“Recouping casualty losses” by Wilfredo U. Villanueva (October 19, 2009)
SUITS THE C-SUITE By Wilfredo U. Villanueva
Business World (10/19/2009)
When taxes become the solution, not the problem
Reports about huge losses from the recent calamities continue to hog the headlines.
Both the government and the business sectors have released preliminary reports on damage running into billions of pesos, and the cost to us of the two typhoons may even exceed that recorded in the aftermath of the cataclysmic 1990 earthquake and the 1991 Mt. Pinatubo eruption.
Sadly, it was Luzon — where big industry is concentrated — which bore the brunt of these catastrophes.
Nightmarish as these events are for business owners, the C-suite particularly, we continue to be heartened by countless accounts of generosity and heroism, and that our nation’s resilience in times of adversity guarantees that business will bounce back.
Inevitably, from a purely business standpoint, the tragedy that befell us — resulting in utter destruction of business property (buildings, equipment, inventory) — begs the fundamental question: What kind of economic relief can mitigate the impact of the severe losses incurred?
Among other things, taxation comes to mind and our tax law provides some definite answers.
Under the Tax Code, ordinary business losses actually sustained during the taxable year, and not compensated for by insurance or other forms of indemnity, are income tax-deductible. So too are losses or destruction of business property resulting from an identifiable event of a sudden, unexpected, or unusual nature — otherwise known in taxation as “casualty losses.”
In fact, casualty loss is what we deal with here, given the circumstances under which so many businesses in Metro Manila, as well as Central, Northern, and Southern Luzon, are certain to claim and report substantial losses for tax purposes this year.
Keep in mind that, under Revenue Regulations No. 12-77, one needs to file with the Bureau of Internal Revenue (BIR) a sworn declaration of loss within 45 days from the occurrence of the casualty, lest the privilege of a loss deduction be forfeited.
The declaration must describe the nature of the event giving rise to the loss, the damaged property and its location, basis of the property and its value before and after the event, and the amount of insurance or other compensation received or receivable. Evidence of said items should be furnished or be readily available for scrutiny by the BIR.
In general, the deductible loss is limited to the difference between the value of the property immediately preceding the casualty and its value immediately after, but shall not exceed the business property’s depreciated cost, and reduced by any insurance or other compensation received. If property was totally destroyed, the net book value immediately preceding the casualty should be used as the basis in claiming losses, also to be reduced by any amount of insurance or compensation received. If the loss arose from partial damage to property, the cost to restore the property to its normal operating condition should be used for purposes of computing deductible loss, but in no case exceeding the entire property’s net book value immediately before the casualty.
The excess, if any, of the replacement cost over said net book value should be depreciated over the remaining useful life of the property.
Those whose factories or stores had been inundated or ravaged by destructive winds will be picking up the pieces and try to resurrect the business.
More likely than not, they have insurance cover (hopefully including “Acts of God,” which has been extensively written about in recent days.) They will claim under their insurance policy and will use the proceeds to rehabilitate the property.
In this discussion, insurance recovery is a key factor to consider as the amount so recovered is deducted from the amount of loss that can be deducted for tax purposes.
Thus, it is best to tackle the principle of involuntary conversion of property, a US tax doctrine which the BIR has relied upon.
Why? Because it is possible that the insurance proceeds exceed the actual amount of damage incurred, and the same is either entirely used to restore the property, or part of it is expended for other purposes.
An involuntary conversion occurs when property, due to complete or partial destruction, is involuntarily converted into property similar to or related in use to the property so destroyed, or to cash such as insurance.
The BIR recently addressed this issue, referring to situations where the entire insurance proceeds were used to rehabilitate/restore the destroyed assets.
There are two concerns here. First is whether the excess of the amount of insurance proceeds over the net book value or cost basis of the insured assets is taxable gain, to which the BIR replied in the negative, citing US principles. Moreover, the excess of the rehabilitation/replacement costs of the destroyed assets over their acquisition cost or adjusted cost basis is not a deductible loss, but shall be capitalized and depreciated. The second issue is whether the insurance proceeds are subject to value added tax, where the BIR also held otherwise because the receipt thereof is not in the ordinary course of the taxpayer’s business.
In essence, relief is at hand for businesses that have gravely suffered from the recent catastrophes. Tax may not be necessarily foremost in the C-suite’s mind because rebuilding the business is top priority.
However, when tax filing season approaches, the losses sustained will be reckoned and will surely figure heavily in the income tax calculation.
Be very mindful, though, of the fact that the BIR — tasked as it is in ensuring proper tax calculation and payment — will carefully scrutinize claims for casualty losses, because tax deductions are in the nature of an exemption and are therefore strictly construed. Therefore, observe carefully the rules that govern the recognition of these types of losses. Otherwise, you may not be able to convert your loss into a gain.
(Wilfredo U. Villanueva is a Tax principal of SGV & Co.)
This article was originally published in the BusinessWorld newspaper. It is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.