Should new accelerated depreciation be taken into account in a BI claim?

This question was put to me as a result of the Australian Federal Governments decision to assist Australian businesses as part of the stimulus package following the outbreak of COVID-19.

The short answer is no. I explain the reason for this answer below, whether you insure depreciation expense or not as an Insured Standing Charge. I end with a summary of the rules around which entities and assets are eligible to the change in depreciation expense. With these rules, I do urge business owners to obtain specialist advice from their tax accountant on the taxation implications. I will concentrate on the insurance ramifications.

Why the answer is no.

Let me start by saying that the underlying principle of a traditional business interruption policy is to put the insured back in the same position financially, as they would have enjoyed but for the loss.

Assuming the Insured was not affected by an insured event and acquired an asset that qualified for the new deprecation rate, then they would have benefited by the change in deprecation allowance in their tax return, in any event.

I stress I am looking at a traditional policy covering Gross Profit but while the basis of settlement is slightly different for Gross Revenue –or Gross Rentals– the end answer to this question on depreciation is the same for all three traditional bases of settlement.

The depreciation expense would have gone up in their tax return and, as such, their tax liability. Everything else, being equal, would have gone down.

When you calculate a business interruption claim, you first start with the reduction in turnover. The change in depreciation rate would not feature in this calculation.

Next, you look at the definition of [insurable] Gross Profit. This is typically defined as:

GROSS PROFIT:  the amount by which:

(a)        the sum of the Turnover and the amount of the Closing Stock and Work in Progress shall exceed

(b)        the sum of the amount of the Opening Stock and Work in Progress and the amount of the Uninsured Working Expenses as set out in the Schedule.

Note: The amounts of the Opening and Closing Stocks and Work in Progress shall be arrived at in accordance with the Insured’s normal accountancy methods; due provision being made for depreciation.”

For the sake of clarity, I would mention the depreciation above is in respect of stock in trade, including work in process to take into account obsolescence in stock. It is NOT referring to depreciation of the income earning assets of the business.

I have always recommended depreciation of the assets of the business to be insured as an Insured Standing Charge. All of us at LMI, take our own advice in any sum insured calculation that we do, unless specifically instructed not to do so and against our advice, by the Insured.

Next, you go to the definition of [insurable] Gross Profit which reads:

“RATE OF GROSS PROFIT: The rate of Gross Profit earned on the Turnover during the financial year immediately before the date of the Damage.”

The all-powerful “Adjustments Clause” applies to the Rate of Gross Profit and this reads:

“Adjustments shall be made to the Rate of Gross Profit, Annual Turnover, Standard Turnover and Rate of Pay-Roll, as may be necessary to provide for the trend of the Business and for variations in or other circumstances affecting the Business either before or after the Damage or which would have affected the Business had the Damage not occurred, so that the figures thus adjusted shall represent as nearly as may be reasonably practicable the results which, but for the Damage, would have been obtained during the relative period after the Damage.”

[Emphasis mine]

The change in depreciation rate is not as a direct result of the damage or disruption to the Insured’s business but rather a change in government policy due to the effect of COVID-19, on the Australian economy. As such, no adjustment should be made.

Even if it were found that the change was as a result of the damage which, to my mind, is a nonsense, and depreciation expense was insured, then all you would be doing is adjusting the depreciation expense down and the net profit up by the same amount and so the Rate of [insurable] Gross Profit would be come out exactly the same.

Even if depreciation expense was not insured, I am back to the argument that no adjustment should be made as the change has nothing to do with an individual insured’s claim under their policy. To avoid this argument it is just another reason why depreciation should be insured. Insurers, you are not missing out as you get the premium on the insured expense.

Having gone through this calculation, and considered the ramifications of the adjustment clause, then the next step is to consider the Increase in Cost of Working benefit. This reads:

(b)        In respect of Increase in Cost of Working:     

the additional expenditure necessarily and reasonably incurred for the sole purpose of avoiding or diminishing the reduction in Turnover which, but for that expenditure, would have taken place during the Indemnity Period in consequence of the Damage, but not exceeding the sum produced by applying the Rate of Gross Profit to the amount of the reduction thereby avoided.

The expense has, by definition, gone up during the Indemnity Period, but again the increase fails the “as a result of the damage” test. As such, the Insured is not able to claim the extra expense as part of their claim.

The next step in the claim calculation is to look at savings. This is an important part of putting the client back where they would have been, but for the damage. As Lord justice Brett stated in Castellain v Preston (1883)[1].

The very foundation, in my opinion, of every rule which has been applied to insurance law is this, namely, that the contract of insurance contained in a marine or fire policy is a contract of indemnity, and of indemnity only, and that this contract means that the insured, in the case of a loss against which the policy has been made, shall be fully indemnified, but shall never be more than fully indemnified.”

[Emphasis mine]

This clause would have no effect, as there is no saving in an expense during the indemnity period. Even in the case of a very long indemnity period, any saving in a subsequent financial year in the depreciation expense would be off set by the increase in the first year. Thus, there would be no net saving in the expense all other things being equal.

I would also remind readers that the NSW Court of Appeal[2] has now unanimously resolved the debate in favour of policyholders, holding that depreciation is not a charge or expense “payable” out of Gross Profit, according to the formula under an Industrial Special Risks [ISR] Policy, and therefore should not be deducted as a “saving”, even if this means a qualification to the principle of indemnity.

So, in summary, an adjustment to reduce the loss is not available to insurers as a result to the changes in the depreciation rate announced in the Federal Government’s stimulus package, any more than it can be claimed as an increase in cost of working.

Besides answering this question, I really hope that brokers and Insureds appreciate the folly of trying to calculate their own business interruption claim. It is a very complex calculation and easy to unintentionally mess it up. I strongly recommend you engage a professional claims preparer, like one of the team at LMI Group, who can guide you or your client through it, allowing the business owner to focus on getting their business up and running again as quickly as possible. The fee is typically insured, so the cost is not being deducted from the Insured’s settlement. To me, it is a no brainer and yet so many are left to sort it out themselves, leaving them stressed and frustrated.

To learn more, please check out my book on Business Interruption Insurance and Claims and or Understanding the ISR Policy.

Eligible Small business entity

A small business with an aggregated turnover of less than $10 million, and using the simplified depreciation rules, those assets over the instant asset threshold which are eligible for the accelerated depreciation are added to the general small business pool. The business can deduct an amount equal to 57.5% (rather than 15%) of the business portion of a new depreciating asset in the year you add it to the pool. In later years the asset will be depreciated under the general small business pool rules.

Other business entities

An entity with aggregated turnover less than $500 million in the income year and not using the simplified depreciation rules, you may be eligible to deduct an amount if the asset is a qualifying asset.

The amount the entity can deduct in the income year the asset is first used or installed ready for use, is:

• 50% of the cost (or adjustable value where applicable) of the depreciating asset
• plus the amount of the usual depreciation deduction that would otherwise apply but calculated as if the cost or adjustable value of the asset were reduced by 50%.

Effectively, together with the instant asset write-off rules, the accelerated depreciation deduction applies to assets with a cost (or adjustable value if applicable) of:

• $150,000 or more in the 2019–20 income year
• $1,000 or more in the 2020–21 income year.

Eligible assets

To be eligible to apply the accelerated rate of deduction, the depreciating asset must:

• be new and not previously held by another entity (other than as trading stock)
• be first held on or after 12 March 2020
• first used or first installed ready for use for a taxable purpose on or after 12 March 2020 until 30 June 2021
• not be an asset to which an entity has applied the instant asset write-off rules or depreciation deductions.

Eligible assets do not include:

• second-hand depreciating assets
• some specific Division 40 assets subject to low value and software development pools
• certain primary production assets
• buildings and other capital works for which you can deduct amounts under Division 43
• other specific capital asset and expense deductions
• assets you were committed to acquiring before 12 March 2020.

To learn more visit: https://www.ato.gov.au/Business/Depreciation-and-capital-expenses-and-allowances/Backing-business-investment—accelerated-depreciation/#Eligibility

[1] Castellain v Preston (1883) 11 QBD 380.

[2] Mobis Parts Australia Pty Ltd v XL Insurance Company SE [2018] NSWCA 342.