Sarah Bradford looks at a test case on business interruption insurance and considers whether and how receipts from successful claims should be taxed.
Business interruption insurance provides cover to compensate for losses where the business is severely disrupted or required to close as a result. The policy will usually provide compensation for the loss of net income as a result of the full or partial suspension of business operations. It will also cover normal operating expenses that the business has to continue to meet, such as rent and payroll costs, despite the suspension of the business activities.
Covid-19 insurance cover?
Business owners that had the foresight to include business interruption cover in their business insurance understandably expected that they would be covered for losses resulting from the forced business closures during lockdowns imposed due to the Covid-19 pandemic. However, their insurers did not always agree.
As is often the case, the devil is in the detail; the wording of many policies was such that diseases were excluded from the scope of the cover, unless named. As Covid-19 was unheard of when the policies were taken out, the disease was not specified in policies before the pandemic.
FCA test case
Large numbers of businesses suffered (and are suffering) significant losses as a result of the Covid-19 pandemic, resulting in a high volume of claims under policies with business interruption cover.
Some policies only contain basic business interruption cover, which is focussed on property damage. Other policies offer wider cover, including disease clauses (covering business interruption as a result of infectious and notifiable diseases) and prevention of access clauses (covering prevention of access and public authority closures or restrictions). While some insurers accepted claims under policies that included these clauses for losses arising from the Covid-19 pandemic, others did not. The inconsistency in approach led to widespread concern over the lack of clarity and certainty.
The Financial Conduct Authority (FCA) brought a test case last year to provide clarity for policyholders and insurers on the key areas of contractual uncertainty. The test case concerned a representative sample of 21 types of policy issued by eight insurers, with the FCA putting forward the policyholders’ arguments to the best advantage of the public interest. The outcome of the test case affected 370,000 policyholders holding 700 types of policies with 60 insurers.
The case was heard by the High Court last year. The High Court judgment in September 2020 resolved many, but not all, of the key issues. As agreement could not be reached on all issues, the FCA and insurers took ‘leapfrog’ appeals to the Supreme Court (bypassing the Court of Appeal).
‘Disease clauses’ and ‘prevention and access’ clauses
The Supreme Court gave their ruling on 15 January 2021 (The Financial Conduct Authority & Ors v Arch Insurance (UK) Ltd & Ors [2021] UKSC 1). The Supreme Court upheld the High Court’s finding that the ‘disease clauses’ and the ‘prevention and access’ clauses in the representative sample provided cover for the Covid-19 pandemic. However, the Supreme Court ruling went further, finding that cover may also be available for partial closures and for mandatory closures that were not legally binding.
The Supreme Court ruling concludes legal arguments for 14 types of policies issued by six insurers, and also for large numbers of similar policies, under which claims will now be successful. The FCA’s test case removes the need for policyholders to resolve key issues with their insurers, providing clarity and certainty.
Policy checker and guidance
In the light of the rulings, the FCA has published a raft of useful information on their website.
This information includes a policy checker and FAQs which policyholders can use to find out whether their insurance policy is covered, and draft guidance on how to prove the presence of coronavirus as this is a condition for certain types of policy.
Tax implications
Businesses that are able to make a successful claim under a business interruption policy will need to consider the associated tax implications. As a general rule, HMRC states (in their Business Income manual at BIM42450) that:
‘In most situations, if the insurance premiums are allowable deductions from trading profits, the receipts from the policy are taxable as trading income. Where no deduction is allowed, often the receipts are not taxable as revenue’.
The starting point, therefore, is to consider whether a deduction was claimed for the associated insurance premiums.
Deductibility of insurance premiums
The extent to which insurance premiums are deductible in computing trading profits depends on what is insured and whether the insurance has been taken out for the purposes of the trade.
The general rule is that expenses are deductible to the extent that they are wholly and exclusively incurred for the purposes of the business. This test must be met to secure the deductibility of insurance premiums, as for other expenses.
HMRC confirm that policies insuring against loss of profits from the following contingencies are deductible in computing trading profits:
- a fire at the business premises;
- interruption or loss of income producing assets, such as the business premises or plant and machinery;
- interruption or cessation of the supply of raw materials, stock, water supply, fuel, etc. needed to carry on the business; and
- events causing loss of profits for a temporary period.
Thus, premiums paid for business interruption cover should be deductible in computing trading profits.
Tax treatment of receipts
As noted above, HMRC’s stance is that where a premium is deductible in computing trading profits, any receipt derived from that policy should be taken into account in computing trading profits.
In its guidance at BIM40751, HMRC also lists specific receipts that are taxable as trading profits, such as recoveries to compensate a trader for a hole in their commercial profits.
When to include in trade profits
The time at which the insurance receipt should be taken into account as a trading receipt will depend on various factors, including the basis of preparation of the accounts.
An unincorporated business that prepares accounts under the cash basis should take the insurance receipt into account in the accounting period in which the receipt was received. For example, if a business prepares accounts to 30 June each year and receives an insurance receipt in February 2021 in respect of the first lockdown, the receipt would be taken into account in the year to 30 June 2021 (despite the fact that the receipt related to losses arising in the first Covid-19 lockdown, which fell in the previous year).
However, for unincorporated businesses which prepare accounts under the accruals basis and for companies who must prepare accounts this way, the normal rule is that the receipt should be taken into account for the period in which the event that gave rise to the receipt fell. Following this rule, receipts that are received in respect of a loss of profits and costs incurred due to business closures in the first lockdown would be taken into account in the accounting period in which this lockdown fell, rather than the period in which the receipt was received.
Where the indemnified losses were not identified until a later date (as is the case in relation to business interruption insurance claims met as a result of the FCA test case) it is the date that these losses were ascertained that is relevant. In this instance, this is likely to be the date of the Supreme Court ruling in January 2021 – later than the first lockdown, but earlier than the date on which the receipt was received.
For subsequent claims for loss of profits as a result of closures in later lockdowns (where there is less likely to be uncertainty as to whether losses arising from the interruption of the business as result of Covid-19 are covered), where the accruals basis is used the receipt should be taken into account as a trading receipt for the accounting period in which the period that business was closed or disrupted due to Covid-19 measures fell.
Practical tip
Businesses that have business interruption cover should visit the FCA website to see if they are likely to be able to make a successful claim. Any insurance receipts received as a result should be included when calculating trading profits. The timing of the receipt will depend on the basis on which the accounts are prepared.
