Understanding the Difference Between Depreciation and Capital Allowances
Navigating the complexities of accounting and tax rules is crucial for businesses, particularly when it comes to capital expenditure. A key area where accounting and tax treatments diverge is in the write-off of capital assets.
Depreciation in Accounting
In accounting, depreciation is charged to spread the cost of an asset over its useful economic life. This might be done using methods such as a 33% reducing balance basis or a 25% straight line basis, depending on the asset.
Capital Allowances for Tax Purposes
For tax purposes, however, relief for capital expenditure comes in the form of capital allowances. The type and amount of capital allowances available vary depending on the nature of the asset.
Types of Capital Allowances
Annual Investment Allowance (AIA): This allows a 100% deduction in the year the expenditure is incurred, up to the £1 million AIA limit, applicable to qualifying plant and machinery expenses.
Writing Down Allowances: For expenses not covered by AIA, writing down allowances are provided at 18% for main rate expenses and 6% for special rate expenses.
Full Expensing for Companies: Companies can fully expense qualifying new plant and machinery, offering immediate relief for the total amount without a cap, unlike AIA.
50% First-Year Allowance: Available to companies for new qualifying assets that would otherwise qualify for special rate allowances, useful if the AIA limit is reached. This is available until 31 March 2026.
100% First-Year Allowance for New Zero Emission Cars: As expenditure on cars is not eligible for AIA, full expensing, or the 50% first-year allowance, this provides a valuable deduction.
Adjusting Profit for Tax Purposes
Due to these differences, adjustments are required to convert accounting profit into taxable profit. Depreciation must be added back, and capital allowances (or balancing charges) must be deducted from the accounting profit.
When AIA or full expensing is claimed, tax relief is realized sooner than it is for accounting purposes, leading to a lower taxable profit in the year of expenditure. However, in subsequent years, the accounting profit will be lower as depreciation continues but the capital allowances have already been claimed.
Consider A Ltd, a new company, which spends £200,000 on plant and machinery and claims the AIA. The company charges depreciation at 30% on a reducing balance basis. If the accounting profit is £350,000 after depreciation of £60,000, the taxable profit is adjusted to £210,000 by adding back the depreciation and deducting the capital allowance.
Understanding the distinction between depreciation and capital allowances is vital for accurate financial and tax planning. Businesses should be aware of the various allowances available and how they impact both accounting and taxable profits. For specific guidance tailored to your business, professional advice is recommended.
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