The Hindu Business Line : Tax effect of insurance compensation

Recent terror attacks at vantage locations show how vulnerable our nation is, notwithstanding the economic prosperity and the improved standard of living of the people.

The attacks have great psychological ramifications as well.

In the backdrop of any development, whether positive or otherwise, one of the questions that crops up is the revenue and tax impact of such event.

The terror attacks pose the following tax issues, such as:

i) receipt of insurance compensation for destruction of assets; (ii) insurance compensation in respect of damage to assets; (iii) compensation for consequential loss (loss of profit); and (iv) compensation for injury or loss of life.

Insurance compensation

Insurance compensation towards destruction of capital assets is chargeable to capital gains as Section 45(1A) covers a wide gamut of causes for the loss, such as (i) flood, typhoon, cyclone, hurricane, earthquake; (ii) riot or civil disturbance; (iii) accidental fire or explosion; and (iv) action by an enemy or action taken in combating an enemy, whether with or without declaration of war.

Destruction of capital assets, if any, in the recent terror attacks is covered by item (iv) above.

The amount of insurance compensation received in respect of capital assets destroyed is taxable.

However, when such compensation is used for replacing the destroyed assets then it will be tax neutral because of the block asset concept of classification of assets.

Insurance compensation received for other consumables (other than capital assets) however would be chargeable to tax just like the sale of those items.

The receipt would be tax neutral due to matching concept of accounting (Universal Radiators vs CIT — 201 ITR 800 SC).

Damage to assets

Amounts received from insurance company for damage to assets and the application of such compensation for restoring the asset to its original condition will not have any tax implication since the receipt would be matched by the expenditure.

Where the insurance compensation is higher than the actual expenditure incurred for restoring the asset to its original condition, the surplus too is not chargeable to tax as held in the Sirupur Paper Mills (112 ITR 776 SC) case.

Consequential loss

In addition to insurance of capital assets and stock-in-trade, taxpayers take insurance for loss of profit which may be due to the dislocation of business consequent to any eventuality. For example, the Taj Hotel management has stated that it would take about a year to be back on rails and for having not earned income for the intervening period, the consequential policy cover would indemnify the taxpayer.

Such receipt however is chargeable to tax since it is received in ‘lieu of income’ which would have been earned otherwise (CIT vs Manna Ramji & Co — 86 ITR 29 SC). The recipient however has to bear overhead expenses with or without matching incomes from any other source and the insurance compensation might also be used for meeting those expenses.

In result, only the net income after all expenses would be the total income for tax purposes.

Compensation

With frequent accidents in recent times, compensations are announced to those who are injured and those who succumb to those injuries. The amounts received as compensation by individuals or legal heirs from the Central or State Government or local authority are exempt from tax if such accident satisfies the definition of ‘disaster’ defined in the Disaster Management Act, 2005.

This exemption in Section 10(10BC) was inserted by the Finance Act, 2007 with retrospective effect from April 1, 2005.

This section was inserted four decades after the enactment of the statute, probably realising the fact that such accidents and compensations are becoming more frequent in the recent times.

(The author is an Erode-based chartered accountant.)

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