This article is a basic introductory guide to capital allowances. What are they, what are the basic rules about claiming this valuable tax relief, and is it always a good idea to claim?
We shall be answering these questions in the following discourse. Subsequent articles will deal with the special types of allowance available for plant and machinery, and we shall end the series by looking at the new rules for fixtures.
But first, the most important question of all…
What are capital allowances?
In a nutshell, capital allowances are a form of tax relief given for depreciating assets.
We have already encountered capital allowances in a previous article, Starting a Property Business, where it was explained that the effect of claiming an allowance is to improve the rental yield of the property. And indeed, the topic appears quite frequently in the property world, especially in the context of fixtures, which we shall look at in a later article. However, it is important to note that capital allowances are relevant to any type of business, not just property investment.
The starting point is that capital allowances are an exception to the rule that a business cannot deduct capital expenses against its revenue receipts1. Broadly, allowances are available for certain items of a one-off nature – capital items that, while they aren’t required to be replaced on a regular basis, nevertheless are subject to wear and tear as the years go by.
But instead of using the depreciation figure from the business accounts, tax relief is given in accordance with the rules set out in the capital allowance legislation. These rules govern what you can and can’t claim for, what are the rates of relief and how to make a claim.
In our previous article we stated that the following items are normally deductible in a property business, but they are just as relevant to a trading operation: fixtures and fittings, electrical systems for heating, lighting and ventilation, or fire and burglar alarms. These items are known as plant and machinery, which is the most common type of allowance.
We shall therefore be looking at the capital allowance regime in the context of plant and machinery. However, it is important to note that there are all sorts of other allowances, each with its own individual set of rules. For example tech businesses might be interested in the reliefs for knowhow and R&D (not to be confused with the R&D tax credits), as well as patent allowances available for individual business owners2.
Let us now take a closer look at the legislation.
What are the conditions?
In order to qualify for plant and machinery allowances, the following conditions must hold3:
- A person must incur capital expenditure on plant and machinery;
- The plant and machinery must be used wholly or partly in a business carried on by that person. This includes a trade or a property letting business, as well as a number of other activities specified in the legislation4;
- The person owns the plant and machinery as a result of incurring the expenditure;
- In the case of plant and machinery which becomes a fixture incorporated into land or a building, ownership of the fixture is determined by whoever owns the relevant land interest5.
These are the basic rules. We now look at a few points which are worth bearing in mind when dealing with this topic.
You can’t claim capital allowances if the expenditure isn’t capital
This sounds obvious, because it is. If the expenditure isn’t of a capital nature, it can’t qualify for an allowance. But this doesn’t necessarily mean that no tax relief is available at all – in fact, as the following example shows, a business might actually be better off if capital allowance treatment doesn’t apply.
For example, a property developer is regarded as carrying on a trade rather than an investment business, and so the properties are held on revenue account. This means that the fixtures attached to the property assets are also revenue items and don’t qualify for an allowance.
But revenue expenditure is fully deductible in calculating business profits – the entire amount can be written off in a single year. For capital allowances, the expenditure is normally written off gradually over a number of years, depending on the writing down rate. This will normally be 18% but is reduced to 8% for long life assets, or other special rate items. In other words, for expenses on capital account, it takes longer to obtain the tax relief.
Allowances have to be claimed
Capital allowances are given effect by treating them as revenue expenses to be deducted from income profits6. However, the deduction isn’t automatic, even though the relevant requirements are satisfied. In order to benefit, the allowance must actually be claimed on the relevant tax return7.
The time limit for making a claim will depend on whether the business pays income tax or corporation tax:
- For companies subject to UK corporation tax, the time limit is two years from the end of the accounting period during which the expenditure is incurred8;
- For income tax purposes, the time limit is the 31 January following the tax year in which the expenditure is incurred9. For example, for plant and machinery acquired in the tax year 2013/14, the time limit for claiming is 31 January 2015. However, those taxpayers wishing to deliver a paper return must claim by 31 October 2014 – otherwise the claim must be made electronically;
- The income tax procedures apply equally to individuals and non-resident companies that invest rather than trade in the UK. For example, non-resident corporate landlords are not subject to corporation tax but pay income tax on their rental profits;
- For individuals doing business through a partnership, the allowance is claimed on a separate partnership return10. When each individual partner is allocated his share of the profits, this will automatically include his share of the allowance11. There is therefore no need to claim again through the individual return.
You don’t actually have to claim an allowance at all
The legislation states that you don’t need to claim your full entitlement – a partial claim is allowed, provided this is specified in the return12. In fact, there is absolutely no obligation to claim an allowance at all.
Why would you not want to make a claim? Tax reliefs don’t grow on trees – surely if the money is offered one shouldn’t look a gift horse in the mouth. The following example shows one circumstance where claiming the allowance can actually leave a business worse off in tax terms.
Consider the example of two companies A and B that are members of the same corporate group. The following table shows the position of their respective profits and losses for two years, calculated before using up any allowances or group relief.
A has a plant and machinery pool worth £100m, for which we shall assume that the writing down rate is 18%. Accordingly A is entitled to a writing down allowance of £18m in Year 1 (we shall find out what this means in the next article).
This is perfect, as A also has a profit of £18m for that particular year – the entire amount can be relieved, leaving A with an overall tax liability of nil. On the other hand, B has incurred a loss of £18m which A can also use to relieve its profits by way of group relief13.
So A has two choices:
- Claim the allowance of £18m; or
- Claim the group relief from B.
If A claims the allowance, then its profits are reduced to nil. This means that group relief in respect of B’s loss is no longer available – A has no profits left14. In fact, the £18m worth of group relief isn’t lost for Year 1 only, it is lost forever. Group relief claims can only be made in respect of corresponding accounting periods – it isn’t possible to carry forward to subsequent years15.
This is what A’s position looks like if the allowance is claimed in Year 1:
The effect of claiming in Year 1 is as follows:
- A’s taxable profits are reduced to nil;
- A’s capital allowance pool is now £82m (£100m less the £18m claimed);
- This entitles A to claim an allowance of £14.8m in Year 2 (18% of £82m);
- In addition, A can also use B’s Year 2 loss of £2m to further reduce its profits to £3.2m;
- But the Year 1 loss of £18m is wasted. If it had to be claimed at all, Year 1 was the time to do it.
This is what the position looks like if A claims the group relief instead of the allowance in Year 1:
As we can see, A is better off as a result of claiming the group relief:
- Because the allowance wasn’t claimed in Year 1, the pool has been left intact at £100m;
- Accordingly, for Year 2, A may claim a writing down allowance of £18m (being 18% of £100m) – effectively the previous year’s allowance;
- A can supplement this by using B’s Year 2 loss of £2m to bring it’s total taxable profits down to nil.
So are the allowances lost if you don’t claim them?
Those readers who paid careful attention to the last example will already know the answer!
However, the answer is slightly more complicated. In the next article, we shall see why the legislation permits this, but for now, the following is a general explanation.
One needs to distinguish between the capital allowance for the expenditure, and the tax relief that goes with it. As far as plant and machinery allowances are concerned, a failure to claim an allowance doesn’t lead to a loss of tax relief, but can impact on the timing of the relief.
For example, we saw how A was able to carry forward an allowance of £18m in order to benefit from group relief which would otherwise have been lost. So the effect of not claiming is a delay in achieving the tax relief associated with the capital expenditure, although A is not worse off as a result.
But what about the fact that there is a time limit for claiming? Surely this means that the allowance is indeed lost if not claimed within the statutory period?
Again, the answer is that the tax relief is not lost, but simply delayed. If A wishes to claim the £18m allowance for Year 2, this needs to be specified on the relevant tax return by Year 4 at the latest. Failure to meet the deadline means that A cannot use the £18m to reduce its Year 2 profits to nil. However, this £18m is still available for Years 3 onwards, provided A claims in time. In other words, it is the opportunity to claim for a specific year that is lost, but the tax relief remains intact for future years.
In our example we saw that the rate of relief is unaffected by the decision not to claim the allowance – A was able to simply carry forward the same £18m that it would have been entitled to claim in Year 1. But in certain situations, the rate of relief can be adversely affected and the relief can even be lost altogether.
Suppose that an item of capital expenditure qualifies for a First Year Allowance. This is more valuable than a writing down allowance as it enables the business to write off the entire amount in a single year, instead of having to claim over a period of years at reduced rates. However, to obtain the full benefit, relief must be claimed for the year in which the expense is incurred16. If no claim is made, tax relief for subsequent years is only available at the lower writing down rates17 – the opportunity to write the whole amount off in a single year is lost.
Technically, the allowance is lost but the tax relief is intact18. But in certain cases outside the plant and machinery regime, failure to claim means that both allowance and the tax relief are lost This is the case with the R&D Allowance where the tax relief must be claimed in a single year – a partial claim can be made, but there is no opportunity to claim any balance in subsequent years19.
So is it better to claim the allowance anyway?
The answer will depend on the particular circumstances. In our previous example, if Company A had claimed the writing down allowance it would have lost the benefit of group relief. It hasn’t lost out by carrying forward the £18m allowance to the following year. On the other hand, failure to claim the First Year Allowance can have an adverse impact on the tax position in future years because of the lower rate of relief that applies.
But what is the situation where not all of the First Year Allowance is required – should you still claim the whole amount, or just that part that you need? Time for another example.
Suppose that A purchases equipment worth £40m, which qualifies for a First Year Allowance. To make the illustration clearer, we shall assume that initially, A has no plant and machinery pool to draw from, and no obliging fellow group member with tax losses to surrender.
In Year 1, A has profits before allowances of £20m, so doesn’t need the full £40m to set against these profits. So A claims just £20m – this is the situation, assuming a corporate tax rate of 23%:
What has happened here? Why is the allowance for Year 2 only £3.6m when it ought to be the £20m left over from Year 1?
We already know the answer. Because the remaining £20m wasn’t claimed for Year 1, it can only be relieved in future years by way of a writing down allowance. In order to claim tax relief on the balance, the £20m must go into a writing down pool, and be written off at reduced rates. Assuming a rate of 18%, only £3.6m can be deducted from Year 2 profits, leaving a balance of £16.4m to be claimed in future years.
Now look at what happens when the entire £40m is claimed instead.
Although A doesn’t need the whole allowance in Year 1, the effect of making a full claim gives rise to a trading loss of £20m. This loss can now be carried forward to the following year20, and the net result is that there are no taxable profits for both Year 1 and Year 2.
It is important to see what has been going on. The distinction between an allowance and the associated tax relief is a subtle, but important one.
- The First Year Allowance can only be claimed in the year of expenditure – which is Year 1;
- The allowance itself – or the residue – cannot be carried forward like a trading loss, but must go into the writing down pool. The effect is that the expenditure takes longer to relieve against future profits because relief is given at a lower rate;
- But by claiming the full amount in the first year, the allowance has “merged” into a trading loss which can be carried forward in its entirety.
This concludes our introductory article on capital allowances. In the next article we shall discuss the three different types of allowance available for plant and machinery. We shall also look more closely at the mechanism by which tax relief is delivered – hopefully this will clarify some of the points that have been discussed today.
Links: Curtis Plumstone Associates is a specialist outfit that advises on capital allowance claims. There is a lot of practical advice on their blog – you can find more about what constitutes plant and machinery in this post.
- ITTOIA 2005 ss 33, 28(b), 272; CTA 2009 ss 53, 49(a), 212. ↩
- See CAA 2001 Parts 6-8. For patents, UK corporates are entitled to tax relief in accordance with the accounting treatment under the IP rules in CTA 2009 Part 8. ↩
- CAA 2001 s 11. ↩
- CAA 2001 ss 11(2), 15. ↩
- CAA 2001 s 176. ↩
- CAA 2001 s 2(1), and Part 2 Chapter 19 for plant and machinery allowances – see in particular s 247 where allowances are treated as trade expenses, ss 248-250 for various types of property business, and s 253 for companies with an investment business. ↩
- CAA 2001 s 3. ↩
- FA 1998 Schedule 18 paragraphs 14(1)(a), 81(1)(a) – this assumes an accounting period of 12 months which is normally the case. However, in certain circumstances this time limit may be modified depending on whether the accounting period is longer or shorter. In addition, the effect of a HMRC enquiry can extend the time limit. ↩
- TMA 1970 s 8(1D). ↩
- TMA 1970 ss 12 AA, 42(6), 42( 7)(c). ↩
- TMA 1970 s 8(1B). ↩
- CAA 2001 s 51A(7) for the annual investment allowance; CAA 2001 s 52(4) for first year allowances; CAA 2001 s 56(5) for writing down allowances. ↩
- CTA 2010 s 129. ↩
- CTA 2010 ss 137(1), 137(3)(b), 138, 140(1). The amount that B can surrender is limited to A’s total profits – so if the latter is nil, A cannot turn this into a trading loss by simply deducting B’s loss. If this were possible, A could then carry this loss forward to future years. ↩
- CTA 2010 s 130, in particular s 130(2) Requirement 2. ↩
- CAA 2001 s 52(2). ↩
- CAA 2001 s 58(5). ↩
- It is arguable that if one takes account of the time value of money, the tax relief is effectively reduced if it is delayed. ↩
- CAA 2001 ss 441 – the rules for R&D are silent as to what is to happen to any balance that hasn’t been claimed. ↩
- CTA 2010 s 45. ↩
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