What are capital allowances?

How do capital allowances work?

Ordinary running costs are deducted from profit in the year they are incurred. Capital items — things that last — are not. Instead the tax system gives you an allowance: a proportion of the cost, or all of it, that you can deduct in each year.

For most plant and machinery, which covers tools, computers, vans, furniture and fittings, the annual investment allowance lets you deduct the whole cost in the year you buy it, up to a limit set on gov.uk. Anything above the limit, and most cars, goes into a pool and is written down by a percentage each year.

The depreciation in your accounts is ignored for tax. It is replaced by the capital allowance figure, which is why the profit in the accounts and the taxable profit are rarely the same number.

A worked example

A decorator trading through a limited company buys a van for £14,000 in the year. Her profit before the purchase is £30,000. In the accounts the van is a fixed asset, depreciated over perhaps five years at £2,800 a year, so accounting profit is £27,200.

For corporation tax, the depreciation is added back and a capital allowance claimed instead. A van is plant and machinery and qualifies for the annual investment allowance, so the full £14,000 is deducted in year one. Taxable profit is £16,000.

In later years the van is still being depreciated in the accounts, but the tax relief has already been used. The accounts and the tax computation stay out of step until the van is sold or scrapped, at which point they settle up.

How do capital allowances differ from depreciation?

Depreciation is an accounting estimate of how much of an asset's value was used up in the year. You choose the method and the useful life. Capital allowances are the tax rules for the same thing, and HMRC chooses the rate.

Both spread the cost of an asset over time; they simply do it at different speeds. In the accounts, you show the depreciation. On the tax return, you add it back and claim the allowance. Sole traders on the cash basis largely sidestep the whole area, because most equipment is simply deducted when paid for, with cars the main exception.