How to properly account for insurance payouts for the lost property of a sole proprietor in the Czech Republic?

Receiving compensation for damages from an insurance company is a situation that requires special attention in a sole proprietor’s tax accounting in the Czech Republic. Let’s look at some practical examples to understand how to act correctly in such cases.

Section 4(1)(d) of the Income Tax Act (ITA) taxes insurance payments for lost property as income for the entrepreneur. Including the compensated property in the business assets at the time of the insured event is crucial.

If the entrepreneur has incurred losses, these are expenses for their elimination. The insurance payment, in turn, compensates for these increased expenses. Let’s take a closer look at a specific example.

Example 1: The entrepreneur is not a VAT payer

Entrepreneur A, who maintains tax records, owns an insured car. Entrepreneur A commissioned the repair for Entrepreneur B, a VAT payer, after the car sustained damage. The cost of the repair is CZK 121,000 (including 21% VAT). The insurance company covers 95% of the cost, and the remaining 5% (CZK 6,050) is the deductible of entrepreneur A.

Option A: The insurer pays compensation directly to Entrepreneur A

Entrepreneur A, who is not a VAT payer, incurred a total cost of CZK 121,000 for the car repair due to his inability to deduct the included VAT. Considering the car’s exclusive business use and its status as a business asset, Section 24(1) of the Income Tax Act recognizes all repair costs as tax-deductible expenses, based on the interpretation of Section 25(1)(u).

Tax accounting records the insurance indemnity from the insurance company as a cash transaction.

The insurance indemnity is not subject to VAT because it is not a purchase. Since entrepreneur A does not pay VAT, we calculate the insurance indemnity of 95% from the total repair cost, including VAT.

This results in a reduction of CZK 6,050 in the tax base for income tax (the deduction for Entrepreneur A).

Example B: Entrepreneur A is a VAT payer, and the insurance company pays compensation directly to him

This option differs from the previous one in that entrepreneur A is a VAT payer. Assuming that entrepreneur A, as a VAT payer, makes only taxable supplies with the obligation to pay output tax or exempt supplies but with the right to deduct taxes (for example, supplies of goods and services abroad under fulfilled conditions), then entrepreneur A has the right to deduct VAT on the taxable supply received from the repair shop. Thus, the car repair actually costs him only CZK 100,000, since he receives CZK 21,000 back from the state by claiming an input tax deduction in his tax return.

In this case, the insurance indemnity will be based on the repair price minus VAT. In this situation, entrepreneur A’s actual expenses for the deductible when settling the claim are CZK 5,000, i.e., 5% of the repair cost excluding VAT.

Example C: Entrepreneur A is not a VAT payer, and the insurance company pays the repair directly to the contractor

In practice, insurance companies often compensate for damages by paying the repair bill directly to the contractor. This guarantees that the contractor actually uses the compensation to cover the claim’s associated costs. The entrepreneur entitled to compensation pays the contractor the remaining amount if the insurance payment does not cover the full cost of the repair.

Entrepreneur A’s tax accounting partially reflects this transaction in non-monetary form as a kind of set-off of accounts receivable and payable.

Suppose that entrepreneur A, who keeps tax records, is not a VAT payer. The cost of repairs for entrepreneur B, who is a VAT payer, amounts to CZK 100,000 plus an additional CZK 21,000 VAT. The insurance company reimburses 95% of the repair cost, the remaining 5% is the deductible of entrepreneur A. The insurance company pays the repair bill directly to the contractor, acting on behalf of its client, entrepreneur A.

As for option A, the impact on the income tax base is the same. This is logical, since the nature of business transactions, amounts, and the position of entrepreneurs have not changed. The only difference is that business A’s cash flow does not reflect the compensation for paying the repair bill, but tax accounting must account for it.

It is crucial that entrepreneur A’s tax accounting reflects both taxable income (compensation for damage to the entrepreneur’s business assets) and tax expense (payment of the repair bill), in compliance with the Income Tax Act.

Example D: Entrepreneur A is a VAT payer, and the insurance company reimburses the damage by paying the repair bill directly to the contractor, Entrepreneur B.

This scenario is based on the same conditions as option C, except that this time entrepreneur A is the VAT payer.

As in option B, the insurance company provides a benefit of 95% of the repair cost excluding VAT, since the VAT amount included in the repair price at the repair shop (CZK 21,000) will be refunded to entrepreneur A by the state through a tax deduction claim.

Thus, entrepreneur A reimburses the repairman a total of CZK 26,000, of which CZK 5,000 covers the repair cost, including VAT (deductible) and tax expenses, and CZK 21,000 covers the VAT reimbursement on the car repair invoice. As a VAT payer, entrepreneur A will demand this reimbursement through the VAT return, which will then reflect in the cash book as expenses that do not affect the income tax base.

Reflecting Insurance Payouts in Tax Accounting

In all the scenarios discussed above, we examined the same economic essence: a claim for compensation for damage, which, from the perspective of the law, is taxable income. The damage itself represents additional expenses incurred by the entrepreneur in eliminating the consequences of this damage by repairing the property.

If the economic essence of the transactions does not change, tax accounting or the income tax base should not change just because the insurance company pays the entrepreneur directly or pays the supplier’s debt in cash.

If the insurance company pays the debt on behalf of the entrepreneur directly to the contractor for the repair of the property, then these transactions are “invisible” in the entrepreneur’s cash journal but must be reflected in tax accounting, so the reflection of non-cash transactions in the non-cash journal is used.

Navigating the complexities of tax accounting for insurance payouts can be challenging. Our team of experts specializes in providing comprehensive accounting and tax advisory services tailored to the needs of sole proprietors and small businesses in the Czech Republic. Contact us for personalized support and to ensure your business remains compliant with all tax regulations.

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