Take Account of the Cost of an Asset - “Add capital allowances”

Add capital allowances

Depreciation was removed as an expense earlier on in this process. We now take that into account by considering capital allowances.

The difference between depreciation and capital allowance is subtle. Depreciation takes account of the cost of an asset in any given year in the company accounts. Capital allowances takes account of the costs of the same assets in any given year for the purposes of corporation tax. You may need to read that twice!

Depreciation is valued at a fixed percentage of the asset value each financial year. For example, if we depreciate some IT costs over five years, then 20% of the cost of the IT will be applied to the accounts each year, for five years. Capital allowances are a percentage of the remaining value. Hence, for a five year capital allowance,

  • the first year we apply a 20% charge (as with depreciation).
  • In year two, it is 20% of the remaining value ie 16% (20% of 80%) as 20% was accounted for in year 1.
  • In year three, we have capital allowances in years one and two of a total of 36%, therefore we have a capital allowance of 12.8% (100% - 36% = 64%; 20% of 64% = 12.8%).
  • And so on.

Phew. I am still trying to find some logic behind this, let me know if you have an explanation.

The design of capital allowances seeks to encourage investment. It does this by increasing the “cost” declared in the early years of an asset. Higher costs in the early years reduces corporate tax in the early years. Hence, by reducing corporation tax in the early years, it ought to help cash flow the purchase of the asset.

Capital allowances can be significant. Where you have significant assets you ought to get advice or help. A couple of rules to wet your appetite:

  • First year allowance on cars and green technology is 100%. You would therefore gain the full tax reduction in the first year
  • The annual investment allowance is £25K. For many small businesses, this would provide tax relief very early in the lifetime of the asset. In the recent Autumn statement, this allowance was increased to £100K starting on 1st January 2013 to run for two years.

For the guidance from HMRC please see: http://www.hmrc.gov.uk/incometax/relief-capital.htm