Insurance monies and capital gains tax explained

Posted: 09/05/2014

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Many people amass large collections of art, antiques, jewellery or other collectables, which may rise substantially in value since the time they were acquired. 

If you are going to make a considerable investment in such items then it is essential that you ensure that your items are completely protected to the fullest extent.  With specialist insurance cover, you will likely be insured against accidental, water and fire damage, theft and, possibly, depreciation of value if restoration is needed.

The tax consequences of an insurance claim are often overlooked and vary considerably depending on the nature of the loss and, in some cases, how and when the insurance proceeds are used.

In this article we examine some of the main considerations in relation to capital gains tax (CGT) and its interaction with insurance proceeds as faced by the fictitious art collector Jonathan. 

The basics

Wasting

A chattel which is considered a ‘wasting asset’ is exempt from CGT (section 45(1) Taxation of Chargeable Gains Act 1992 (‘the Act’)).  An asset is wasting if it has a useful life of fewer than 50 years determined at the date the asset is acquired and by reference to the purpose for which it was obtained.

Plant and machinery is always treated as having a useful life of fewer than 50 years.  HMRC guidance confirms that it regards clocks, watches, trains, boats and yachts as machinery and, as such, they will be exempt from CGT.  All motor vehicles (to include classic cars) are exempt from CGT.

There are some anomalies:

• In the recent case of HMRC v The Executors of Lord Howard of Henderskelfe [2014] Civ 278, the Court of Appeal was persuaded that a painting by Sir Joshua Reynolds, Portrait of Omai, was a wasting asset on the basis that it was ‘plant’.  Paintings do not usually qualify as plant pertaining to their lack of commercial nexus.  In this case the painting was used in a business; it was loaned to a company and exhibited by it in a heritage property open to the public.  The decision is surprising to say the least as the painting in question had been owned by the Howard family since 1796.  The Court of Appeal agreed that the painting met the definition of ‘plant’ (Yarmouth v France (1887) 19 QBD 647) as it was employed in a business.  The executors sold the painting for £9.4 million without charge to CGT.  It is not known at the date of this article whether HMRC is to appeal the case to the Supreme Court.  In the absence of an appeal, the Government will likely consider legislation to block this loophole.
• Wine has often been considered as a wasting asset; however, HMRC guidance states that, where the facts justify it, they would normally contend that wine (and spirits by extension) is not a wasting asset if it appears to be fine wine which not unusually is kept for substantial periods, sometimes well in excess of 50 years. 

Non-wasting

For chattels with an expected useful life exceeding 50 years, the following rules apply:

• Where bought and sold for less than £6,000, any gain will be exempt and any loss cannot be offset against other capital gains realised in the same tax year.
• Where the chattel cost more than £6,000, but was sold at a loss, the disposal proceeds are deemed to be £6,000 less any cost of sale.
• Where the chattel is sold for more than £6,000, but bought for less than £6,000, the gain is calculated in the normal way, but cannot exceed the maximum chargeable gain.  This is calculated as 5/3rds of the gross proceeds less £6,000.

If the chattel sold is part of a set and sold to the same person, the above rules are applied to value the entire set, rather than its individual parts.  A set refers to a group of items which are similar and complimentary and where the total value is greater than the sum value of its parts.

A charge to CGT arises whenever an asset is disposed of.  When calculating the gain or loss of an item, any insurance compensation is the deemed proceeds.  Where an item is given away, or sold at an undervalue to a connected person (relatives, trustees, partners and companies) its full market value is used to determine the CGT arising.

Scenario facts

In his collection Jonathan owns a painting by Russian realist Ivan Shishkin that he purchased for £700,000 in 2005.  That sum is his ‘base cost’ for CGT purposes. Every couple of years that followed, Jonathan had the painting appraised and if the value increased, Jonathan diligently increased his insurance cover. As at January 2014 the painting was worth £1 million, however, Jonathan failed to have the painting appraised over the last couple of years when demand for Shishkin’s work had risen sharply.  Jonathan’s insurance policy only provides cover for £800,000. The painting is proudly displayed in Jonathan’s central London property. For income tax purposes Jonathan is an additional rate (‘AR’) taxpayer.

Scenario 1: Gone for good

Whilst Jonathan was away for a short break in January 2014, his property was burgled and, amongst other things, the painting was stolen.  A Police investigation draws a blank and all hopes of recovering the painting are dashed.

A condition of the insurance cover was that Jonathan’s property was to be fully alarmed when not occupied and that he should have a comprehensive CCTV system in place.  At the time of the burglary neither the alarm nor the CCTV system was operational.  In the circumstances, the insurance policy was invalidated and Jonathan did not receive a payout.  He has lost an asset worth £1 million.

When considering Jonathan’s 2013/14 tax return one has to look to section 24 of the Act to determine the correct way of reporting the loss:

'Section 24: Disposals where assets lost or destroyed, or become of negligible value

(1) […] the occasion of the entire loss, destruction, dissipation or extinction of an asset shall, for the purposes of this Act, constitute a disposal of the asset whether or not any capital sum by way of compensation or otherwise received in respect of the destruction, dissipation or extinction of the asset.' 

The loss of the painting is, for CGT purposes, a deemed disposal in January 2014 for nil consideration.  As a result, Jonathan can include a capital loss in his 2013/14 tax return equal to the base cost of £700,000. 

Jonathan can deduct that loss from any gains made that year or, if the loss exceeds any such gains, in later years.   Little comfort in the circumstances…

Scenario 2: Underinsured

Jonathan’s alarm and CCTV system were fully operational. In those circumstances the insurance company is prepared to pay out and he receives the full amount covered, £800,000, in May 2014.

Given the current price of Shishkin’s paintings, circa £1 million, Jonathan is unable to replace the stolen Shishkin.  Jonathan is disappointed and decides to use the insurance monies to purchase a share in a racehorse expending the full £800,000.

When considering Jonathan’s tax return, one must now consider section 23(4) of the Act:

'23: Receipt of compensation and insurance money not treated as a disposal

(4) If an asset is lost or destroyed and a capital sum received by way of compensation for the loss or destruction, or under a policy of insurance of the risk of the loss or destruction, is within one year of receipt, or such longer period as the inspector may allow, applied in acquiring an asset in replacement of the asset lost or destroyed the owner shall is he so claims be treated for the purposes of this Act –

(a) as if the consideration for the disposal of the old asset were (if otherwise of a greater amount) of such amount as would secure that on the disposal neither a gain nor a loss accrues to him, and

(b) as if the amount of the consideration for the acquisition of the new asset were reduced by the excess of the amount of the capital sum received by way of compensation or under the policy of insurance, together with any residual or scrap value, over the amount of the consideration which he is treated as receiving under paragraph (a) above.' [author’s emphasis]

The Act does not define the phrase 'replacement asset' and one has to delve into HMRC’s CGT Manual which states that HMRC will interpret the phrase 'reasonably' and that a claim in respect of a replacement asset which is of similar function and type to the original asset will be within section 23(4). 

It does not necessarily follow that a painting by Shishkin must be replaced with another painting by Shishkin or even a painting with a painting.  With no definitive definition there is clearly some flexibility in favour of the taxpayer.  Suppose a sculpture was purchased as a replacement asset for a painting.  On first blush the two items are distinctly different, but one could strongly argue, in the author’s opinion, that both items serve a similar function – a focal piece to be admired and studied, possibly an investment – and are both types of ‘art’. 

In cases of uncertainty, the taxpayer would strongly be advised to seek clearance from HMRC that it regards the proposed replacement asset as falling within the scope of section 23(4).  One must always remember that HMRC’s Manuals and other guidance are merely documented statements of its understanding and interpretation of the legislation in question.  Of course HMRC officers will naturally assume that the guidance is technically correct, but their decision is not final and can be challenged if the taxpayer disagrees.

Notwithstanding the flexibility, Jonathan’s purchase will not qualify as a replacement asset and he will not benefit from the rollover relief afforded by section 23(4).  Instead, he will be treated as having disposed of the painting for £800,000. 

The gain on the disposal will be calculated in the usual way:

	£
Proceeds	800,000
Less: cost	(700,000)
Gain	100,000
Less: annual allowance	(11,000)
Chargeable gain	89,000
Tax (higher/AR) at 28%	24,920

The funds were received in May 2014, therefore, the deemed disposal should be reported in Jonathan’s 2014/15 tax return, notwithstanding that the painting was stolen in the previous tax year. 

As Jonathan bought the share in the racehorse without first calculating the CGT payable, he did not retain any funds with which to settle the tax and will need to fund it from other resources.

Scenario 3: A top-up

Although the insurance monies only amount to £800,000, Jonathan is prepared to purchase another painting by Shishkin for £1 million by topping-up with £200,000 from his savings.

In this case, Jonathan has used all of the insurance monies towards a replacement asset within the scope of section 23(4) of the Act and relief is available.  The relief operates to deem the insurance monies of £800,000 to be equal to the allowable cost of the painting (£700,000):

	£
Deemed insurance proceeds	700,000
Less: cost	(700,000)
Gain/Loss	nil
Excess above deemed proceeds (£800,000 -   £700,000)	100,000
Base cost of replacement asset	1,000,000
Less: excess as above	(100,000)
Revised base cost	900,000

Scenario 4: An eye for a bargain

Suppose that Jonathan was able to purchase a replacement Shishkin for £725,000 and, as a result, has £75,000 of surplus funds from the insurance monies.  Section 23(5) of the Act must now be considered:

'(5) A claim shall not be made under subsection (4) above if part only of the capital sum is applied in acquiring the new asset but if all of that capital sum except for a part which is less than the amount of the gain (whether all chargeable gain or not) accruing on the disposal of the old asset is so applied, then the owner shall if he so claims be treated for the purposes of this Act –

(a) as if the amount of the gain accruing were reduced to the amount of the said part (and, if not all chargeable gain, with a proportionate reduction in the amount of the chargeable gain), and

(b) as if the amount of the consideration for the acquisition of the new asset were reduced by the amount by which the gain is reduced under paragraph (a) of this subsection.'

Accordingly, Jonathan will only be taxed to the extent that the insurance proceeds are not reinvested in the replacement asset:

	£
Insurance proceeds	800,000
Cost	(700,000)
Gain	100,000
Less: rollover relief (purchase price – base cost) £725,000 - £700,000	(25,000)
Proceeds not reinvested	75,000
Less: annual exemption	(11,000)
Chargeable gain	64,000
Tax (higher/AR) at 28%	17,920
Base cost of new painting
Cost	725,000
Less: rollover relief	(25,000)
Revised base cost	700,000

Scenario 5: Mea culpa

In an alternate reality, Jonathan’s painting was not stolen and he has enjoyed it for many years.  One day, whilst moving the painting, Jonathan’s watch caught the canvas causing a tear.

Fortunately the painting can be restored for £100,000.  Once repaired the painting will be worth £950,000, but if left in its current damaged state it is only worth £750,000.  The insurance company is prepared to pay the costs of the restoration.

Jonathan adores the painting and, without hesitation, uses the £100,000 (received in May 2014) to restore it.  For CGT purposes this constitutes a part disposal:

	£
Insurance proceeds	100,000
Less: cost x (A/(A+B)) £700,000 x (£100,000/(£100,000 + £750,000))	(82,352.94)
Gain	17,647.06
Less: annual exemption	(11,000)
Chargeable gain	6,647.06
Tax (higher/AR) at 28%	1,861.18
Base cost remaining
Original cost	700,000
Less: cost utilised above	(82,352.94)
Add: restoration spend	100,000
Revised base cost	717,647.06

Is seems rather unfair that Jonathan should be treated as having made a part disposal for CGT purposes when all of the insurance monies have been spent on the restoration.  Section 23(1)(a) of the Act can assist:

'If the recipient so claims, receipt of a capital sum within paragraph (a), (b), (c) or (d) of [the Act], s 22(1) derived from an asset which is not lost or destroyed shall not be treated for the purposes of this Act as a disposal of the asset if the capital sum is wholly applied in restoring the asset […].'

A claim under section 22(1)(a) results in the part disposal being ignored and instead the base cost of the painting is reduced by the sum expended on the restoration resulting in a revised base cost of £600,000 (£700,000 - £100,000).  This form of rollover relief effectively postpones the gain until the painting is disposed of by Jonathan.

Conclusion

Tax is very rarely at the forefront of one’s mind, especially so when you are concerned about replacing a stolen chattel or restoring one that has been damaged. 

However, as you will have seen from the scenarios considered in this article, receipt of insurance monies is treated as a normal disposal.  A variety of reliefs exist to prevent an immediate charge to CGT.  However, the reliefs are not automatic and need to be claimed by the taxpayer, in some cases, within a strict period of time.

Early advice is, therefore, highly recommended.

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