How to Reduce Your Taxes Using Capital Allowance?
Do you want to know how to lower the taxes that your business pays? One of the ways to do this is by claiming Capital Allowances. Capital allowance is essentially ‘depreciation’ of assets, but for tax purposes. In any typical business, there are generally two types of expenses –
- Operational expenses: routine costs that a company frequently incurs, such as advertising costs and server subscriptions. These expenses are usually used for a shorter period of time.
- Depreciation/amortisation expenses: deductions that gradually reduce the value of assets over the period that the business uses the assets for (usually longer than 1 year). For instance, if you buy a car for your business, you can depreciate the total value of the car over the years that you use it for by recognising a depreciation expense each year for a portion of the total value.
Depreciation is not based on cash flow, so the methods that businesses use to depreciate their assets for accounting purposes can be ambiguous at times. Therefore, for tax reporting, Capital Allowance is used to standardize the way that businesses depreciate their assets. As you probably know by now, the HMRC has little sense of humour when it comes to dealing with ambiguity in tax filings.
How Do You Claim Capital Allowances?
Capital allowance is claimed when filing your tax return. If you are a sole trader, then you can claim capital allowances on your Self Assessment tax return. If you are a partner in a partnership, then you can claim capital allowances on your partnership tax return. If you are filing taxes for a limited company, then you can claim capital allowances on your company tax return. The total capital allowances that you claim will then be deducted from your profits before tax, which reduces the total profits that you have to pay tax on.
For example, if you claim total capital allowances of £4,000 for the year, and your total profits before tax is £10,000. Then, the capital allowances will be deducted from total profits before tax, so that you will only have to pay tax on £6,000 of total taxable income.
What Can You Claim Capital Allowances On?
The general rule is that you can claim capital allowances on most fixed assets that you own and use in your business. Per HMRC rules, you can claim capital allowances on assets that you keep to use in your business, known as ‘plant and machinery’, which includes:
- Equipment: such as computers that you use for your business, office furniture and equipment (i.e. printers, scanners)
- Machinery: such as manufacturing machinery/equipment used in your business
- Business vehicles: such as cars used for your business, trucks (i.e. food trucks), vans (i.e. moving company vans, promotion vans)
The HMRC is strict about what you CANNOT claim capital allowances on, these include:
- Assets leased/rented, because you must own the asset in order to claim tax deductions on it
- Land and structures
- Items used only for business entertainment (e.g. a yacht)
If you are unsure, you can find a complete list of items that you can claim capital allowances on here.
The value of the asset is how much you paid for it. If you owned the item before you started using it in your business or it was a gift, then you should use market value as the value of the asset instead. Market value is the price that the asset would be sold on the market for at the time when you acquired it into your business.
When you claim capital allowances on assets, you will need to put them into asset pools. I will explain in the next section what types of asset pools there are. Think of asset pools as a way to categorise the assets into groups, so that you don’t have to calculate capital allowances for every asset individually. Also, it will be easier for you to track the remaining asset balances after deducting capital allowances.
Types of Capital Allowances
There are several different types of capital allowances that you can claim:
1) Annual Investment Allowance (AIA) — 100%
You can claim 100% of the cost of plant and machinery in the first year that you purchase it, up to a limit of £200,000. This is the current limit for 12-month periods from 1 January 2016. If your accounting period is less/more than 12 months, you will need to pro-rate the AIA limit. For example, if your accounting period is 9 months, then you can claim AIA up to £150,000 (£200,000/12 x 9).
Note: the AIA limit may change each year, this is the most current one from 1 January 2016. You should check the HMRC website whether the amount has changed since then.
You can claim AIA on most plant and machinery, EXCEPT for:
- Items owned before you started using them in your business
You can claim writing down allowances on these items instead.
You can only claim AIA in the period you bought the asset. This is either: a) when you signed the contract, if payment is due within less than 4 months, or b) when payment is due, if it’s due more than 4 months later.
AIA can only be claimed in the first year you bought the asset; it can’t be used later on. For most startups, because the business may be loss-making in the first few years of operating, business owners may not think it’s important to claim capital allowances, as it will only increase their tax loss. However, tax loss can be carried forward to offset against taxable income in the future, so you should still try to claim capital allowances in the current year.
2) First Year Allowance — 100%
Similar to the AIA, you can claim 100% of the cost of certain assets in the first year you bought them. The GOOD NEWS is that you can claim first year allowances in addition to AIA, they don’t count towards the £200,000 AIA limit.
You can claim ‘enhanced capital allowances’, which is a type of first year allowance for certain energy and water efficient assets:
- Cars with low CO2 emissions
- Energy saving equipment that’s on the energy technology product list
- Water saving equipment that’s on the water efficient technologies product list
- Plant and machinery for gas refueling stations
- Gas, biogas and hydrogen refueling equipment
- New zero-emission goods vehicles
Normally, you can’t claim first year allowances on items your business bought to lease out to other clients or for use in a property that you let out.
3) Writing Down Allowances — 8% or 18%
Writing down allowance is the most commonly used type of capital allowance. It can be used if you have claimed the maximum AIA (£200,000) for the year and want to claim more, or if you want to claim capital allowance on items that don’t qualify for AIA (e.g. cars). Under this type of capital allowance, you can deduct a % of total cost of the asset for each tax year going forward, until you fully reduce the value of the asset to £0.
For example, you bought a car for £10,000. In the first year when you purchased the car, you can claim 18% of the total cost as a writing down allowance:
Writing down value = £10,000
Writing down allowance = £1,800 (£10,000 x 18%)
Writing down value carried forward to next year = £8,200 (£10,000 — £1,800)
You can continue to reduce the total value of the car each year by claiming writing down allowance of 18% on the remaining writing down value carried forward, until the value reduces to £0.
The % used for the writing down allowance depends on the type of asset and the asset pool. There are 3 types of asset pools: a) Main pool with 18% rate; b) Special rate pool with 8% rate; and c) Single asset pools with 18% or 8% rate depending on the asset.
a) Main rate pool — 18%
This is the most commonly used type of pool. You can include all plant and machinery in this pool, unless they are included in the other two types of pools.
b) Special rate pool — 8%
You can claim 8% on:
- Integral parts of a building
- Items with a long life: usually items with a useful life of at least 25 years qualifies for this category
- Thermal insulation of buildings
- Cars with CO2 emissions more than 130g/km
Except for cars, you can already claim AIA on the other items listed above. Therefore, you should only claim writing down allowance on those items if you have already exceeded the AIA limit.
If the total remaining balance in your special rate pool is £1,000 or less, then you can apply the small pools allowance to claim the entire remaining amount.
For assets that you partially use outside of your business, you need to first calculate what the total capital allowance is, then reduce the capital allowance by the amount you use outside of the business. For instance, using the same example as above for the car purchased, if you use the car 30% of the time for personal use, then you have to reduce the total writing down allowance by the personal use portion. Therefore, the total writing down allowance you can claim on the car is £1,800 x 70% = £1,260.
c) Single asset pools — 18% or 8%
You may need to create separate pool(s) for single assets that:
- have a short life
- used partially outside of your business
- cars (each car needs to be put into a separate single asset pool)
You can decide whether you want to treat something as a short life asset. You can move the balance into the main rate pool in the next accounting period/tax year if you are still using the item after 8 years. For assets that you use partially outside of your business, usually the HMRC prefers that you put it into a separate asset pool for better tracking.
Note: make sure that you tell the HMRC if you decide to create a short life asset pool for a limited company. You can communicate this on your tax return. You must do this within 2 years of end of tax year when you bought the item.
If you are a sole trader or partner, let the HMRC know in writing. You should include how much the item cost and when you acquired it in the letter. The deadline is the online filing deadline (31 Jan) for the tax year after the one you bought the item in.
Disposal of an Asset
What happens when you sell the assets that you claimed capital allowances on? The HMRC considers that you have ‘disposed’ of an asset if you:
- Sold it
- Gave it away as a gift or transferred it to another party
- Swapped it for another item
- Got compensated for it (i.e. received insurance payout for it)
- No longer use it in your business
- Started to use it outside of your business
You need to first determine how much you sold it for. The value is usually how much the sale price was. If you didn’t sell it or sold it for less than what it was worth to a connected party, then you will need to use market value as the disposal value.
If disposal value is exceeds asset pool balance
If you claimed 100% of the original asset cost under AIA/first year allowance or if the disposal value exceeds the total remaining balance in the asset pool, then you need to add the difference to your company’s profits in the tax return. This is called a ‘balancing charge’.
Note: if you sell an asset for a price higher than the original purchase cost, you can only use the original purchase cost as the disposal value.
Example 1: you claimed 100% AIA on a computer that you purchased for £3,000 originally. A few years later, you sold the computer for £1,000. Since there is no remaining value in the asset pool that this computer is in, the total disposal value of the asset (£1,000) will be added to your business’ profits for the year in the tax return.
Example 2: you claimed writing down allowance on a car solely used for your business that was purchased for £10,000 originally. You have been claiming writing down allowances of 18% on the car every year for two years. In the third year, you sell the car for £15,000. At this time, the remaining balance in the asset pool (assuming the car is the only asset in the pool) is £6,724. You should deduct the original purchase price of the car (£10,000, because the sale price is higher than purchase price) from the remaining asset pool balance (£6,724), the difference is a negative balance of -£3,276. You will then need to add the difference of £3,276 to your company’s profits in the tax return.
If disposal value is below asset pool balance
If the disposal value is lower than the remaining balance in the asset pool where the asset disposed of was included, you can continue to claim writing down allowances on the amount remaining after the disposal.
For example, you sold a car for £3,000, the car was originally purchased for £10,000. You have been claiming writing down allowance of 18% on the car every year for two years. In the third year, when you sold the car, the remaining balance in the asset pool is £6,724. You should deduct the sale price of the car (£3,000) from the remaining asset pool balance (£6,724). The difference is a positive balance of £3,724. You can then continue to deduct 18% of the writing down allowance carried forward value of £3,724 for every tax year going forward, until you reduce the value to £0.
To find out more about capital allowances, check out gov.uk website for more information.