2015-0605581E5 Treatment of insurance proceeds and recapture

Principal Issues: What is the treatment of insurance proceeds for capital equipment, business interruption and potential CCA recapture?

Position: Treatment of proceeds for equipment depends on whether equipment was lost/destroyed or damaged; proceeds for business interruption are treated in same manner as business revenues; recapture is treated in same manner as revenues generated by the property in respect of which the CCA deductions were made.

Reasons: See below.

Author: Kom, Joel
Section: 12(1)(f), 13(1), 13(4), 13(21), 54, 44(1), 44(2), 125(7), 248(1)

XXXXXXXXXX                                      2015-060558
                                                              J. Kom

January 4, 2016

Dear XXXXXXXXXX:

Re: Treatment of insurance proceeds and recapture

We are writing in reply to your email of August 25, 2015 and your telephone conversation (Fitzgerald/XXXXXXXXXX) of August 27, 2015, wherein you requested our views on the tax treatment of certain insurance proceeds and any related recapture of capital cost allowance (“CCA”) under the Income Tax Act (the “Act”).

You indicated that your client (“Aco”) operates an active business from rented premises; however, during Aco’s XXXXXXXXXX taxation year, a XXXXXXXXXX damaged both the rented premises and certain depreciable equipment it owned and used in its business. Aco was forced to suspend its business operations for XXXXXXXXXX months until a suitable new leased location was found.

Aco filed insurance claims relating to the XXXXXXXXXX and settled the claims in its XXXXXXXXXX taxation year. It received as proceeds from insurance one amount for the loss of capital equipment and another amount for lost revenues due to business interruption.

You seek our views on the tax treatment of these respective insurance proceeds. You also seek our views on whether any subsequent income inclusion from the recapture of CCA would be considered active business income (“ABI”) for the purposes of the small business deduction (“SBD”).

Our Comments

This technical interpretation provides general comments about the provisions of the Act and related legislation.  It does not confirm the income tax treatment of a particular situation but is intended to assist you in making that determination. The income tax treatment of transactions will only be confirmed by this Directorate in the context of an advance income tax ruling request submitted in the manner set out in Information Circular IC 70-6R5, “Advance Income Tax Rulings”.

Treatment of insurance proceeds for loss of capital equipment

Generally speaking, the treatment of insurance proceeds for loss of capital equipment will depend on whether the proceeds were for the loss/destruction of property or damage to property. If they were for the latter, the treatment will further depend on whether the proceeds were spent on repairing the damage. There are three provisions in the Act that will largely dictate the proceeds’ treatment: paragraph 12(1)(f); subsection 13(21); and section 54.

Paragraph 12(1)(f)

Paragraph 12(1)(f) states that insurance proceeds will be included in income if they relate to damage to equipment and the taxpayer spent them on repairing the damage. The taxpayer must have spent the proceeds on repairs within the same tax year the taxpayer received the proceeds and within a reasonable time after the damage. Determining “a reasonable time after the damage” is a question of fact. This income inclusion is generally offset by the taxpayer deducting the repair expense from income, to the extent that the expense is not on account of capital.

Subsection 13(21) and Section 54

Subsection 13(21) defines “proceeds of disposition” (“POD”) for the purposes of section 13, which deals with various aspects of depreciable property. There is a similar definition of POD in section 54; this definition applies to Subdivision c. These definitions include, inter alia:

(c) compensation for property destroyed and any amount payable under a policy of insurance in respect of loss or destruction of property; and

…

(f) compensation for property damaged and any amount payable under a policy of insurance in respect of damage to property, except to the extent that the compensation or amount, as the case may be, has within a reasonable time after the damage been expended on repairing the damage.

This means a taxpayer will have POD if: it receives insurance proceeds for lost/destroyed property; or it receives insurance proceeds for damaged property, provided that these proceeds were not spent on repairing the damage within a reasonable time. Once again, it is a question of fact whether insurance proceeds are for lost/destroyed property or damaged property.

If insurance proceeds are included in a taxpayer’s income based on paragraph 12(1)(f), they will not be counted as POD based on the wording of paragraph (f) of the above-noted definition of POD. If a taxpayer is considered to have POD then the disposition of a depreciable property could lead to potential recapture, capital gain or terminal loss. Additionally, the replacement property rules relating to recapture in subsection 13(4) and relating to capital gains in section 44 may also be considered. Generally speaking, the replacement property rules may prevent recapture and/or a capital gain from occurring where replacement property is acquired within specified time limits. Additional information about these rules can be found in Interpretation Bulletin IT-259R4, “Exchanges of Property.”

Treatment of insurance proceeds for lost revenue due to business interruption

Insurance proceeds for lost revenue are treated in the same manner as the revenue which the proceeds are meant to replace. This treatment is based on the surrogatum principle. The proceeds should be reported using the method that presents the truest picture of the taxpayer’s revenues.

Whether any CCA recapture would be treated as ABI

Paragraph 4 of Interpretation Bulletin IT-73R6, “The Small Business Deduction”, indicates that “Income of the corporation for the year from an active business,” as defined in subsection 125(7), means the corporation’s income for the year from an active business carried on by it, including any income for the year pertaining to or incident to that business.

ABI does not include any income for the year from a source in Canada that is a property within the meaning assigned by subsection 129(4). It is a question of fact whether a property is used principally in an active business. Factors to be considered in determining whether a property is used in an active business include the actual use to which the asset is put in the course of the business, the nature of the business involved and the practice in the particular industry.

In general, an amount included in income under subsection 13(1) is considered to be income from the same source against which CCA on the property was deducted. This means that any CCA recapture will generally be treated in the same manner as the revenues related to the property from which CCA had been deducted.

We trust that these comments will be of assistance.

Yours truly,

Michael Cooke, CPA, CA
Manager
Business Income and Capital Transaction Section
Business and Employment Division
Income Tax Rulings Directorate

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