What are capital allowances?
Capital allowances give tax savings for businesses, and property investors, that buy assets for longer-term use in the business. The tax savings from capital allowances are fully approved (so as long as they are properly claimed, they do not in any sense constitute tax avoidance or tax evasion) and are often extremely valuable.
Tax law distinguishes between:
- day-to-day costs (“revenue expenditure”) such as heat and light, employee salaries, stationery – all of which are simply written off in calculating the business profits; and
- expenditure (“capital expenditure”) on items that have a more enduring benefit, usually over several years – such as the cost of buying buildings, cars, machinery or computers.
Revenue expenditure is written off as it is incurred, so a person spending £10,000 on employee salaries will obtain immediate tax relief on that figure.
Capital expenditure cannot be deducted directly when working out the taxable profits, but tax relief is often available by way of capital allowances. Not all capital expenditure qualifies for capital allowances, however. For example, the cost of buying land does not usually qualify.
What different types of capital allowances are there?
The rules for all capital allowances are governed by legislation, including in particular the Capital Allowances Act 2001. This Act of Parliament, which is updated most years, contains completely separate regimes (with very different rules), depending on the nature of the capital expenditure.
The most common types of capital allowance are for expenditure on:
- plant or machinery (which is a very broad term, such that these allowances are relevant for nearly all businesses);
- certain commercial buildings and larger structures; and
- research and development.
One of the biggest difficulties in practice is to draw the line between expenditure on plant and machinery on the one hand, and on buildings on the other. This is because a significant part of the cost of any property (e.g. the lighting and water systems) will in fact constitute plant and machinery.
No capital allowances claim can be made until the expenditure has been accurately divided between the different categories. There are often grey areas, especially in relation to the definition of “plant or machinery”, and many dozens of cases have been argued out in the courts and tax tribunals, for well over a hundred years.
Who can claim capital allowances?
The rules vary according to the type of allowance. In general, however, capital allowances are available for businesses (sole traders, partnerships and limited companies) and for commercial property investors. Owners of holiday properties that qualify under the special tax rules for furnished holiday lettings can also claim.
Capital allowances are not usually available for residential properties, though communal parts of residential blocks may qualify in some circumstances.
What is plant or machinery?
Plant and machinery allowances (PMAs) are the most important type of capital allowance, giving immediate or longer term tax relief for the costs of plant and machinery.
It is usually fairly obvious if something is a machine, but the meaning of “plant” is much less clear cut. The most important distinction is between apparatus with which and the setting within which a business is carried on.
In practice, plant and machinery includes everything from cars and computers to lifts and escalators and to huge machines. Even some very large assets, such as grain stores, can be plant or machinery.
What are fixtures?
Accountants use the term “fixtures and fittings” quite loosely, but the law defines precisely what is meant by “fixtures” for capital allowances purposes.
In the capital allowances sense, fixtures are just one type of plant and machinery. More specifically, a fixture is an item of plant or machinery that is so installed in or to a building or land as to become legally part of that building or land.
So all fixtures are plant or machinery, but not all plant or machinery is a fixture. A car or a laptop computer is plant, but is not a fixture. A lift or radiator, once fitted into a property, is a fixture and is also plant or machinery. Plant and machinery allowances are in principle available for all of these items, but the rules for fixtures are more complex.
What are integral features?
The term “integral features” is used to define certain types of fixture, so integral features are a subset of the term “fixtures”. It follows that they are by definition plant or machinery.
The meaning of “integral features” is very specific. The term includes heating systems for both space and water; systems of ventilation, air cooling or air purification; floors and ceilings forming part of such systems; lighting and other electrical systems; cold water systems; lifts, escalators and moving walkways; and external solar shading.
Take the example of a hotel or care home:
- tables, chairs and beds are all plant or machinery, and PMAs can be given for the cost, but they are not fixtures or integral features;
- toilets, baths and showers are again plant and machinery, and they are also fixtures, but they are not integral features;
- the central heating system (boiler, pipework and radiators) are integral features; by definition, they are therefore fixtures, and in turn they are therefore plant and machinery.
The distinction between integral features and other fixtures can affect the timing of the available tax relief.
The distinction between fixtures and other plant and machinery is of even greater significance, especially in the context of buying or selling property, where very different rules apply to the transfer of fixtures.
What are embedded capital allowances (or embedded fixtures and features)?
Many sources refer to “embedded capital allowances”, “embedded fixtures” or “embedded features” within a property. At Six Forward, we don’t use these terms, as they do not have any legal definition and they can therefore cause confusion.
Some people will use “embedded fixtures” to denote any fixtures, whereas other people use the term to mean only integral features.
In practice, both “fixtures” and “integral features” have precise legal definitions, and it is much safer to use these correct terms than to confuse matters with terms such as “embedded fixtures” that have no such precise meanings.
What capital allowances are available when buying a property?
Plant and machinery allowances (PMAs) are particularly valuable for commercial (non-residential) properties. If a business is buying an office block, or a hotel or care home, or a pub or restaurant – or any other type of non-residential property – a big part of the cost will typically qualify for capital allowances as plant or machinery. These allowances are given for the fixtures (including the integral features) within the property.
The percentage of expenditure qualifying for capital allowances varies – depending both on the type of property and a range of other factors – but can be anything up to 40% or more of the cost of the property. So if a care home is being bought for £2million, it is possible that perhaps £800,000 will qualify as fixtures for which the buyer can claim PMAs. That could be worth as much as £360,000 in tax savings. And that is in addition to capital allowances for any non-fixtures that may be bought as part of the deal.
Capital allowances are not given more than once, so the vendor and purchaser of the property have to agree how to divide up the valuable tax relief in relation to the fixtures (and indeed to any other plant or machinery). This is a negotiation point, and the earlier the party to the transaction gets good advice, the better that party is likely to do. There are very particular hoops to jump through to protect the tax relief, and failing to deal with these properly can mean that the capital allowances tax savings are permanently lost to both parties.
How is tax relief given for capital allowances?
The method of giving tax relief is different for different types of capital allowances.
For plant and machinery allowances, relief may be given by way of annual investment allowances, first-year allowances, writing-down allowances, or sometimes balancing allowances.
What are annual investment allowances?
Annual investment allowances (AIAs) are one of the ways in which capital allowances are given for the cost of plant and machinery.
AIAs allow immediate tax relief for a certain level of expenditure, unlike writing-down allowances (see below), which require the tax relief to be spread out over many years. Some assets (e.g. cars) do not qualify for AIAs.
The government can, and often does, play around with the amount of AIAs that can be claimed at any given time. At the moment, AIAs can be given of up to £1 million per year. When the AIA limit is reduced, some very complex transitional rules apply, which can even have retrospective effect.
Related businesses have to share one amount of AIA. So a group of companies, for example, can normally only claim AIAs on one amount per year. However, it can split the single allowance between the different companies in any way it chooses.
Professional guidance is always needed if a business is claiming PMAs for high levels of expenditure.
What are first-year allowances?
First-year allowances (FYAs) are another mechanism for giving the allowances that are available for plant or machinery.
Like annual investment allowances, they give immediate tax relief, and (even better) there is no yearly cap on the amount that can be claimed. However, FYAs are given only to certain entities and for certain types of expenditure.
FYAs are generally available for cars or vans with zero emissions, for plant or machinery for gas refuelling stations and for electric vehicle charging points.
FYAs are given on a more restricted basis – only for limited companies – for expenditure at certain designated freeport sites and investment zones (special tax sites), and under the rules for “full expensing”.
Various general restrictions apply. There are also numerous specific restrictions. For example, the relief for special tax sites is not available to property investors.
To qualify for FYAs, the expenditure must be on assets that are acquired unused and not second-hand.
What are writing-down allowances?
Writing-down allowances (WDAs) are given when AIAs or FYAs are not available for the cost (or full cost) of the plant or machinery. The big difference is that FYAs and AIAs (up to the AIA limit) can allow immediate tax relief for the whole cost, whereas WDAs are given much more slowly.
WDAs are usually given either at 18% or (in certain specified cases) at just 6%. Most cars attract WDAs at the lower rate, which means that the tax relief lags a long way behind the true rate of depreciation.
WDAs are given on a reducing balance. So, for example, a business spends £10,000 on something that does not qualify for AIAs, but for which allowances are due at 18%. In the first year the allowance will be £1,800, leaving a balance of £8,200 to carry forward to the next year. Allowances in Year 2 will be £1,476 (18% of £8,200), and so on year by year.
In practice, most assets are merged together (“pooled”), and the pool grows as new assets are added, and reduces as allowances are given or as disposal proceeds are received.
What capital allowances issues arise when selling a property?
A person who has claimed plant and machinery allowances (PMAs) must take account of any subsequent disposal proceeds, and in some circumstances these proceeds will mean that a negative capital allowance, known as a balancing charge, is imposed on the seller. The effect of this is to create a higher tax charge for the seller.
Where a property is sold, this reversal of earlier tax relief can usually be avoided through the mechanism of a “fixtures election”, which allows capital allowances disposal proceeds to be set at a level agreed with the buyer. It is vital for a person contemplating the sale of a property to obtain early capital allowances advice to avoid a large and unnecessary tax bill.
Claiming PMAs does not result in a higher capital gains tax (CGT) or corporation tax (CT) liability on capital gains when the property is sold; the worst that can happen is that CGT or CT relief for capital losses may be restricted.
How do you claim capital allowances?
Capital allowances should be claimed as part of the tax computations that in turn form part of the annual tax return.
What are structures and buildings allowances?
Structures and buildings allowances (SBAs) are another type of capital allowance, totally separate from plant or machinery allowances. Different rules therefore apply.
SBAs are given for certain construction costs (including conversion and certain renovation costs) incurred from 29 October 2018 onwards. They are not available if the construction costs were incurred before that date, even if the property has been bought more recently.
SBAs are not given for the costs of land or of residential property. In the case of commercial property, the costs must be apportioned between those elements that qualify for PMAs, those that qualify for SBAs, and those (e.g. the land element) that do not qualify at all.
The concepts of AIAs, FYAs, WDAs, fixtures, etc. do not apply for SBA purposes. Instead, allowances are given at a flat rate of 3%, writing the qualifying costs off over a period of just over 33 years.
A person selling a property on which SBAs have been claimed will not suffer a balancing charge. Unlike the position with PMAs, however, the sale of a property can trigger a higher CGT or CT bill to the extent that SBAs have been claimed.
What are research and development allowances?
Research and development allowances (RDAs) are yet another type of capital allowance, totally separate from PMAs or SBAs. Again, therefore, the rules are very different.
RDAs (previously known as scientific research allowances) are given for qualifying expenditure on “research and development” (R&D). Defining R&D is therefore a crucial first step.
HMRC guidance makes it clear that expenditure on R&D can include expenditure on facilities or assets used by employees who are carrying on R&D. An employee’s car, for example, may qualify for full and immediate relief (which is much more generous than the relief under the plant and machinery regime). Dwellings are usually not able to qualify, though the rules here are less strict than for SBAs.
RDAs are available for traders only, not for professions or vocations. RDAs are given in full at the outset, so (once more) the concepts of AIAs, FYAs, WDAs, fixtures, integral features, etc. do not apply.
Where an asset on which RDAs have been claimed is sold, a balancing charge may arise.
Are there any other capital allowances?
Yes. The capital allowances described above are the ones most commonly seen in practice. In brief, however, the following types of capital allowance are also available:
Mineral extraction allowances
Typically for companies working in the oil industry, but may also be relevant for a business involved with extracting minerals such as gravel or sand.
A relief for income tax only (not corporation tax), for traders incurring qualifying expenditure on the acquisition of “know-how” (e.g. knowledge of industrial information or techniques).
Another relief for income tax only (not corporation tax), for traders incurring qualifying expenditure on the acquisition of “patent rights” (i.e. the right to do something that would otherwise be an infringement of a patent).
Available where a person carrying on a qualifying trade incurs qualifying expenditure on dredging. The concept of “qualifying trade” is widely drawn, including not only the maintenance or improvement of navigation, but also trades such as fishing, manufacturing, processing and storage.
Old capital allowances
The tax rules change quite often, and the following capital allowances are no longer available: industrial buildings allowances, agricultural buildings allowances, business premises renovation allowances, assured tenancy allowances, flat conversion allowances.
Are capital allowances high risk?
As long as a capital allowances claim is properly formulated, by professionals with a detailed understanding of the (sometimes complex) law, then the claim is wholly legitimate. With full disclosure of any grey areas, in a way that meets HMRC and case law guidelines, a capital allowances claim poses no greater risk than any other part of the business tax computations.
In reality, there are three main risk areas:
- If the capital allowances rules (the legislation and the extensive associated case law) are poorly understood, then a claim may be made where there is in reality no entitlement to the allowances. As HMRC can re-open business accounts up to 20 years later (if they make a “discovery”), this can create a long-term threat to the business, if it faces additional tax charges plus interest and penalties.
- On the other hand, no business in a competitive environment can afford to pay more tax than it has to, and the biggest commercial risk is to fail to claim valuable tax relief that is intended to be given. As long as entitlement to claim the capital allowances has been established, and as long as appropriate disclosure is made to HMRC, the business can be fully protected against future problems.
- Very particular issues arise when commercial property is being bought and sold. These issues make capital allowances a specialist topic, and the party that is being properly advised can have a huge advantage in terms of securing the available tax relief.
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