Pizzicato’d

KEY POINTS

• The loss of an asset equates to a disposal.
• Relief when compensation is reinvested.
• Relief is restricted when only part of proceeds is reinvested.
• The treatment of repair costs.
• Matching liability with cash available.

Sitting on the train during my morning commute into London, I picked up my copy of Metro and came across an article that caught my attention a little more than is usual.

Min-Jin Kym, a violinist originally from South Korea, was having a quiet cup of coffee at a cafe in Euston station when she became the unfortunate victim of a carefully planned theft.

In fact, she could not have been much more unfortunate, because while she was distracted by two young men playing the role of decoy, a third man stole (plucked?) her 300-year old Stradivarius which was resting by her feet.

Its value? Approximately £1 million. Ouch!

To make matters worse, Ms Kym had failed to increase her insurance premiums to cover the full uplift in value, leaving her with a policy covering just £750,000 and an original purchase price of £500,000.

Now, while I’m sure that the majority of my fellow commuters were feeling either: (a) complete sympathy; (b) complete bewilderment as to why any sane person would carry around a violin worth £1 million in central London, let alone leave it lying around on the floor; or (c) a combination of these, my mind was, of course, wondering what exactly might be shown on her 2010/11 tax return.

On the assumption that she falls within the charge to UK capital gains tax, the amount does depend in part on the attitude of the insurer and in part on whether her beloved violin is ever returned to her.

While I would not want to prejudge what or what not might appear on Ms Kym’s tax return, perhaps we could assume that, completely coincidentally, there were a series of unreported Stradivarii thefts from other violinists on that same day as they stopped for a coffee in different London railway stations.

Their financial circumstances were the same as Ms Kym’s and I have considered the various consequences below.

Musical maelstrom

David had his violin stolen from Paddington station. His was a ‘worst case scenario’ and, alas, the insurance company decided that, in these times of austerity, they could not possibly pay out to people who leave their possessions lying about in cafes, and so no insurance proceeds were received. In this instance, TCGA 1992, s 24(1) is relevant.

TCGA 1992, s 24: Disposals where assets lost or destroyed, or become of negligible value.

‘Subject to the provisions of this Act … the occasion of the entire loss, destruction, dissipation or extinction of an asset shall, for the purposes of this Act, constitute a disposal of the asset whether or not any capital sum by way of compensation or otherwise is received in respect of the destruction, dissipation or extinction of the asset’.

As David has technically disposed of his violin for nil consideration, he can include a capital loss equal to the base cost of £500,000 in the 2010/11 tax return. Simple for the tax adviser – as outlined in David – a nightmare for the client.

Sympathetic sonata

Stephane had his violin stolen at Liverpool Street station but, for him, things are a little brighter. He strikes it lucky at the insurance company call centre and gets through to a sympathetic claims handler and they have offered him the full £750,000 insurance payout.

However, it’s nowhere near enough to buy another violin of equal standing and so he tells you that he’s decided to invest in a property instead.

Unfortunately for our violinist, a house purchase does not qualify as a ‘replacement asset’ which would have enabled a form of rollover relief to be obtained under TCGA 1992, s 23(4):

TCGA 1992, s 23(4): Receipt of compensation and insurance money not treated as a disposal. (Where all applied to purchase of new asset)

‘If an asset is lost or destroyed and a capital sum received by way of compensation for the loss or destruction, or under a policy of insurance of the risk of the loss or destruction, is within one year of receipt, or such longer period as the inspector may allow, applied in acquiring an asset in replacement of the asset lost or destroyed the owner shall if he so claims be treated for the purposes of this Act:

(a) as if the consideration for the disposal of the old asset were (if otherwise of a greater amount) of such amount as would secure that on the disposal neither a gain nor a loss accrues to him; and

(b) as if the amount of the consideration for the acquisition of the new asset were reduced by the excess of the amount of the capital sum received by way of compensation or under the policy of insurance, together with any residual or scrap value, over the amount of the consideration which he is treated as receiving under paragraph (a) above.’

The term ‘replacement asset’ is not defined in the legislation, but HMRC refer to this question in the Capital Gains Manual at CG15745 (‘Assets damaged/destroyed: “Replacement”’) and say that ‘the word “replacement” can be interpreted reasonably. A claim in respect of a replacement asset which is of similar function and type to the original asset is within TCGA 1992, s 23(4)’.

Here the gain is therefore calculated in the normal way as shown in Stephane. While not wishing to be the bearer of bad news, now might be the time to tell Stephane that he’s only got about £680,000 (£750,000 – £67,172) in the kitty for his house.

Waterloo waltz

Acme Music Co have booked their star violinist Jean-Luc on a worldwide tour. Unfortunately his violin was stolen from Waterloo station and being without a top-of-the-range violin is just not an option.

He is also offered £750,000 by the insurance company and decides to use all the insurance proceeds, plus £10,000 from his rainy-day fund, to buy a new violin three months after the theft of his Stradivarius.

In all of the possible scenarios, the date of deemed disposal is the date on which the proceeds are received, meaning that there is the potential for an asset to be lost or damaged in one tax year, and taxable in the next.

All proceeds have been reinvested in a replacement asset within 12 months, and so – as shown in Jean-Luc – a claim under TCGA 1992, s 23(4) is available.

This will deem the disposal proceeds to be equal to the allowable cost of the violin, creating a no gain/no loss position. In addition, the excess proceeds reduce the base cost of the replacement asset for a future disposal.

A combination of heart and head

Yehudi had his violin stolen from Victoria station and it has become clear that the instrument will never be returned. He is understandably nervous about investing such a large amount in another one.

Equally, playing Beethoven on a borrowed Yamaha just isn’t going to cut it. As a compromise, he buys a replacement violin costing a conservative £525,000 and a claim under TCGA 1992, s 23(5) means that he is taxable now only to the extent that his insurance proceeds have not been reinvested. See Yehudi.

TCGA 1992, s 23(5): Receipt of compensation and insurance money not treated as a disposal. (Where part only applied to purchase of new asset)

‘A claim shall not be made under subsection (4) above if part only of the capital sum is applied in acquiring the new asset but if all of that capital sum except for a part which is less than the amount of the gain (whether all chargeable gain or not) accruing on the disposal of the old asset is so applied, then the owner shall if he so claims be treated for the purposes of this Act:

(a) as if the amount of the gain so accruing were reduced to the amount of the said part (and, if not all chargeable gain, with a proportionate reduction in the amount of the chargeable gain); and

(b) as if the amount of the consideration for the acquisition of the new asset were reduced by the amount by which the gain is reduced under paragraph (a) of this subsection.’

Lost and found

Here’s where it gets a little more complicated. Niccolo had his Stradivarius stolen at Marylebone station, but the violin has been found and handed in to the lost property office. But it’s not all good news as it appears to have been badly damaged along the way.

Further inspection confirms that it will cost £300,000 to have it restored at which point it will be worth £950,000. Its unrestored market value is a healthy £600,000.

Fortunately, the insurance company is willing to pay the full £300,000 (much better than the £750,000 that it originally thought that it would have to pay) and Niccolo now has the choice of whether to restore his violin or leave those scratches and use the money elsewhere.

Imperfection is not an option and, without hesitation, the full £300,000 is used to restore the violin, which constitutes a part-disposal as shown in Niccolo.

If Niccolo does not have £35,000 down the back of the sofa to settle the capital gains tax liability on the above disposal, a claim can be made under TCGA 1992, s 23(1)(a).

TCGA 1992, 23(1)(a): Receipt of compensation and insurance money not treated as a disposal.

‘If the recipient so claims, receipt of a capital sum within paragraph (a), (b), (c) or (d) of TCGA 1992, s 22(1) derived from an asset which is not lost or destroyed shall not be treated for the purposes of this Act as a disposal of the asset if the capital sum is wholly applied in restoring the asset...’

Such a claim means that the part disposal in Niccolo is ignored and the base cost of the violin is adjusted as shown below.

In effect, the claim postpones the gain on the part disposal by reducing the base cost available on a future disposal.

A good deal better?

Sarah had her violin stolen from St Pancras station, but like Niccolo she was fortunate and her violin was handed in to the local police station.

Unfortunately, and also like Niccolo, the violin had been damaged as well.

It could be that if Sarah shops around a little, she might find a specialist in the art of violin restoration who is more than happy to restore her Stradivarius at a discount simply for the love of his craft. Equally, and perhaps more likely, Sarah herself could choose to spend some of the money sprucing it up and keep some back for a well-deserved five-star holiday in the Bahamas.

The crucial question is: how much?

The treatment here depends on whether or not less than 5% of the insurance proceeds, i.e. ‘small proceeds’ were not reinvested.

Let’s say that a restoration specialist offers to carry out the work on Sarah’s violin for £290,000, which would leave his happy customer with a perfect violin and £10,000 spare change in her pocket.

HMRC’s Tax Bulletin 27 of February 1997 confirms that ‘small’ equates to the higher of 5% of the capital sum received or £3,000.

As Sarah’s remaining £10,000 represents 3% of the total insurance monies received, a claim under TCGA 1992, s 23(1)(b) will avoid a part-disposal in the year of receipt and results in (you’ve guessed it) a reduction to base cost.

TCGA 1992, s 23(1)(b): Receipt of compensation and insurance money not treated as a disposal.

‘If the recipient so claims, receipt of a capital sum within TCGA 1992, s 22(1)(a), (b), (c) or (d) derived from an asset which is not lost or destroyed shall not be treated for the purposes of this Act as a disposal of the asset if ... the capital sum is applied in restoring the asset except for a part of the capital sum which is not reasonably required for the purpose and which is small as compared with the whole capital sum...’

If Sarah chooses this route, the computation will be as shown in Sarah.

But what if more than 5% of the insurance proceeds can be saved? Coincidentally, Sarah’s rival Vanessa was next door at King’s Cross station when her violin was stolen. It was also subsequently recovered, but in a damaged state.

With a little research, Vanessa finds that she can secure an even better deal with an expert restorer who, after much negotiation, agrees to complete the work for £280,000, representing a saving of about 7% of the total insurance monies received. In this instance, the default position is a part-disposal calculation as in Vanessa 1.

Note that the proceeds figure represents the total insurance monies received and ‘B’ in the ‘A over A plus B’ cost calculation is the unrestored market value of the violin.

Clearly, with a capital gains tax liability of £34,505, but only £20,000 in hand, Vanessa is not in the best position. Under TCGA 1992, s 23(3) a claim for partial relief is available.

TCGA 1992, s 23(3): Receipt of compensation and insurance money not treated as a disposal

‘If, in a case not falling within subsection (1)(b) above, a part of a capital sum within s 22(1)(a) or (b) derived from an asset which is not lost or destroyed is applied in restoring the asset, then if the recipient so claims, that part of the capital sum shall not be treated as consideration for the disposal deemed to be effected on receipt of the capital sum but shall be deducted from any expenditure allowable under Chapter III of this Part as a deduction in computing a gain on the subsequent disposal of the asset.’

Section 23(3) allows the immediate tax due to correspond with the cash available.

In contrast to Vanessa 1, the proceeds not reinvested are used alongside the restored market value in the calculation. Additionally, a proportion of the restoration spend is also deducted as shown in Vanessa 2.

With all avenues explored, the only dead cert is that our champion violinist will surely rue the day that she left her prized possession unattended.

Heather Miller is a private client tax senior at Wingrave Yeats Chartered Accountants and Business Advisors. She can be contacted on 0207 3170952 and by email. The views expressed are her own.

Issue: 4298 / Categories: Comment & Analysis , tax by numbers