Revenue vs capital expenditure – Does it still matter?

When a business incurs high levels of expenditure on property or other assets, the question can arise of whether the expenditure should be:

• Written off in the profit and loss account, and claimed in full as a revenue deduction for tax purposes; or
• Capitalised in the accounts, with tax relief then claimed via the capital allowances regime.

The accounting and tax treatments usually but not invariably mirror one another.

The division between revenue and capital expenditure is often resolved by reference to cases from the 1930s (Bullcroft Main Collieries) and the 1950s (Samuel Jones & Co). Both concerned replacement industrial chimneys, and they reached opposing conclusions: one was held to be capital expenditure and the other revenue.

Does it still matter?

Many businesses can nowadays claim annual investment allowances to give immediate tax relief for capital expenditure. So it may be thought that HMRC are no longer interested in the distinction.

That is not the case! We were recently engaged to act after a client had written off refurbishment expenditure approaching £1 million to revenue. After extensive discussion, HMRC forced a reversal of that position, imposing penalties in the process. Capital allowances were then claimed to mitigate the damage, but correct treatment from the outset would have preserved the client-accountant relationship and avoided both penalties and a considerable amount of correspondence that nobody wanted to pay for.

If expenditure is capital in nature, but is claimed as a revenue deduction, that is an incorrect computation of profits. Given that high levels of revenue expenditure invariably attract questions from HMRC, trouble is almost inevitable. And as generous capital allowances are often available if everything is done properly, it is better from every possible angle to make a correct claim in the first place.

What do the tax rules actually say?

For income tax purposes, s. 33 of the Income Tax (Trading and Other Income) Act 2005 states that “in calculating the profits of a trade, no deduction is allowed for items of a capital nature”.

The identical rule for corporation tax is at s. 53 of the Corporation Tax Act 2009. The corporation tax regime also imposes a requirement to calculate profits in accordance with generally accepted accounting practice (s. 46), which in turn distinguishes between revenue and capital expenditure.

Of course, the distinction between revenue and capital expenditure is not always clear cut in practice.

Those chimney cases, considering predecessor versions of the current statutory rules, discussed the concept of the “entirety”. In Bullcroft Main, the judge said that “If you replace in entirety, it is having a new one and it is not repairing an old one”. So the cost of the chimney was held to be capital. In the later case, though, the cost was revenue in nature as the chimney was “physically, commercially and functionally an inseparable part of an ‘entirety’, which is the factory.”

Particular considerations can arise when an asset, such as a property, is bought in a dilapidated state, so money has to be spent to bring it up to scratch. Again, there is contrasting case law on this subject. One key test here is whether the asset in question can in fact be used to generate income before the work is carried out: if not, that is a strong indicator that the cost should be capitalised, being part of the cost of acquiring a usable asset in the first place.

The special rule for integral features

The capital allowances rules also add a complication of their own.

If a business incurs expenditure on replacing all or most of an integral feature, this is automatically treated as new capital expenditure, even if it would otherwise be treated as revenue expenditure. This rather complex rule is given in the Capital Allowances Act 2001, s. 33A and 33B, but the policy intent is clear. As HMRC state at CA 22340, the purpose is precisely “to prevent some businesses from seeking to claim that they have really incurred a revenue expense on a repair to a larger asset such as the building itself, in other words, that they have not incurred capital expenditure”.

The legislation here imposes a 50% test, so the rule applies where expenditure on an integral feature amounts to more than half of the cost of replacing the item in question at the time the expenditure is incurred. A related anti-avoidance provision prevents attempts to sidestep the restriction by spreading the expenditure over many months.

What is the solution?

The answer to all this is not difficult! The expenditure should be properly analysed, taking an overall view of the transaction, to see whether it is correctly treated as revenue or capital in nature. And where integral features are involved, attention should be paid to the specific capital allowances rules.

The good news is that a high percentage of capital expenditure on refurbishing a property is likely to qualify for capital allowances. The qualifying expenditure will have to be split between integral features and other fixtures, but annual investment allowances (AIAs) can be claimed on all of it, subject to the overriding limit of £1 million per year (s. 51A(5)).

At Six Forward, we engage with our accountant clients to discuss and assist with the distinction between revenue and capital expenditure. Where expenditure is properly treated as capital, or where the special rules for integral features do or may apply, we provide a full support service in preparing robust and fully defensible claims, greatly reducing the risk of problems with HMRC.