Assessable income: recoupments - insurance proceeds for destruction of capital works

Are insurance proceeds received by a taxpayer for the destruction of capital works an assessable recoupment under section 20-20 of the Income Tax Assessment Act 1997 (ITAA 1997)?

No, insurance proceeds received by a taxpayer for the destruction of capital works are not an assessable recoupment under section 20-20 of the ITAA 1997, as the taxpayer cannot deduct an amount for the loss for which the insurance proceeds are received.

The taxpayer owned a rental property which included capital works within the meaning of that expression in section 43-20 of the ITAA 1997.

As a result of flooding, the capital works were destroyed in the taxpayer's 2010-11 income year.

In earlier income years, the taxpayer deducted amounts pursuant to section 43-10 of the ITAA 1997 for the cost of constructing the capital works that were destroyed.

The taxpayer held a contract of insurance in respect of the capital works, under which damage by flooding was a listed event.

As a result of damage caused by flooding and operation of the contract of insurance, the insurer paid the taxpayer an amount of money calculated by reference to the current replacement cost of the capital works destroyed.

Subdivision 20-A of the ITAA 1997 provides that 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.

Under subsection 20-20(2) of the ITAA 1997, an amount received as recoupment of a loss or outgoing is an assessable recoupment if the taxpayer: (a) received the amount by way of insurance or indemnity; and (b) can deduct an amount for the loss or outgoing for the current year, or did deduct or could deduct an amount for the loss or outgoing for an earlier income year under any provision of the Act.

Subsection 20-20(1) of the ITAA 1997 provides that an amount is not an assessable recoupment to the extent that it is ordinary income, or it is statutory income because of a provision outside of Subdivision 20-A of the ITAA 1997.

Ordinarily, an amount paid to compensate for loss acquires the character of that for which it is substituted ( Federal Commissioner of Taxation v. Dixon (1952) 86 CLR 540; (1952) 5 ATR 443; 10 ATD 82; ATO ID 2002/175 ).

In the present case, the insurance proceeds were received for the loss of capital works and, therefore, take on the character of those capital works. As the insurance proceeds are capital in nature, and there is no provision outside of Subdivision 20-A of the ITAA 1997 that specifically includes the insurance proceeds in the taxpayer's assessable income, subsection 20-20(1) of the ITAA 1997 does not exclude the amount from being an assessable recoupment.

In order to determine whether or not the insurance proceeds are an assessable recoupment, it must be considered whether the insurance proceeds received are a recoupment. Recoupment is a defined term and has the meaning given by subsection 20-25(1) of the ITAA 1997. Under paragraph 20-25(1)(a), a recoupment of a loss or outgoing includes any kind of insurance.

The term 'insurance' is defined in Butterworths Concise Australian Legal Dictionary , 1997, Butterworths, Sydney, as: The relationship of indemnity which exists between two parties, the 'insurer' and the 'insured', irrespective of whether the relationship arises by statute or by contract: R v. Cohen; Ex parte Motor Accidents Insurance Board (1979) 141 CLR 577; 27 ALR 263. The insurance relationship most commonly arises by a contract of insurance. A contract of insurance exists where one person (the 'insurer') undertakes, in return for some agreed consideration (the 'premium'), to pay another person (the 'insured') a sum of money, or provide an equivalent benefit, on the happening of a specified event, the occurrence or timing of which is uncertain: Prudential Insurance Co. v. Commissioners of Inland Revenue [1904] 2 KB 658.

The taxpayer was a party to a contract of insurance under which the insurer was bound to make a payment to the taxpayer upon the happening, to the capital works, of certain events. Upon the destruction of the capital works, the insurer paid an amount to the taxpayer. Accordingly, the insurance proceeds are received as recoupment for the purpose of paragraph 20-25(1)(a) of the ITAA 1997, and are a recoupment for the purposes of paragraph 20-20(2)(a) 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 considers the phrase 'for the loss or outgoing' in the context of subsection 20-20(3) of the ITAA 1997).

In the present case, the relevant loss or outgoing for which the taxpayer has been recouped is 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 a taxpayer. As in the present case, it extends to a loss incurred as a result of the destruction of an asset.

Whilst the taxpayer may be 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 a future 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 the taxpayer cannot deduct an amount for the loss or outgoing for which the insurance proceeds are received as recoupment, the insurance proceeds received by the taxpayer for the destruction of the capital works are not an assessable recoupment under section 20-20 of the ITAA 1997.