When you buy stock or small or everyday things for your business, you can deduct the cost from your income before having to calculate the tax that is due. This is why it is called tax deductible (business) expenses.
In your accounts, you might categorise them as stock, materials or office supplies as appropriate… and they appear in your profit and loss account as business expenses.
However, when you buy larger items such as equipment or machinery that you expect to last over a year, then these items are called business assets. Expenditure on assets is called capital expenditure.
Capital expenditure is handled differently in your accounts and in your tax return.
In your accounts, assets appear on your balance sheet not your profit and loss account.
Each year, a proportion of the cost of each asset is charged to your profit and loss account – this is what called “depreciation”. Effectively, this spreads the cost of the capital expenditure over several years of accounts.
There is a section in your balance sheet for assets. This shows the net amount of the asset. This is calculated as: the original price paid for each type of business asset that you have minus the accumulated depreciation has been charged to your profit and loss account. Accumulated depreciation is the total amount of depreciation charged over the years for each group of assets.
Straight Line Depreciation
Straight line depreciation means that an equal amount of depreciation is charged for each year of the asset’s useful life.
For example, say you purchased a piece of machinery for £10,000 and you expected it to last 4 years and the asset has no scrap value at the end of its life: The entire £10,000 would initially appear on your balance sheet as an asset. Each year, you would charge one quarter of £10,000 ie, £2,500 to your profit and loss account and reduce the amount on the balance sheet by the same amount, leaving £7,500 at the end of the first year.
This £2,500 is the annual depreciation amount and is a reflection of the “wearing out” (or wear and tear) of an item over its expected useful life.
In the second year, another £2,500 of depreciation is charged to your profit and loss account.
Your balance sheet asset would be £5,000 at the end of the second year.£10,000 for the original cost minus 2 x £2,500 for the 2 years of depreciation.
In the third year, another £2,500 of depreciation is charged to your profit and loss account and in the fourth year, a final £2,500 would be charged to your profit and loss account.
For items with a scrap value, you take this into account by not depreciating the full cost of the asset.
For example, if your £10,000 asset has a scrap value of £1,000 at the end of four years, then you would only depreciate £9,000 (£10,000-£1,000). The annual depreciation amount would be £9,000/4 = £2,250 every year for four years. After four years, the net value left would be £1,000.
Reducing Balance Depreciation
With reducing balance depreciation, the asset’s net balance is depreciated by a set rate every year.
For example, if the rate is 25% and the asset cost £10,000, the depreciation in year 1 is £2,500 (25% of £10,000) and the net value of the asset is £7,500.
In year 2, the depreciation is 25% of £7,500, which is £1,875, and the net value of the asset is £5,625 (£10,000 – £2,500 – £1,875)
In year 3, the depreciation is 25% of £5,625, which is £1,406.25 and the net value of the asset is £4,218.75 (£10,000 – £2,500 – £1,875 – £1,406.25)
In year 4, the depreciation is 25% of £4,218.75, which is £1,054.69 and the net value of the asset is £3,164.06 (£10,000 – £2,500 – £1,875 – £1,406.25 – £1,054.69)
Depreciation is NOT a tax deductible or allowable item for tax. So when you calculate your taxable profit, you have to literally “add back” the depreciation amount to the profit (or loss) figure from your accounts.
Instead of depreciation, you are potentially able to claim “capital allowances” for expenditure on “plant and machinery”Capital allowances are what you can claim against #tax instead of depreciation Click To Tweet
Annual Investment Allowance
You can deduct the full cost of the item up to the “annual investment allowance” for many items. The annual investment allowance has temporarily been increased to £1 million (between 1 January 2019 – 31 December 2020).
Annual Investment Allowance is a type of capital allowance where you are allowed to claim 100% of the cost of the asset.
Not all items are eligible for the annual investment allowance. Items that you cannot claim the annual investment allowance for:
- Items you owned before the business started, that were purchased/used for another reason
- Items given to you
Writing Down Allowance
You might be able to claim “Writing Down Allowance” for these items instead. This is a percentage of the item’s value. (Usually, the value is the price you paid for it unless you already owned it or it was a gift – in these cases, you would use the market value instead of the price paid)
The market value is what you would expect to sell it for to an “unconnected” person (ie to someone that you are not related to)
Unfortunately, it is not quite as simple as that because you have to “pool” assets (that aren’t eligible for Annual Investment Allowance) together and then work out the Writing Down Allowance for the whole pool.
If you have different assets that qualify for different rates (percentages) of Writing Down Allowance, you will need a different pool for each different rate. This is so that you can apply the 20% rate to one pool of assets and 6% to another pool, for example.
First Year Allowances
There are also “First Year Allowances” which can be anything up to 100% of the asset’s cost. The idea behind this is to encourage businesses to invest in certain areas/technologies.
For business cars, the writing down allowance depends on the car’s CO2 emissions. Some cars are eligible for First Year Allowances.
Cars are able to be used for private use.
Motorcycles (bought from 6 April 2009) lorries, vans and trucks qualify for Annual Investment Allowance. There are lots of rules about what counts as a van (rather than a car) for tax purposes.
When You Can Claim Capital Allowances
You can claim capital allowances for the period in which buy the asset. This means that if you buy the asset on the last day of your accounting year, you can claim the capital allowances in that year’s tax return.
The profit that is in your accounts is not the same as your taxable profit.
When accountants talk about “add backs” these are literally the things (like depreciation) that are added back to the profit per the accounts to get to the taxable profit. These adjustments are common and are the reason why accounting profit and taxable profits are different.
So, in summary, capital expenditure is money spent on assets that last longer than one year. Depreciation is a spreading of that cost over several years. Capital allowances are what HMRC give instead of allowing depreciation as a tax-deduction.