Capital Allowances
Navigating the intricate landscape of self-employment is no easy feat, especially for contractors. Amidst the myriad of regulations, one term stands out prominently: Limited Companies.
If understanding what you can and can’t expense wasn’t tricky enough, as a limited company director, you must also be aware of capital allowances. But what exactly are limited company capital allowances, and how do they work?
In this comprehensive guide, we delve deep into the heart of limited companies. Whether you’re an aspiring contractor or a seasoned veteran seeking clarity, this guide aims to empower you with the knowledge to make informed decisions.
What Are Capital Assets?
Most day-to-day expenses you incur running your business are typically offset against profit, reducing corporation tax. Not all costs are allowable for tax purposes, though. Items that have a long-lasting benefit to the company are known as ‘capital assets’ (or ‘fixed assets’) and are accounted for differently.
‘Capital assets’ describes significant purchases used for an extended period (usually longer than a year) and not sold as part of your regular business operations. They can include equipment such as machinery, cars, vans, or even intangible items such as an expensive piece of software paid for upfront rather than by subscription.
The size of your business is a factor in determining whether an expense is defined as ‘capital’ or not. For smaller businesses, spending £750 on a computer could be a significant enough purchase to qualify it as a capital asset. For a larger company, this would usually be considered a regular expense.
Capital assets are treated differently from day-to-day expenses in terms of tax and accounting. Failure to treat them correctly may mean you pay more tax than is necessary.
Accounting For Capital Assets
Due to the long-term nature of capital assets, they go on the balance sheet, and the decrease in the value of these assets over time is known as depreciation. Depreciation can be thought of as an ongoing, regular expense. Every year, part of the asset’s value is deducted from your business’ profits.
Depreciation is an accounting concept that spreads the cost of the assets you purchase over the period you use them. HMRC does not consider it an allowable expense, so you have to add back any depreciation charges when calculating taxable profits. HMRC instead grants relief in the form of capital allowances.
What Are Capital Allowances?
Capital allowances provide tax relief for the reducing value of certain capital assets by writing off their costs against your business’ taxable income. There are several capital allowances, each with different rules regarding what relief you can claim:
i) Annual Investment Allowance (AIA)
The AIA provides tax relief on assets qualifying as plant and machinery (excluding cars). The total cost of qualifying assets is combined, and anything under the capped amount receives 100% tax relief as an immediate deduction against profits.
Any expenditure above the cap is added to the Writing Down Allowance.
ii) Writing Down Allowance (WDA)
Expenditure on assets that don’t qualify for AIA (either because it’s not plant and machinery or the AIA limit has already been met) gets grouped into different ‘pools’. The three types of pool are (i) Main Pool (with a rate of 18%), (ii) Special Rate Pool (with a rate of 6%), and (iii) Single Asset Pool (with a rate of 18% or 8% depending on the item).
Items are allocated to the Main Pool unless they are a particular type that should be added to the other two pools. HMRC offers guidance regarding how to work out which pool is correct.
Tax relief is provided on a reducing balance basis. The total costs of the pool are added together, and the reduction is then calculated using the relevant rate. This figure is then used to reduce profits for the year and reduce the value of the WDA pool.
iii) Enhanced Capital Allowance (ECA)
If you purchase an asset that qualifies for ECA (or ‘100% first-year allowance’), you can deduct the total cost from your profits before tax in the year of purchase. HMRC maintains a list of qualifying expenditures.
iv) Super-Deduction
To help the country recover from COVID-19, between 1 April 2021 and 31 March 2023, companies investing in qualifying assets could claim a 130% deduction in the year of expenditure without a maximum cap. As of 01 April 2023, this is no longer available.
Selling A Capital Asset
If you sell a capital asset during the year, you need to make various adjustments to the allowances you have claimed:
i) Balancing Allowance
The balancing allowance is calculated as the balance of the asset brought forward from the previous year minus the sale proceeds of the asset at the time of sale. As you have not claimed the total amount of the original capital allowance, corporation tax is reduced.
ii) Balancing Charge
If the sale price of the asset is greater than the residual value of the pool brought forward, a balancing charge is due. It increases corporation tax as you have received excess allowances on the original cost.
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Other maintenance costs, such as insurance, are allowable business expenses and can be used to offset corporation tax. Whether you buy or lease, you must ensure all documents are in your company’s name, and all payments go through the company’s bank account.
Other maintenance costs, such as insurance, are allowable business expenses and can be used to offset corporation tax. Whether you buy or lease, you must ensure all documents are in your company’s name, and all payments go through the company’s bank account.