Updated in July 2016
This guide looks at claiming capital allowances to minimise your business’ tax bill. All rates and allowances correct at the time of publication. For the purpose of this article, a business may be a limited company, a partnership or a sole trader.
A capital allowance is the HMRC or tax equivalent of depreciation.
For example, a business buys a machine for £10,000 and believes the machine has an estimated useful working life of 10 years. The business may choose to depreciate the asset at the rate of £1,000 a year until it has a net book value of zero after 10 years.
Depreciation is generally not allowed for tax purposes and therefore any depreciation in the accounts must be added back to increase taxable profits. Instead, you may be able to claim a capital allowance.
Capital allowances are HMRC’s was of making tax fair and equitable when it comes to calculating taxable profits.
Why is depreciation added back and a capital allowance deducted?
Depreciation policies will vary from business to business. One company may write assets off over 3 years another over 10 years.
If depreciation were an allowable deduction in the tax calculation – a business wishing to reduce its tax liability would write assets off faster and pay less tax than another company that chose to write assets off over a longer period. A business will choose the most appropriate write-off period for their circumstances – for example, a sole trader might replace computers every 5 years whereas a software company might write them off over 2-3 years. Both policies are fair for each business but would result in them paying tax on a different basis.
HMRC will add back depreciation and deduct capital allowances instead – to make the tax charge fair and equitable for all.
Claiming capital allowances
In practice, most capital allowances are concerned with plant and machinery. However, capital allowances can also be claimed for:
- renovation of business premises
- research and development
- mineral extraction
- patents and know-how
- cemeteries and crematoria.
There are no capital allowances for land and buildings, although certain fixed plant and machinery within a building may be eligible.
The government has also announced that there will be some special capital allowances for enterprise zones in assisted areas.
Defining plant and machinery
Machinery is any device with moving parts. It does not have to be connected to any form of power. For example, a locking mechanism is machinery.
Plant is equipment which a person uses to conduct their business. It does not include the premises in which a person conducts their business but might include the equipment within it. This has led to some fine distinctions.
Plant must have an expected life of at least 2 years and be required for the functions of the business so would include items such as computers, laptops, printers, phones, tablets, tool stations and any large asset that is used in the business. Some small items, such as replacement loose tools, or computer peripherals of say £100 or less may be regarded as revenue expenditure. This means that you are able to claim tax relief immediately and not over many years.
Plant and machinery is a fairly old fashioned term still in common use today – in reality, it just means the assets that are used in your business to conduct your business. It would not include assets that you had bought for your hobby, but did not use for your business – these are personal, not business assets.
Say for example Bertie runs a T-Shirt print and Embriodery business – he would be able to claim a capital allowance for his industrial sewing machine against his business, but not for the lathe in his garage that he bought to enjoy his woodworking hobby. Charlie the carpenter, would be able to claim capital allowances for the lathe that she used in her business – but not for her sewing machine that was bought for her hobby.
The exact scope of what comprises plant can at times be very marginal yet have a big impact on the tax you pay. If expenditure qualifies for a capital allowance you will receive tax relief on the whole amount, albeit over many years. If an item does not qualify for a capital allowance it can mean that you do not receive tax relief for it at all.
Calculating capital allowance
There are three types of capital allowance:
- Annual Investment Allowance
There is an annual investment allowance (AIA) which may be claimed against most forms of allowable plant and machinery. THios means that a business (remember this might be a limited company, partnership or sole trader) can deduct the full value of an item that qualifies for annual investment allowance (AIA) from profits before tax.
The main exceptions are for ordinary cars and plant and machinery purchased during a company’s final trading period. At the time of publication, the AIA was up to £500,000 from 1 April (companies) or 6 April 2014 (unincorporated businesses) to 31 December 2015. Reducing to £200,000 from 1 January 2016. The maximum AIA is time apportioned where a business’s accounting period spans a change to the limit.
The annual investment allowance (AIA) is effectively a 100% capital allowance for plant and equipment except for cars.
2. First Year Allowance
If you buy an asset that qualifies for first-year allowances you can deduct the full cost from your profits before tax.
You can claim first year allowances in addition to the annual investment allowance – they don’t count towards your AIA limit. First-year allowances are ‘enhanced capital allowances’ there to encourage business owners to invest in energy efficient equipment.
3. Written down allowances
You must use writing down allowances if:
- you’ve already claimed AIA if you have exceeded the AIA threshold for the year or,
- the item doesn’t qualify for AIA, eg cars, gifts or things you owned before you used them in your business
Written down allowances are a simple flat rate, split into three different pools of asset:
- main pool with a rate of 18% – most plant and machinery
- special rate pool with a rate of 8% – some long life assets or higher emission cars
- single asset pools with a rate of 18% or 8% depending on the item
If plant and machinery qualify for an allowance its value (after any AIA or FYA) is added to either the Main or Special Rate pool (unless tax law requires it to be calculated separately). Separate calculations are needed for certain long-life assets (those with an expected life of 25 years or more), some cars and (if you choose) short-life assets.
There are 2 general pools: 1 at a high rate and 1 at a lower rate. Capital allowances mean that the whole cost of an asset will eventually be allowed for tax. A lower rate consequently means that this process will take longer.
The higher rate pool attracts a writing down allowance of 18% a year; the lower rate pool at 8% a year. Where you acquire assets for both pools it is therefore often preferable to use the AIA against the assets that attract the lower rate. Long-life assets must be included in the lower Special Rate pool.
A writing down allowance on its own will never reduce a pool to zero as each year the writing down allowance is a percentage of the written down value from the previous year.
For example, an asset cost £10,000 and qualifies for the 8% writing down allowance:
- in year 1 you claim an allowance of 8%, which is £800 here, giving a written down value of £9,200
- in year 2 you claim 8% of £9,200, which is £736, giving a new written down value of £8,464.
To avoid small figures, HMRC now allows a pool that has fallen below £1,000 to be wholly written off. In our example, if we only had that 1 asset in that pool it would take 28 years for the value to reduce to less than £1,000. By that time you may have long disposed of the asset.
Short-life assets have an expected life of up to 8 years. These may be left out of the 2 general pools if you wish.
The advantage is that you can claim capital allowances over the expected life of the asset rather than on a reducing basis, allowing tax relief to be obtained much more quickly. This election is commonly made for computer equipment.
We can advise which assets come within the scope and whether it is worth making the election.
Disposing of assets
When an asset is disposed of the proceeds received are deducted from the pool to which the asset was allocated originally. Since pool balances cannot be reduced below zero, in circumstances where the proceeds received from a sale are above the value of the pool a ‘balancing charge’ is created.
This charge is equal to the excess proceeds received (effectively the potential negative balance that would be produced) and serves to increase taxable profits in order to take back the over claimed allowances.
Similarly, a ‘balancing allowance’ may arise where a trade ceases with a pool balance greater than zero. This allows for the entire balance remaining to be written off in full.
Rules for cars
Cars are plant and machinery but have some special rules.
Low emission cars can attract a 100% first-year allowance. That means that you can write off the whole cost against your taxable profits in the year of acquisition.
Higher emission cars attract a writing down allowance of 18% or 8% depending on their emission figures.
Limited Company: If the car is a limited company car, the employee could be liable to pay tax on the ‘benefit in kind’ received by private usage of the vehicle. The amount is also determined by the car emissions.
Sole Trader /partnership: Sole traders and partnerships are individuals trading to make profit – there is no legal difference between the person and the business – so there is no such thing as a company car. There are however 2 ways of dealing with cars:
- The car may belong to the business owner, in which case no capital allowances are allowed but the sole trader may charge business mileage to the business for the use of the car.
- If the car is owned by the ‘sole trade’ business, then a percentage of the car and mileage costs relating to personal use of the vehicle must be disallowed.
There is a very fine line between owned by the individual or owned by the sole trader or partnership – either is acceptable to HMRC and will depend on the individual’s tax position.
Other points to consider
The main rate of corporation tax reduced to 20% from 1 April 2015 and continued at that rate from April 2016. Bringing forward expenditure to an earlier period may result in a greater tax saving. The timing of acquisitions can have significant tax consequences.
If you borrow money to pay for an asset, the loan relationship tax rules may need to be considered.