Whereas most people would understand the meaning of a repair, and could differentiate the repair of a damaged section from a ‘repair’ that enhances the building’s value, and easily distinguish between a repair and a major construction, the tax law in this area is surprisingly complex.
The recent wave of looting and attacks on buildings has resulted in a range of types of destruction, from buildings being somewhat damaged to being completely destroyed.
The insurance payouts may be made by insurance companies on behalf of state-owned insurer Sasria.
However, the tax implications would be the same:
- If the business is registered for value-added tax (Vat), in other words, is a Vat vendor, the insurance payout will result in a deemed output Vat.
- If the insurance payout is greater than the base cost or acquisition cost of the building, this will be a capital gain.
- If building allowances had been claimed as tax deductions by the owner or by the enterprise that owned the building, the insurance payout may have to be included in income (a ‘recoupment’) for that year of assessment in the case of an owner or the financial year in the case of an enterprise. Amounts incurred for repairs in the same year using the insurance payout would then be claimed as deductions. Joon Chong, tax partner at Webber Wentzel, explains: “Building allowances are for capital type expenses, for example building costs. There is a recoupment (i.e. include the insurance payout in ‘income’) if the payout is for the destruction of the building. There is a disposal (through the destruction) and the proceeds is the payout.”
- Where the insurance payout is used to rebuild or purchase replacement assets within 12 months, the owner could elect to spread any recoupment or capital gain over the new write-off period, if the assets were brought into use within three years and the payout is greater than the base costs of the assets.
Repairs and maintenance, or major restoration of a capital asset
Assets or structures within the buildings may have been damaged or destroyed, for example, an escalator, air conditioning system, CCTV security system, fire systems, and water tanks in warehouses. The assets or structures that are not part of the building would be treated as separate assets, such as ‘plant and machinery’, and the tax implications are as set out in the Moneyweb article detailed below.
Where buildings were not completely destroyed and require repairs, the full amounts incurred for the repairs can be claimed as deductions in the year of assessment/financial year incurred. The insurance payout will be included in taxable income in the year of assessment/financial year received as the payout is a ‘recovery’ of the expenses incurred.
There is a fine line between expenses incurred for repairs, and the cost incurred in a major restoration that would reconstruct a substantial portion of the building. Whereas expenses incurred for repairs are ‘revenue in nature’, and thus deductible from taxable income, expenses incurred on a major reconstruction would be ‘capital in nature’, and would not usually be deductible for tax.
A repair would restore an asset to its original position. For example, it would be carried out to fix a broken part as opposed to effecting an improvement. Case law has laid out certain guidelines, that a repair or restoration involves a renewal or replacement of subsidiary parts of the structure.
There is no certainty in regard to where, due to the passage of time that has lapsed from when the building was first constructed, the repair may be viewed as an improvement by the South African Revenue Service (Sars).
The business owner would not have had to effect the repair if it wasn’t for the wave of looting and destruction, and hence the intention of the business owner should be taken into consideration. It would be helpful if Sars issues guidance in this regard.
Chong explains: “Where the damage is [of] such an extent that the asset is destroyed, it is possible that the renovation involves reconstruction of the entire or substantially the whole asset, in which case the expenditure is capital in nature and usually not deductible. The capital expenditure would only be deductible if a specific building allowance applied, for example the building allowance over 20 years available for buildings used in the process of manufacture or research and development. Capital expenditure incurred which is not deductible in terms of a specific provision and which exceeds the Sasria compensation received would then form part of the base cost of the building, reducing capital gains on the future sale of the building.”
She adds: “Where the Sasria compensation is greater than the base cost of the building and the compensation is used to construct the replacement building within 12 months and brought into use within three years, the owner can elect to have any resulting capital gains or recoupment proportionately spread over the new write-off period.”
Lessees claiming leasehold improvements
A lessee impacted by the riots should study the lease agreement.
The lease agreement may require the lessee to carry out improvements to the land or building leased. In this case, the lessee would usually be able to claim as a deduction the ‘fair and reasonable value’ incurred in carrying out the required improvements. This ‘leasehold improvement’ may be deducted over the period of the lease up to a maximum of 25 years.
The lease improvement will be subject to tax in the lessor’s hands “in the year in which the right to have the improvement accrues to the lessor, less the present value of the full value of the improvements over the lease period discounted at 6%”, according to Chong.
She says the “repairs to shelving, flooring, windows and doors as a result of the looting would usually be deductible in full in the year the expense was incurred as they are likely to be repairs”.
She adds: “Where the tenant receives Sasria compensation for the repairs, there is a deemed output Vat on the payment received if the tenant is a Vat vendor. The compensation received for repair expenses would be a recovery and not claimable as deductions. In effect, amounts incurred for repairs which [are] more than the Sasria compensation would be claimable as deductions.”
Chong cautions that “capital type expenditure necessary where the building is burnt to the ground is more complicated”.
She advises that the “remaining unclaimed ‘leasehold improvement’ deductions potentially give rise to a capital loss for the tenant, with the Sasria compensation payment as proceeds”.
“This could give rise to a recoupment for deductions claimed previously and/or capital gain. Where the Sasria compensation is greater than the base cost of the building and the compensation is used to construct the replacement building within 12 months and brought into use within three years, the tenant can elect to have any capital gains or recoupment proportionately spread over the new write-off period.”
Taxpayers are advised that they have the burden of proving any deductions claimed.
They must be prepared to provide supporting documentation. Sars is likely to carefully scrutinise the tax treatment of the Sasria/insurance compensation payments and resulting tax implications, including any tax deductions claimed.
Chong advises: “Ultimately, whether expenses are for repairs, improvement or replacement asset[s] will be very fact-specific. The interplay between the availability of specific building allowances or leasehold improvement deductions for lessees give rise to added complexity.”
She recommends: “Taxpayers should seek advice where necessary to ensure that the Sasria/insurance compensation payments do not give rise to an unexpected tax bill down the line in the form of additional assessments from Sars, with penalties and interest.”