You’ve probably heard your accountant or someone else mention capital allowances to you and if you’ve just started up in business, these may be something of a mystery to you. Your accountant has probably said something along the lines of “they’re allowances on items of capital expenditure, such as plant and machinery for which you can claim tax relief”.
Great, but what are capital allowances and how do they work?
To understand what capital allowances are you first need to understand what a capital item (plant and machinery) is – essentially it’s an asset in your company’s balance sheet.
When your accountant produces a set of accounts for you, he’ll typically produce at a minimum a balance sheet and profit & loss account. The profit & loss account is fairly easy to understand as in simple terms it’s just the sum of all your income less the sum of all your expenses. If a transaction wasn’t put into the profit & loss account then it would have been placed in the balance sheet. For simple set of accounts, the balance sheet is broken up into just a few categories – these are fixed assets, current assets and creditors.
Current assets are items that are used and replaced frequently, such as the money in your bank account or the stock that you buy and sell. It also includes your debtors – people who owe you money. Creditors are people you owe money to.
The last category in the balance sheet is the fixed assets and this is where you will find your capital items. It will contain items that your business has purchased, not to sell, but to use in the business on a day to day basis in order to allow you to carry on your business. It will contain such items as motor vehicles, machinery, buildings, computer equipment and office furnishings.
It is because these items are in the balance sheet and not the profit and loss account that you have not yet been given any tax relief for their cost. So why did your accountant put them in the balance sheet and not the profit and loss account?
These items were put into the balance sheet because they have value and continue to have value. Put it this way, they are just another form of money – you could sell the motor vehicles or the computer equipment and get cash for them. You can’t do that with the tank of fuel you put in your car last week or the electricity you’ve used powering your computer equipment. So these are items that have an enduring benefit to your business.
That motor vehicle you purchased six months ago for £20,000, you won’t get £20,000 for it today if you sell it, so it has had a real cost to your business and that cost we do put into the profit & loss account. Let’s say by the end of the year you could only get £15,000 for the motor vehicle. Then in that year, it has had a real cost to your business of £5,000 – that’s what should go into the profit & loss account and indeed accountants do make an entry in the profit & loss account for that. They call it depreciation. They’ll reduce the value of the asset in the balance sheet and push through a corresponding entry into the profit & loss account to reflect the fall in value (cost to the business) of the asset.
This is where capital allowances come in. HMRC say the figure of £5,000 we just put through is a bit arbitrary and open to manipulation. It was just our guess as to how much the asset had fallen in value during the last year. Because it has reduced the profits of the business and the tax charge is based directly on those profits, we must add back that depreciation amount to the business profits. In it’s place HMRC give us capital allowances. They determine the amount we can deduct from the business profits based on the cost and type of assets we have. That way, it’s not arbitrary or open to manipulation.
That might be so, but sometimes the capital allowances that are allowed don’t really reflect the true cost to the business and have more to do with fiscal policy than reality.
HMRC have many categories for capital allowances. First there is the general or main pool. This is where most capital items are placed. Each year HMRC allow us to take a certain percentage of the balance as a capital allowance. The remainder is carried forward to the next year.
HMRC also have other categories or pools for certain things. For instance with governments becoming increasingly concerned about environmental issues they give tax breaks for things which have a beneficial impact on the environment. To this end, there is a First Year Allowances (FYA) pool where the rate of allowance given is 100% in the year of expenditure. Other items can also qualify for FYAs e.g. research and development expenditure.
There is a pool aimed at small businesses – the Annual Investment Allowance. This also gives 100% allowance in the year of purchase, but the amount that can be claimed is capped to a relatively small amount. Historically the amount has been anywhere between a few tens of thousands and a few hundred thousand.
Expensive cars – they get their own pool and allowances are restricted to a small percentage.
Expensive cars are actually a specific example of the special rate pool, which includes long life assets and “integral features”.
The integral features part needs some explaining. Hopefully by now you’ve started to get an idea what capital allowances are and how they work. So you’ve probably come to the reasonable conclusion that you will get capital allowances on the building you work in? Wrong. Let’s go back a bit and look at our capital items (plant and machinery) again. The definition of plant and machinery has evolved largely from case law.
In Yarmouth v France (1887) plant was defined as:
“…whatever apparatus is used by a businessman for carrying on his business – not his stock-in-trade which he buys or makes for sale; but all goods and chattels, fixed or moveable, live or dead, which he keeps for permanent employment in the business.”
This also makes it clear that business premises are not plant as they are not employed in carrying on the business, but are the place (or setting) in which the business is carried on.
So you won’t get any capital allowances for your business premises, but you might get capital allowances for modifications to your business premises e.g. electric lighting and power systems or air conditioning systems. These are what are referred to as integral features. There are long lists in the tax legislation on what is and what is not an integral feature. Again, much of this was determined by case law.