amount is received, as a result of the application of section EE 52. Section EE 52 treats as taxable any insurance proceeds in excess of an asset's adjusted tax value and expenditure on repairing the asset. This means that an amount greater than the depreciation deductions previously claimed for the asset may be treated as taxable. By contrast, for an asset that is irreparably damaged or rendered useless for earning income, the depreciation rules cap depreciation recovery income at the amount of previous depreciation deductions.

In addition, the depreciation "roll-over relief" rule in section EZ 23B, which was developed last year as a response to the Canterbury earthquakes to give taxpayers the ability to defer any depreciation recovery income, applies only to irreparably damaged assets or buildings that are rendered useless for the purpose of deriving income.

Accordingly, amendments have been made to align the treatment of assets that are uneconomic to repair with the existing treatment under the depreciation rules of assets that are irreparably damaged or rendered useless for earning income. This recognises that assets that are uneconomic to repair in the context of the Canterbury earthquakes are, in substance, very similar to assets that are physically irreparable and therefore should receive similar treatment under the depreciation rules.

This objective is achieved through new section EZ 23C which treats assets that are uneconomic to repair as being disposed of for the amount of insurance received for the asset, on the date of the Canterbury earthquake that caused the asset to be uneconomic to repair. This deemed disposal ensures that section EE 48 in the depreciation rules (which applies to irreparably damaged assets) also applies to assets that are uneconomic to repair.

The criteria for an asset to be subject to deemed disposal and reacquisition under section EZ 23C are:

• The depreciable asset is damaged by a Canterbury earthquake, as that term is defined in section 4 of the Canterbury Earthquake Recovery Act 2011.
• The owner of the asset is entitled to an amount of insurance or compensation for the damage to the item.
• The asset has been assessed by the insurer as uneconomic to repair.
• The damage has not caused the asset to be irreparably damaged or rendered useless for earning income in accordance with section EE 47(4).

The term "Canterbury earthquakes" is defined broadly in section 4 of the Canterbury Earthquake Recovery Act 2011 as "any earthquake in Canterbury on or after 4 September 2010, and includes any aftershock". Accordingly, when assets have sustained cumulative damage through multiple earthquakes and aftershocks, taxpayers can use the date of the earthquake which caused the asset to be damaged to the extent that it is uneconomic to repair as the relevant date of the deemed disposal and reacquisition under section EZ 23C.

The asset is treated as being reacquired on the same date as the deemed disposal for nil consideration. This is to ensure that post-earthquake repairs are correctly capitalised (and not treated as deductible expenditure).

Roll-over relief for income tax liabilities arising from the receipt of insurance for earthquake-damaged assets has been extended to assets that are subject to a deemed disposal and reacquisition under section EZ 23C by an amendment to section EZ 23B.

Section EZ 23C overrides section EE 52, which means that for an asset meeting the criteria for section EZ 23C to apply, section EE 52 will not apply.

The deemed disposal and reacquisition under section EZ 23C is not treated as a disposal or reacquisition for the purposes of the land provisions (sections CB 6 to 23).

Application date

This Canterbury earthquakes-specific amendment applies for the 2010-11 to 2015-16 income years. The Commissioner may exercise the discretion under section 113 of the Tax Administration Act 1994 to amend an assessment.

Cap on depreciation recovery income

New section EZ 23D limits depreciation recovery income calculated under section EE 52 to the amount of depreciation deductions previously taken, when insurance proceeds are received for a repairable damaged asset.

Section EE 52 provides that when insurance proceeds are received for damage to a repairable depreciable asset, the proceeds are taxable to the extent they exceed the cost of any repairs and the asset's adjusted tax value. As noted above, this means that the tax rules may end up taxing more than the amount of earlier depreciation deductions allowed for the asset. In the context of the Canterbury earthquakes, this means that taxpayers may face significant unanticipated income tax liabilities in relation to damaged (but repairable) assets.

The cap on depreciation recovery income determined under section EE 52 is confined to depreciable assets damaged by a Canterbury earthquake (as defined in section 4 of the Canterbury Earthquake Recovery Act 2011), the damage does not cause the asset to be irreparably damaged or rendered useless for earning income, and section EZ 23C does not apply to the asset.

Application date

This Canterbury earthquakes-specific amendment applies for the 2010-11 to 2015-16 income years. The Commissioner may exercise the discretion under section 113 of the Tax Administration Act 1994 to amend an assessment.

Optional timing rule for income and deductions when insurance proceeds are received for earthquake-damaged, irreparable depreciable assets

New section EZ 23F provides an optional rule to smooth the timing of income and deductions when insurance proceeds have been received for depreciable property that has been irreparably damaged or rendered useless for earning income as a result of the Canterbury earthquakes. The timing rule also applies to depreciable assets that are uneconomic to repair and to which section EZ 23C applies. The rule applies to individual items of depreciable property, in line with the general approach under the depreciation rules.

The policy intent is that the matching rule allows the net amount of:

• insurance payments
• disposal proceeds

less

• the write-off of the tax book value; and
• expenditure on disposing of the asset

as determined under section EE 48 to be brought to account for tax purposes by a taxpayer.

The timing rule may be used for a depreciable asset when:

• The asset is damaged by a Canterbury earthquake as that term is defined in section 4 of the Canterbury Earthquake Recovery Act 2011.
• The damage causes the asset to be irreparably damaged or rendered useless for earning income and thus meets the requirements of section EE 47(4) or causes the asset to be subject to a deemed disposal and reacquisition under section EZ 23C.
• The owner is entitled to insurance or compensation for the damage.
• The owner chooses to apply the timing rule to all their depreciable assets meeting the above requirements.

The timing rule provides that any income or deductions are recognised at the earlier of:

• when insurance proceeds, the cost of and proceeds from disposing of the asset have been derived or incurred or are able to be reasonably estimated; or
• the 2015-16 income year.

Whether insurance proceeds and other amounts can be reasonably estimated is essentially a question of fact, which will depend on the individual circumstances of each case. However, it is envisaged that some form of documentation would be required, for example, a written quote from an insurer.

Section EZ 23F overrides the timing rules in sections EE 1, EE 22 and EE 48. The section can also be applied to assets depreciated in a pool.

A person who opts to use the matching rule must use it for all their items of depreciable property that meet the criteria for applying the rule. This is to prevent taxpayers "cherry-picking" the assets to which they apply the rule.

A taxpayer's decision to elect into the matching rule will be reflected in the tax position they take in their return of income for each tax year - no prior notice of election is required.

Application date

This Canterbury earthquakes-specific amendment applies for the 2010-11 to 2015-16 income years. The Commissioner may exercise the discretion under section 113 of the Tax Administration Act 1994 to amend an assessment.

Optional timing rule for income and deductions when insurance proceeds are received for depreciable property that is damaged but repairable

New section EZ 23G introduces an optional rule to smooth the timing of income and deductions when insurance proceeds have been received for a depreciable asset that has been damaged in a Canterbury earthquake but is repairable. The rule is broadly similar to section EZ 23F in design.
 
The timing rule may be used for a depreciable asset when:

• The asset is damaged by a Canterbury earthquake as that term is defined in section 4 of the Canterbury Earthquake Recovery Act 2011.
• The asset is not irreparably damaged or rendered useless for earning income and therefore does not meet the requirements of section EE 47(4) and the asset is not subject to a deemed disposal and reacquisition under section EZ 23C.
• The owner is entitled to insurance or compensation for the damage.
• The owner chooses to apply the timing rule to all their depreciable assets meeting the above requirements.

The timing rule provides that any income or deductions are recognised at the earlier of:

• when insurance proceeds and the cost of repairing the asset have been derived or incurred or are able to be reasonably estimated; or
• the 2015-16 income year.

Section EZ 23G overrides the timing rules in sections CG 4, EE 22 and EE 52. The section is also applicable to assets depreciated in a pool.

Application date

This Canterbury earthquakes-specific amendment applies for the 2010-11 to 2015-16 income years. The Commissioner may exercise the discretion under section 113 of the Tax Administration Act 1994 to amend an assessment.

Property that is available for use

For an item of property to be depreciated, the item must be used in a business or available for use. It was unclear how this rule should be applied when access to depreciable property was temporarily restricted following a Canterbury earthquake.

To clarify the tax treatment in this case, new section EZ 23E treats an item of property as being available for use while access to the property is temporarily restricted due to the effects of a Canterbury earthquake (as defined in section 4 of the Canterbury Earthquake Recovery Act 2011), if the following conditions are met:

• The item was used or available for use immediately before the restriction was imposed.
• The item would be used or available for use in the absence of the restriction.
• The income year is the 2015-16 or an earlier income year.

This amendment allows businesses to continue to have depreciation deductions for their depreciable property even though it is temporarily unavailable for use as a result of a Canterbury earthquake.

Application date

This amendment applies for the 2010-11 to the 2015-16 income years.

Amendments to the pool depreciation rules

Section EE 22 has been amended to address some minor technical issues with the depreciation rules for pool assets, arising from the Canterbury earthquakes.

A new subsection (2B) has been included to ensure that when a person receives insurance proceeds for damage caused to an asset included in a pool, any insurance proceeds that are more than the expenditure the person has incurred in repairing the asset is subtracted from the pool's adjusted tax value. The rationale is to align the treatment of damaged pool assets more closely with the treatment of non-pool assets under the depreciation rules. Under the general depreciation rules, insurance proceeds received that are more than the repair costs incurred for a damaged asset reduce the asset's adjusted tax value. Section EE 22(3) has been amended to clarify that insurance proceeds are included as an amount derived from the disposal of an asset included in a pool, and to ensure that any excess of the insurance proceeds over disposal costs or loss is subtracted from the pool's adjusted tax value on the date of disposal. Again, this aligns the pool depreciation rules more closely with the general depreciation rules.

Application date

These generic amendments apply for the 2011-12 and later income years. However, for a person who is granted an extension of time for filing an income tax return for the 2010-11 income year under the Canterbury Earthquake (Inland Revenue Acts) Order 2011, the amendments apply for the 2010-11 and later income years.

Correction of minor drafting error in roll-over relief provision

An incorrect cross-reference in section EZ 23B(2)(b) has been amended. The reference to "subsection (7)" has been changed to "subsection (8)".

Application date

This generic amendment applies from 4 September 2010, the date section EZ 23B came into force.