Investing in assets for your trade or business can be a substantial expense for both business owners and individuals. Fortunately, the government provides a tax relief known as Capital Allowances to help ease this financial burden.
Familiarising yourself with the fundamentals of capital allowances empowers businesses to make informed investment choices and potentially achieve substantial tax savings. In this article, we present a beginner’s guide to capital allowances, shedding light on their functioning, and the process of claiming them.
Defining Capital Allowances
Capital allowance is a form of tax relief that compensates for the decrease in value of capital assets used in the trade or business. It allows businesses to deduct a portion of the cost of these assets from their taxable profits, effectively reducing their overall tax liability.
This tax relief applies to a wide range of assets, including equipment, machinery, and business vehicles.
Calculating Capital Allowances
To calculate capital allowances, you multiply the qualifying expenditure amount by the relevant tax rate. The capital allowance computations are prepared for specific accounting periods and are considered a trading expense for businesses and should be deducted in arriving at the trading profit figure for the accounting period.
Individual capital allowance computations are not necessary for every capital asset acquired. Rather, capital assets are usually ‘pooled’ into a ‘general pool’ (also known as the ‘main pool’) and one computation is then prepared based on the qualifying expenditure within the pool.
Below is a step-by-step process of calculating capital allowances:
Step 1: Identify Qualifying Assets
Determine the capital assets that qualify for capital allowances. These may include equipment, plant and machinery, and business vehicles.
Step 2: Determine Qualifying Expenditure
Calculate the qualifying expenditure for each asset. This typically includes the purchase price of the asset and any associated installation costs.
Step 3: Group Assets into Pools
Group the assets into the appropriate pools, such as the main pool, special rate pool, or single asset pool. This eliminates the need for individual computations for each capital asset that has been acquired.
Then, calculate the value of the pool by adding the cost of all the assets that are in the pool.
Step 4: Calculate Capital Allowances
Capital allowances are calculated at a fixed rate, currently set at 18%, of the qualifying expenditure on a reducing balance basis. The rate may differ for assets in the special rate pool. For example, cars with low CO2 emissions may qualify for a special rate of 100% for the first year.
Step 5: Apply Balancing Adjustments
If you sell or dispose of an asset that is in the pool, you may need to adjust the value of the pool. You may have to pay a balancing charge if the sale price is higher than the value of the pool, or you may be eligible for a balancing allowance if the sale price is lower than the value of the pool.
Step 6: Claim Capital Allowances
The total amount of capital allowances calculated can then be claimed on the tax return for the accounting period. This will reduce your taxable profits and ultimately, your tax liability.
Question: Can I disclaim Capital Allowances?
There can be some instances where it can be advantageous for the trader to disclaim some (or all) of the capital allowances, for example, where a trader has low profits which may be covered by the personal allowance for the year. In such cases, this can lead to a higher tax written-down value being carried forward which will, in turn, lead to higher capital allowance claims in future years.
Let’s say a small business purchases a machine for £10,000 to be used in their operations. The machine still has a useful life of 5 years and qualifies for an 18% WDA.
In the first year, the business can claim an 18% WDA on the cost of the machine, which is £10,000 x 18% = £1,800. This reduces the taxable profit for the year by £1,800.
In the second year, the business can claim an 18% WDA on the reduced balance of the machine’s cost, which is £8,200 x 18% = £1,476. This also reduces the taxable profit for the year by £1,476.
This process continues until the machine is fully written off or sold, at which point the business can claim a balancing allowance or balancing charge.
Timing of Capital Allowances Receivables
The timing of capital allowances receivables is crucial as it determines when a business can claim and benefit from these tax deductions. By accurately timing the receipt of capital allowances, businesses can optimise their cash flows, manage their tax liabilities effectively, and maximise their overall financial performance.
When expenditure is incurred
Expenditure is considered “incurred” when the obligation to pay becomes unconditional i.e., when the legal obligation to pay normally arises on or within a certain time of delivery of the asset. However, if there is a gap of over four months between the unconditional obligation and payment, the expenditure is incurred on the payment due date.
When work is certified
For capital asset, which is being constructed, the obligation to pay for a completed part becomes unconditional upon certification by an architect or engineer who has inspected the work. Hence, expenditure is incurred on the certification date for capital allowance purposes. However, if the asset becomes the purchaser’s property before the accounting period ends, and certification occurs within one month after, the expenditure is treated as incurred right before the period ends.
For pre-trading expenditure
If capital asset for use in the trade is acquired before trading starts, the expenditure is treated as incurred on the first day of trading.
For Hire Purchase (HP) agreements
For assets acquired under HP contracts, expenditure is incurred when the asset is used, and the four-month rule does not apply. If an initial payment is made in an accounting period before the asset is used, capital allowances can be claimed on this amount in that earlier period. Capital allowances are claimed on the cash price of the asset, while the interest element is deductible from trade profits.
For short leasing agreements
Capital allowances are not available for short leasing agreements (either an operating lease or a finance lease) as the trader does not legally own the asset. Instead, relief is given for the leasing/hiring costs via the profit and loss account.
Understanding the fundamentals of capital allowances is crucial for businesses and individuals looking to minimise their tax liabilities and make informed investment decisions. By taking advantage of capital allowances, businesses can alleviate the financial burden associated with acquiring assets for their trade or business and potentially achieve significant tax savings.