What is Capital Allowance?
Capital allowance is the deduction available to UK tax payers while computing taxable income. In UK, depreciation is not an allowable expense and its place is taken by capital allowance.
Both depreciation and capital allowance become applicable when you buy long-term assets for business purposes. Buildings, plant & machinery and furniture are examples of such long-term assets. As these assets will be used over a number of years, you cannot write their costs off as expense in the year of purchase.
Instead, the typical solution is to estimate their useful life in years, and write off a proportionate amount each year over this life time. This is what we call depreciation. In UK, however, depreciation is not allowed as a business expense.
The capital allowance system also essentially allows you to write off the cost of assets over a number of years. However, the regulations regarding capital allowance is much more complex.
For example, in the case of buildings, the entire cost of the building cannot be the basis for claiming capital allowance. Instead, you have to segregate the cost into First Fix and Second Fix costs. Capital allowance can be claimed only for the Second Fix costs.
First Fix costs include costs up to and including plastering. Second Fix costs are all the costs after the plastering stage to final finishing. These actually include innumerable items such air-conditioning, electrical fittings (but not the wiring), water supply fittings (but not the piping) and so on.
Considering that you pay for the building as a whole, computing the Second Fix costs is a complex exercise requiring special valuation expertise. The result is that many businesses do not claim the capital allowances that they are entitled to, and pay significantly higher amounts of tax than they need to.
Accountants are not typically equipped to identify and value the borderline items eligible for capital allowances.
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Qualifying Activities for Claiming Plant and Machinery Allowances
In a separate article, we noted that persons engaged in qualifying activities can claim Plant and Machinery Allowance (PMA) on expenditure they incur for providing plant or machinery for carrying on the qualifying activity. In this article, we look at what are included under qualifying activities.
CA20010 lists qualifying activities for claiming PMA:
- Trade;
- An ordinary property business;
- Furnished holiday letting business;
- Overseas property business;
- Profession or vocation;
- Mine, quarry or canal or other concern giving rise to profits from land charged to tax as a trade under ITTOIA/S12 (4) or under case I Schedule D in accordance with ICTA88/S55;
- Management of an investment company;
- Special leasing business;
- Employment or office.
To qualify for PMA under the last item above, employment or office, the asset must be “necessarily” provided for use in the office or employment. Expenditure incurred by employees on motor cars or other vehicles does not qualify for PMA from 2002/03 onwards. The rule now is that employees can claim statutory authorized mileage relief for qualifying business travel and not PMA on the vehicle.
Expenditure incurred for the provision of plant and machinery in a building used as a dwelling house does not qualify for PMA. A block of flats, however, is not a dwelling house as such; but the individual flats are. Expenditure that can be apportioned as intended for the common areas of the block are eligible for PMA claims.
Though dwelling houses are not eligible for PMA, property used for commercial letting of furnished holiday accommodation in the UK & EEA is eligible. To qualify, however, the property must:
- Have been available for commercial letting for at least 140 days during the year,
- Have been actually let to members of the public for at least 70 days and
- Not have been let to the same occupant continuously for more than 31 days except under abnormal conditions.
These letting conditions are due to increase from April 2012.
We will look at the details of other qualifying activities in a separate article.
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Section 198 of Capital Allowances Act 2001
Section 198 of the Capital Allowances Act 2001 has a major significance for property transactions. If the seller of the property has claimed capital allowances on any fixtures of the building, the tax relief enjoyed as a result might have to be paid back if the seller does not elect to file an Election Notice under the above section. The Election Notice will specify the items of plant and machinery and the value at which these items are being transferred.
Now, if the value at which the items are transferred is less than the tax written down value, the seller can claim a balancing allowance. On the other hand, if the value is more than the written down value, the seller will be liable to pay back the tax relief enjoyed on the excess claims. The buyer will be entitled to claim capital allowances on the value agreed upon in the Election Notice.
Where no such value is indicated in the contract or Election Notice under section 198 (which can be made within two years of the purchase transaction) the buyer can apportion the value on a just and fair basis and claim capital allowance on eligible items. The seller might be at risk in such a case. It is thus always best to agree upon the value of plant and machinery forming part of the building at the time of sale.
The value so agreed upon is negotiable between the buyer and seller and they can select a value that provides the greatest amount of tax relief. If the buyer pays a higher rate of tax, the seller can indicate the original value of the plant and machinery as the sale value now. The seller will then pay back the full tax relief he enjoyed through capital allowance claims. However, the buyer might agree to share with the seller the extra tax relief the former can get.
The property sale transaction thus provides opportunities for tax planning and the amounts involved can run into tens of thousands of pounds in large value transactions. Ignoring this opportunity would not make good business sense.
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Owner of Fixtures: Elections between Lessor and Lessee
A lease can be of a building or land which is received by the lessee along with several permanent fixtures forming part of the asset. Alternatively, the lease can be an equipment lease for plant and machinery purchased by a lessor and leased out to a lessee. The plant and machinery then becomes a fixture to a building or land used for carrying on a qualifying activity.
In the case of equipment lease mentioned above, the lessor and lessee can jointly elect to treat the lessor as the owner of the fixture provided certain conditions are met. These conditions are:
- The lessee is carrying on a qualifying activity and the leased equipment is used in this activity
- The lessee would have been entitled to claim PMA if that person had incurred the expenditure for providing the equipment
- The plant and machinery becomes a fixture by being fixed to land that is neither a building nor part of a building
- The lessee has an interest (including lease) in the land
- The lessor is entitled to sever the fixture at the end of the lease period and the severed fixture can then be used at another premises for the same purpose
- Under the lease agreement, the lessor will own the equipment on its being so severed
- The lease is one that comes under the category of an “operating” lease (as distinct from a “financing” lease) and
- The plant and machinery is not intended for use in a dwelling house
A similar election can be made where:
- An energy services provider provides plant and machinery that becomes a fixture in a relevant land
- The client of the provider has an interest in the relevant land and the provider doesn’t have such interest
- The provider or a person connected with the provider operates the plant and machinery for the client and
- The plant and machinery is not provided for leasing or for use in a dwelling house
If elections are made as above, the lessee (or client in the case of energy services) will not be treated as the owner of the fixture under section 176 of the Capital Allowances Act 2001 for claiming PMA.
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& Machinery Disposal Events" href="http://www.dsrassetmanagement.co.uk/plant-machinery-disposal-events/" rel="bookmark">Plant & Machinery Disposal Events
In other articles we have seen that when a disposal event occurs, taxpayers are subjected to a balancing charge or allowed a balancing allowance. A balancing charge involves charging back excessive capital allowances claimed and balancing allowance provides relief for claims that are short.
Capital allowances are considered excessive when the disposal value is more than the notional written down value after deducting the writing down allowances from the original cost. If the disposal value is less than the notional written down value, capital allowance claims are treated as inadequate and the shortage is made up through a balancing allowance.
The issue of disposal even becomes relevant in the above context. Disposal events are not confined to sale of an asset. Instead, all the following events are disposal events:
• The taxpayer ceases to own the asset
• Possession of the asset by the taxpayer is lost permanently
• Abandonment of an asset used for mineral exploration and access at the site where it was so used
• The asset ceases to exist
• The asset begins to be used for a purpose other than the qualifying activity
• The qualifying activity itself is discontinued permanently
• The asset is leased under a long funding lease
When a disposal event takes place, the taxpayer is required to bring a disposal value into account. The rules regarding computation of disposal value is somewhat complex; it might not be even the sale value if the sale event is considered a tax avoidance measure.
It is possible that an asset might have more than one disposal event. In such cases, disposal value needs to be brought into account only on the happening of the first event.
It is to be noted that except in the case of single asset pools, the above provisions apply to the pool total as a whole and not to individual assets.
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Plant and Machinery Allowances and Fixtures
Plant and Machinery Allowances (PMA) can typically be claimed only by the owner of the asset. However, in hire purchase contracts, the hirer can claim PMA on the hired asset even though legally that person is not yet the owner. The legal owner, the person who buys the asset and hires it out, cannot claim PMA.
The case with fixtures is also similar. Fixtures are attachments to buildings or land that are considered permanent and provide a lasting improvement to the building or land. If the building or land is leased out to a lessee and the latter incurs expenditure on adding such a fixture, that person is not legally the owner of the fixture.
However, in such a case, fixtures legislation allows the lessee to claim PMA on the fixture. Even if the expenditure on the fixtures is incurred by the lessor, that person might make a joint election with the lessee under CAA01/S183 (1)(e) whereby the lessee becomes entitled to claim PMA on the fixture. Fixtures legislation treats the lessee as the owner of the fixtures in such a case and disallows the lessor from claiming PMA on the same fixtures.
A fixture is different from chattel. Chattels are also tangible just like fixtures. However, they are moveable and have not been affixed to the building or land. Even chattels can become fixtures once they are fixed to the immoveable property on a permanent basis to improve the property. For example, a central heating system that has not become part of the building is considered a chattel (it can still be moved to another building and fixed there, for example).
Even though tenant’s fixtures, i.e. fixtures affixed by the tenant to the immoveable property is distinct from landlord’s fixtures in that the tenant can remove these fixtures when that person leaves, the distinction between tenant’s and landlord’s fixtures is not relevant in the context of fixtures legislation.
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Mineral Extraction Allowance
Mineral Extraction Allowance (MEA) is an allowance that can be claimed by persons engaged in the trade of mineral extraction. Only persons actually carrying on the trade, and not lessors of mineral-bearing land, are entitled to make claims. Claims can also be made only when there is actual trade; activities such as mineral exploration are not considered “trade.”
The trade of mineral extraction means trade involving working with a source of mineral deposits. Mineral deposits include “any natural deposits capable of being lifted or extracted from the earth and geothermal energy whether in the form of aquifers, hot dry rocks or otherwise.” Examples include sand and gravel mining, oil extraction and hard rock mining, in addition to geothermal energy.
While exploration itself is not considered trading, allowance can be claimed on exploration expenditure when trading starts. “Qualifying expenditure” for claiming allowances include:
• The acquisition of mineral deposits and rights.
• Exploration and development expenditure.
• Restoration costs.
• Certain pre-trading expenditure.
• Planning permission.
Pre-trading expenditure include plant and machinery that might not be in existence at the time of commencing trade. Cost of plant and machinery used during the exploration but disposed off before commencement of trade is included in qualifying expenditure for a balancing allowance claim. Any disposal proceeds such as sales or insurance proceeds are deducted from the costs and only the net amount is included.
Licences and planning permissions for working the mineral sources typically include obligations to restore the site after the extraction has ceased. Provided the restoration costs are incurred within three years after ceasing the trade, such restoration costs are also included as qualifying expenditure.
There are rules for including and excluding different types of expenditure while computing qualifying expenditure. Details can be found on the relevant HMRC Web page CA50200.
We will look at the regulations for claiming Mineral Extraction Allowances in a separate article.
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Is this a Loophole?
In a separate post, we looked at capital allowances that are allowed as a deductible expense for computing taxable income. We noted that capital allowances allow long-term expenditures, such as on buildings, plant & machinery and furniture, to be written off as expenses over their expected useful lives. We noted in particular that computing capital allowances on buildings is a complex exercise that accountants are not typically equipped to handle well.
The complexity of capital allowance claims on buildings might make people think that these involve taking advantage of some loophole in law which might be resisted by tax authorities.
Let us look first at what the term loophole means.
In the context of law, it typically involves wording that can be interpreted in an ambiguous manner allowing people to interpret it in their favour and avoid complying with the intended legal obligation. It can also involve an omission while drafting the law that enables people to circumvent it by taking advantage of the omission in some way.
Capital allowance claims are not based on any such loop hole. It is based on specific provisions of the law intended to encourage investment in capital assets. Based on established law dating back to 1878, it confers a right on taxpayers which they can claim in a straightforward manner and without recourse to any devious practices.
In fact, thousands of capital allowance claims on buildings have been made and paid out. The goal should be to prepare a detailed report that will clearly list the items and the reasons why these items are eligible for capital allowance. In addition to being accurate, the report should also ideally be in a format approved by HM Revenue & Customs.
This is a task for surveyors and valuers, and also requires familiarity with the complex provisions of capital allowance regulations as they apply to buildings.
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How can Capital Allowance Help Me?
Most of us would like to save on the taxes that we pay to the government.
Businesses pay taxes on their business profits. By reducing the amount of profit that is taxable, we can save on taxes.
You cannot show reduced profits by resorting to creative accounting because creativity is not appreciated in this field, particularly by investors and tax authorities.
The only way you can reduce profits is by including all the expenses that tax authorities allow you to deduct from your revenue before arriving at the taxable profit. Capital allowance is one such expense that is legally allowed to be deducted.
Capital allowance can be seen as the writing down of long-term assets used in the business. These assets will typically be used for several years and the cost of the asset is spread over this useful life.
Tax authorities have estimated the useful lifetimes of the major classes of long-term assets and have also prescribed how to compute the capital allowance over this period. For example, you can claim capital allowances at 20% of the “declining value” of Plant & Machinery every year.
While most businesses already claim allowed capital allowances on moveable assets such as plant, furniture and office equipment, that is not typically the case in the case of buildings. It is estimated that 96% of buildings have not their capital allowances claimed.
This happens because the rules for computation of capital allowances on buildings are complex. You cannot claim a specified percentage of the total value of the building. Instead, you must identify the “moveable” items such as light and water supply fittings, air conditioning plant and so on, value them and claim capital allowances on this value.
There is no time limit for making capital allowance claims, and you can save a significant amount of tax by getting an expert on capital allowance claims help you make the claims.
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History of Capital Allowances
Up to late 19th century (1878 to be precise) there were no capital allowances.
In 1878, a “wear and tear” allowance was introduced for traders in plant and machinery by allowing them to reduce their income by the allowance amount. For mills and factories, a “mills and factories” allowance was available. The quantum of the allowance was an amount considered “just and reasonable” and tended to represent the “economic” depreciation in the value of the equipment.
A new system of allowances was introduced in 1945 to replace the above allowances. The wear & tear allowance was replaced with:
- An initial allowance of 20% on plant & machinery for the first year
- Annual writing-down allowances to represent the usage of the asset over the years; the rate was fixed by Inland Revenue and was generally 25% for plant & machinery
- A balancing adjustment when the asset was retired or sold to ensure that the total relief was equal to the actual reduction in value over the period of ownership
The mill & factories allowance was replaced by:
- An initial allowance of 10% on new buildings
- Annual writing-down allowances at 2%
- A balancing adjustment when the asset was retired or sold to make total relief equal to actual reduction in value
The building allowance was confined to industrial buildings, and shops, offices and even hotels were excluded.
An investment allowance, over and above the allowances above, was introduced in 1954 to encourage investment in industrial assets including buildings.
The system was simplified in a major way in 1971 to eliminate burdensome record-keeping and computational requirements. A further simplification in 1984 saw the elimination of initial and first year allowances, among others.
There were other changes reintroducing and withdrawing different allowances in pursuit of specific policies until capital allowances were consolidated in 1990. There was a further revision and the current legislation is CAA2001.
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Fraudulent claimants threaten legitimate allowances
Businesses are able to claim capital allowances when they enter into a long funding lease for their buildings and machinery.
However, some firms are attempting to claim back twice their entitled tax relief by entering into, “contrived, circular transactions involving the sale, leaseback and reacquisition of their plant and machinery” over a period of a few weeks.
In a written statement to MPs, Treasury Exchequer Secretary David Gauke said: Legislation, which will have effect from today (Wednesday 9th March), will be introduced in Finance Bill 2011 to confirm that lessees engaging in transactions of this type are only entitled to tax relief up to the actual amount of their expenditure on plant or machinery.”
He also explained that this legislation would be forcibly enforced so as to “protect future losses to the Exchequer”.
However, whilst some firms are over-claiming on their capital allowances, a whole host of others are completely unaware that they are entitled to claim anything. Consequently, they may be missing out on large sums of money.
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FLA urges Treasury to extend green tax relief" href="http://www.dsrassetmanagement.co.uk/fla-urges-treasury-to-extend-green-tax-relief/" rel="bookmark">FLA urges Treasury to extend green tax relief
The Finance and Leasing Association (FLA) is calling on the Treasury to extend tax relief on energy efficient equipment to the asset finance sector.
The association believes that the extension would benefit small businesses and is calling specifically for the relaxation of the Enhanced Capital Allowances (ECAs) to cover energy saving equipment hire.
ECAs enable a business to claim up to 100 per cent first-year capital allowances on their spending on qualifying plant and machinery. Currently the ECAs apply to businesses that purchase equipment with a bank loan but not when that equipment is leased.
The FLA claims that if the ECA system was extended to include leasing companies, it would support investment in energy efficient companies by small businesses, because the benefits would be passed on through better commercial leasing rates.
A spokesperson for the FLA told Greenwise: “It would give the asset finance companies the scope to pass on the ECA through decreased rentals.”
It is hoped that, as well as offering small businesses increased support, the FLAs latest bid to the Treasury may highlight the many other benefits that can be gained through ECAs.
This article was written by Katie-Jill Rowland
Capital Allowance Related Posts
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FYA) on Plant & Machinery" href="http://www.dsrassetmanagement.co.uk/first-year-allowances-fya-on-plant-machinery/" rel="bookmark">First Year Allowances (FYA) on Plant & Machinery
Until April 2008, small and medium enterprises were eligible to a first year allowance (FYA) of 40 or 50 percent on plant and machinery. FYA has now beer replaced with Annual Investment Allowance (AIA) that is available to large as well as small and medium enterprises. However, FYA is still available to businesses engaged in certain industries.
We look at these industries and their FYA eligibilities in this article.
Environmentally Beneficial Plant & Machinery
CA23135 regulates that 100% FYA is allowable on plant and machinery used for improving water quality and reduce water use, for expenditure incurred after 1 April 2003. These include:
• efficient taps;
• efficient toilets;
• flow controllers;
• leakage detection;
• meters;
• rainwater harvesting equipment;
• water reuse systems;
• cleaning in place equipment;
• efficient showers;
• efficient washing machines;
• small scale slurry and sludge dewatering equipment;
• vehicle wash water reclaim units;
• efficient industrial cleaning equipment;
• waste management for mechanical seals.
Energy Saving Plant & Machinery
CA23140 specifies that capital expenditure on new energy saving plant and machinery is eligible for 100% FYA. The items must be included in a qualifying technology or product list issued by the Secretary of State for the Department of Environment, Food and Rural Affairs to qualify for FYA. CA23140 specify the conditions and class of items.
Other eligible Items
CA23153 makes expenditure on cars with low carbon dioxide emissions eligible for 100% FYA. The cars must be new and not second hand cars, and must be either an electric car or a car with CO2 emissions of not more than 110gm per km driven. See CA23153 for conditions and other details.
CA23155 allows expenditure on natural gas and hydrogen refueling equipment at a gas refueling station, 100% deductible as FYA. Items such as storage tanks, compressors, controls and meters, gas connections and filling equipment are examples of eligible equipment. Biogas equipment also qualifies.
CA23157 provides 100% FYA for expenditure incurred by a company wholly for the purpose of a trade of extraction of oil or gas in the UK or UK Continental Shelf.
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History of Capital Allowances
Up to late 19th century (1878 to be precise) there were no capital allowances.
In 1878, a “wear and tear” allowance was introduced for traders in plant and machinery by allowing them to reduce their income by the allowance amount. For mills and factories, a “mills and factories” allowance was available. The quantum of the allowance was an amount considered “just and reasonable” and tended to represent the “economic” depreciation in the value of the equipment.
A new system of allowances was introduced in 1945 to replace the above allowances. The wear & tear allowance was replaced with:
- An initial allowance of 20% on plant & machinery for the first year
- Annual writing-down allowances to represent the usage of the asset over the years; the rate was fixed by Inland Revenue and was generally 25% for plant & machinery
- A balancing adjustment when the asset was retired or sold to ensure that the total relief was equal to the actual reduction in value over the period of ownership
The mill & factories allowance was replaced by:
- An initial allowance of 10% on new buildings
- Annual writing-down allowances at 2%
- A balancing adjustment when the asset was retired or sold to make total relief equal to actual reduction in value
The building allowance was confined to industrial buildings, and shops, offices and even hotels were excluded.
An investment allowance, over and above the allowances above, was introduced in 1954 to encourage investment in industrial assets including buildings.
The system was simplified in a major way in 1971 to eliminate burdensome record-keeping and computational requirements. A further simplification in 1984 saw the elimination of initial and first year allowances, among others.
There were other changes reintroducing and withdrawing different allowances in pursuit of specific policies until capital allowances were consolidated in 1990. There was a further revision and the current legislation is CAA2001.
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PMA on Fixtures already Installed on Leased Land or Building" href="http://www.dsrassetmanagement.co.uk/pma-on-fixtures-already-installed-on-leased-land-or-building/" rel="bookmark">PMA on Fixtures already Installed on Leased Land or Building
Where a fixture goes along with the leased property to a lessee, the owner of the fixture is determined by the particular facts of the case.
Where the lessor was or would have been entitled to claim PMA on the fixture, and the lessee pays a premium for the lease that is treated as capital expenditure for the fixture, the lessor and lessee can elect to treat the lessee as the deemed owner of the fixture. If such an election is made, the lessee becomes entitled to claim PMA on the fixture.
The lessor will then show a disposal event for the fixture.
On the other hand, if the lessor was not entitled to claim PMA on the fixture, then the lessee, who carries on the qualifying activity in which the fixture is used, will be treated as the owner of the fixture entitled to claim PMA. This usually happens when the lessor is holding the fixture in a trading capacity and not for a qualifying activity.
If it so happens that the PMA has already been claimed by another person entitled to claim it, for example, if the lessor had earlier leased the fixture to a person carrying on a qualifying activity (and claims PMA on the fixture), and subsequently grants a superior lease to another person, this latter person will not be entitled to claim PMA on the fixture.
Where a lessee incurs expenditure on installing a fixture, and the lessor makes a contribution towards the cost, the latter can claim PMA on the contribution if the lessee, who is the deemed owner of the fixture, is entitled to PMA.
It will be noticed that the rules relating to PMA are more than a bit complex. Taxpayers should consult a specialist on capital allowances for immoveable property to ensure that they claim what they are entitled to.
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