Warr on...

When a business incurs an expense it can generally deduct that expense in calculating its taxable profits. But what happens when a business invests in plant (such as machinery or office equipment)? The business has incurred a cost in the same way as if it incurred an expense and the reason for incurring that cost was exactly the same, to help the business generate profits. But unlike an expense, plant purchased by the business is likely to be used by the business for several years and so the asset purchased will be consumed by the business over a number of years. The question raised is how tax relief should be given for an asset that is used over a period of years.

Accountants have addressed this problem with the concept of depreciation. This requires businesses to write off their investment in plant over its effective useful life by means of a depreciation policy. The problem governments have faced with the concept of depreciation is that businesses have a tax motif for setting a high deprecation rate. For this reason the government have stepped in and established a tax mechanism for businesses to write off the costs of their investment in plant over a period of time. This mechanism is known as “capital allowances”.

For many years businesses have been entitled to claim a Writing Down Allowance at a rate of 25% per annum on a reducing balance basis on most of their investment in plant. So for example, if a business purchased a computer costing £1600, it would write off for tax purposes £400 in the year of purchase, £300 in the next year, £225 in the year after and so on. Plant purchases are usually pooled together and when plant is sold, the disposable proceeds are deducted from the brought forward pool value, before calculating capital allowances. This type of allowance is known as a “Writing Down Allowance”. From time to time, the government has tried to encourage business investment by a higher capital allowance to be claimed in the year an asset is purchased. This capital allowance is known as a “first year allowance”. For the 2007/08 tax year, which ends on 31st March 2008 for companies and 5th April 2008 for sole traders and partnerships, the rate of first year allowance is 50% for most businesses. So if a small company with a 31st March year end purchases a machine for £2000, it may claim a first year allowance of £1000 instead of a Writing Down Allowance of £500.

From 6th April 2008 for sole traders and partnerships and 1st April 2008 for companies the system is changing. Each business will be entitled to claim an “Annual Investment Allowance” which will replace the first year allowance. Under the new regime, business will be able to claim 100% relief on up to £50,000 of plant purchases in each year. Expenditure in excess of this limit will be pooled. The Writing Down Allowance will remain, but the rate will reduce to 20%.

The vast majority of businesses will see an advantage when the new rules come into effect, only very large businesses will be worse off. Any businesses considering capital expenditure on plant in the near future should look at how much it expects to be invested in the next 12 months. If this is less than £50,000 it should defer the expenditure until after the end of the current tax year. If on the other hand it expects to invest more than £50,000 over the next 12 months, it should incur the expenditure now.

Date of Article: 21st February 2008