Tax & Capital Expenditure
Fred runs a small chain of high street launderettes: the business has an annual turnover of 6 million and assets of 4 million. The number of employees varies between 40-60 people during the year. Fred is planning a new venture: an environmentally friendly laundry service for working parents which he intends to house in a specially designed building. The project will use the latest technologies for rainwater harvesting, water conservation, solar powered lighting and energy efficient boilers. Other equipment including washing machines and drying racks (which may or may not be moveable) will be sourced from Fred's normal suppliers.
Fred expects to need numerous expensive consultants, who will advise on the most appropriate equipment, design the building and assist with the planning enquiry. You have been engaged as freds planning director, and he he shown you his draft of the business plan for the green laundry. You are surprised to see that Fred has shown 'nil' for all costs relating to the building, the specialist equipment and the professional fees. When pressed about this he explains that he thought that our tax system was designed to subsidise this kind of capital expenditure.
Structure: Introduction,Legal Rules and Authority
Fred has a chain of high street launderettes with an annual turnover of 6 million and assets of 4 million with number employees 40 to 60. The new venture involves environmentally friendly laundry service for working parents. This needs a specially designed building. The project will use the latest technologies for rainwater harvesting water conservation, solar powered lighting and energy efficient boilers. He plans to use existing suppliers to supply washing machines and drying racks fixed and movables.
A planning director is needed to plan and control the project which would involve seeking advice from different consultants. The business plan prepared by Fred shows nil costs for the building, specialist equipment and the professional fees under the a misconception that the tax system was designed to subsidise this kind of capital expenditure.
Fred's business could be classed as a small to medium size business considering the level of turnover which is (6million), assets (4 million) and number of employees (40-60). It is not clear from the question whether the building he is in the Enterprise Zone or not however assuming it is then it could qualify for 100% Capital Allowances on this building. Thereafter the annual allowance of 4 per cent would be available for this building and 25 per cent for plant and machinery.
At present the business plan does not take into account any costs relating to the building or its refurbishment costs. It needs to take into account the initial cost of the building plus the costs, which he is going to incur in converting it into an environmentally friendly launderette. This obviously means use of most water efficient and energy saving boilers and washing machines. The Inland Revenue has introduced various capital allowances schemes since 1997 to encourage investment by particular type of business and in particular type of assets. Although the capital expenditure itself would not be allowed as a deductible expense from his trading profits but the capital allowance can be deducted from the profits thus writing off the capital cost of the assets. Capital allowances take the place of depreciation, as depreciation is not an allowable deduction for the tax purposes. This must be taken into account while building up a business plan for his new venture.
Also the first year allowance would allow to set bigger proportion of the capital expenditure on assets which could be set against the trading profits of that period. This will free some of the vital cash flow needed for the first crucial months of the business when business is still in its infancy and not a lot of cash coming in.
The business plan must show the original cost of the building and plant and machinery with related cost added to it. The business plan must show the fees for the architects, consultants and other professionals. It should also take into account when it has to pay its customers and when it expects its customer to pay. This will also then show how much money has been injected in this new venture and whether the business is going to need any borrowing from the bank to fund all the planned special features to make the specially designed building workable.
It should also show how and when Fred expects business to start to breakeven and make profit. First few months are undoubtedly going to be loss making and it is more than likely that the venture would make a loss in the first year and the capital allowances will increase that loss if claimed in that year. However, the loss can be carried forward to subsequent years and set against the profits for those years.
With regard to washing machines and drying racks are treated as plant and machinery and eligible to claim First Year Allowance of 50% . Also the nature of business which Fred is claiming to be environmentally friendly then undoubtedly he will be using energy saving equipments. The Inland Revenue has started a scheme from 1 April 2001 whereby small and medium size businesses can claim 100 per cent First Year Allowances if they invest in energy saving plant and machinery. This scheme is referred to as the Enhanced Capital Allowances Scheme. The same rules apply if the business invests in water efficient plant and machinery. If the washing machines used in the business are water efficient, if Fred is marketing his business as environmentally friendly then he would have to use such as Boilers and Washing machines anyway, then these would qualify for 100 per cent First Year Allowance. The allowance is also given on water efficient / conserving machinery and equipment such as water meters, leakage detection equipments and efficient taps. Fred will be allowed to include other cost to it such as installation of various equipment in the launderette as well as costs of altering the building to install energy efficient equipment. Fred will have to claim the enhanced first year allowances in the same way as capital allowances through his corporation tax return forms.
First year allowances can be used to reduce the corporation tax by setting all the above allowances against the taxable profits. The reduction in the tax on trading profits will help Fred with his cash flow and fund the business. If the business does pay tax in the first year it would most definitely help to claim all these allowances specified above.
An Industrial building and equipments are classed as fixed assets. Equipments such as washing machines and drying racks treated as plant and machinery and will depreciate through wear and tear, building will appreciate provided it is maintained properly. A plant is defined as ' whatever apparatus is used by a business for carrying on his business, not his stock but includes all goods and chattels, fixed or moveable which is kept permanently for his business'.
Plant has a specific function within the business, but a building only provides a setting. Plant is moveable but building is immovable. Building includes mains services of water, electricity, gas and sewerage systems. Therefore when the building is being designed for this specific purpose then expenditure on the provision of mains services will be regarded as part of the cost of the buildings and will not qualify for capital allowances. The expenditure on apparatus to provide electrical light or power, hot water, central heating, alarm and sprinkler systems would qualify for capital allowance. Fred needs to consider the building regulation will have to be complied with which requires Fire regulations and Health and Safety Act.
An Architect, a builder and other related professionals need to be provided for in the business plan.
Fixed assets used in the business do depreciate due to wear and tear arising from their use however it is not an allowable deduction from the business's profits for income tax purposes. However, there are certain types of fixed assets which are eligible to claim relief in the form of capital allowances.
Capital expenditure is not deductible as day to day trading expenses from the revenue of the business however the taxable profits are then reduced by capital allowances. These capital allowances are only available on certain assets and governed by Capital Allowances Act 2001. These allowances are available to companies, sole traders and partnerships on plant and machinery and treated as day to day running expense of the business in the accounting period they are claimed.
In order to claim Capital Allowances on an expenditure incurred in buying an asset, that asset must be a qualifying asset. It is irrelevant how that purchase is funded, loan or bank overdraft; however interest on such funding is an allowable expense.
If the asset bought by the business qualifies for the capital allowance then it will be claimed in the form of 'Writing Down Allowances (WDA). WDA of up to 25% of qualifying expenditure in the first and subsequent years is available. A qualifying expenditure consists of original cost after any allowances already given. Theses allowances can be claimed in part or in full by sole traders and partners.
If a plant and machinery is bought by a small or medium size business during July 1998 to July 2000 then it would qualify for an enhanced first year writing down allowance of 40% of the cost provided the turnover of the business is not over 11.2 million, assets of the business are not more than 5.6 million and business has less than 250 employees.
The rates for Capital Allowances for 2004/2005 are 50% allowances can be claimed on the qualifying fixed assets bought by a small business. This allowance is available for the first year. Similarly, a medium sized business can claim 40% capital allowance in the first year on qualifying fixed assets. The Writing down Allowances are still at 25%.
When a business sells the asset which it no longer needs, there will be a balancing charge on the difference between the sale proceeds and the written down value. This usually equals to the amount of the actual depreciation. On the other hand if that fixed asset is sold for less than its current written down value then there will be a 'balancing allowance' which would be available as a way of granting relief. It should be noted that a balancing charge cannot be more than the amount of allowance given. Also if the business makes any profit on the sale of those assets then it would be liable to capital gains tax.
A 100% First Year's Allowance is available on expenditure by small companies on information and communication technology equipment in the four year period from 1 April 2000 to 31 March 2004. It is also available on car which electrically propelled or does not emit more than 120 gm CO2. The year in which a business ceases to trade no First Year Allowance or Written Down Allowances are given in that final period of account. Each asset is deemed to be sold on the date when the business stops trading.
It is possible for a business to make an election to treat an item as Short Life asset provided that the asset is disposed of within four years of the accounting period in which it was bought and a balancing charge or allowance is made on its disposal. In case of assets bought on Hire Purchase, these are treated as being purchased outright for the cash price. Therefore the buyer is eligible to claim the capital allowance on the cash price from the date when the agreement begins.
In a case of big companies such as Glaxo or Orange Plc they are likely to have several items of plant and machinery. Then allowances are given by reference to a 'pool' of expenditure. The reason for that is the assets in the pool are treated as one asset. If one asset in the pool has been sold then the sale proceeds of threat item is deducted from the written down value of the pool. Generally, this adjustment is known as 'balancing adjustment. This also allows to have smaller amount of capital allowances in later years. A balancing charge only arises if the assets in the pool are sold for more than the written down value of the whole pool.
There are two sources of the rules on what qualifies as plant and machinery. These rules help decide whether or not the plant in question is eligible for capital allowances. Statute gives list of items which does not qualify as plant but does not give a comprehensive list on what does qualify. Certain items such as thermal insulation and computer software are specifically defined as plant by statute. Also there is ample case law which illustrates how certain items have been accepted as plant.
Expenditure on a building as well as any asset which is incorporated in a building and therefore forms a part of that building does not qualify as expenditure on plant. Therefore walls, floors, mains services waste disposal systems are classified as buildings and not plant. On the other hand heating systems, lifts, sound insulation provided mainly to meet the particular requirements of the trade, partition walls, where movable and intended to be moved are classed as plant.
On a sale of a building, the vendor and the purchaser have an option to enter into a joint election to decide how they wish to split the sale proceeds between the building and its fixtures. The anti-avoidance rules set out in the Act ensure that the capital allowances are given on a fixture do not exceed the original cost of the fixture. In practice the sale is designed in such a way that majority of plant and machinery which is built on site or fixed to the factory floor is taken out to avoid the possibility of these becoming a part of a building rather than a plant. Also if the business has spent money on structures or on works which involves alteration of land then that expenditure does not qualify as expenditure on plant.
Capital allowances on assets are available in the year the asset is bought and also through out the period that asset is owned by the business.
As there is no statutory definition of plant and machinery, one has to look at the case laws to see how they are defined. But there are certain items whose expenditure are specifically allowed, for example, those incurred by traders complying with fire regulations, heat insulation in industrial buildings, meeting safety requirements for sports grounds. Under the Capital Allowances Act 2001 certain expenditure on buildings is not allowed to be treated as plant or machinery. However the Act does give a list of items of expenditure which is generally accepted as plant and machinery and therefore qualifies for the capital allowance.
The definition of plant posses a problem, because it is difficult to decide the 'apparatus' which is used in a business to carry out normal business activities and then distinguish it from the 'setting' in which it is carried on. It then follows that if an assets is such that it becomes part of the settings, then such an asset would not qualify for allowances unless such items of assets are treated as part of the building itself and not as plant, for example, if the asset in question is an industrial building. The Act gives some lee way for a business for which atmosphere or ambience is important then the expenditure could qualify for capital allowance. The expenditure on shop fronts, flooring and suspended ceilings does not qualify for capital allowance. However, lifts and central systems are treated as plant, but basic electricity and plumbing systems are not.
If an asset is used for private purpose by a sole trader or by a partner in a business then that asset is treated as a single asset pool. Application of this rule is not extended to cover the directors of family companies. In a capital gains tax calculation, capital allowances are not deducted from the cost of an asset but it is taken into consideration while calculating capital loss.
Case Law - Advantages of Capital Allowances
- Capital expenditure is not deductible as day to day trading expenses from the taxable profits of the business however the taxable profits are then reduced by capital allowances
- In the first year of a new business when money coming in to the business is limited, a 100 per cent capital allowance helps with the cash flow to fund the business
- Capital allowances can be used to create a loss and then can be carried forward to set against the profits in the subsequent years. This is particularly helpful especially when there are no profits to set the loss against and therefore effectively wasting it.
- Capital allowances help to reduce the tax bill so that the money saved can then be used reinvest in the business
Disadvantages of Capital Allowance
- Unlike depreciation, a capital allowance is not deductible every month and therefore a business has to wait until the end of the year to use these allowances against the profit for the year
- 100 per cent allowance is only available in the first year and only on certain specific items and if the equipment needed for the business is not on the Inland Revenue's list then it does not qualify for the allowance
- The annual capital allowance either on industrial building or plant and machinery are claimed on straight line or reducing balance method as required by the Inland Revenue and the business does not have a choice of method.
The following case law analysis shows how courts to define plant for capital allowances
In a recent case Alan Shove (HMIT) v Lingfieldpark 1991 Limited An artificial race track was installed at the race track which was held to be part of the main premises and therefore did not comply with the requirements of section 24 of the Capital Allowances Act 1990. Similarly, in Fred's business specific design which would become part of the building would not qualify for the capital allowances.
In Yarmouth v France plant referred to a horse and defined as 'whatever apparatus is used by a businessman for carrying on his business: not his stock in trade which he buys or makes for sale; but all goods and chattels, fixed or movable, live or dead, which he keeps for permanent employment in the business' by L J Lindley. However, the washing machines which are not his stock in trade and drying racks which are fixed which he is going to use permanently in his business would be treated as plant and therefore qualify for capital allowance.
A Function test was applied in later cases which made a distinction between those plant which were actively used in business (qualifying) and those setting in which the business was carried on (non-qualifying).
In the Schofield v R & H Hall case, the cost of a concrete grain silos was allowed because apart from storing grain they were designed to make the process of unloading and distribution more efficient. The cost of making building more energy and water efficient would qualify for enhanced capital allowance under the Inland Revenue's scheme.
In Munby v Furlong case, a barrister was allowed the cost of his textbooks in his law library. His argument was that, plant includes tools of trade which are used everyday in the course of their profession. It is not just confined to physical things. His argument was upheld.
In IRC v Barclay Curle & Co Limited the cost of dry dock was held to be plant. It was considered to be an apparatus for carrying on the business and not premises in which the business was carried on. However in Benson v Yard Arm Club Limited a ship owner used his ship as a floating restaurant which did not qualify for capital allowance. He argued that it should be treated as plant because the ship was used to conduct the business from.
In Jarrold v John Good & Sons Ltd movable office partitioning was allowed because it was not regarded as part of the setting in which the business was carried on.
It was held in St John's School v Ward that prefabricated building were not regarded as plant for school because the structures did not form an active part of the trade but it only acted as a shelter.
In Dixon v Fitch's Garages Ltd the taxpayer claimed that a concrete canopy over a petrol service station was a plant. However, it was considered to be part of the setting in which the trade was being done and therefore rejected.
In Brown v Burnley Football and Athletic Co Ltd it was held that a football club's spectator stand was not considered to be a plant as it did not perform any function in the actual carrying out of the club's trade.
In CIR v Scottish and Newcastle Breweries Ltd , light fittings, décor and murals in licensed premises and hotels were held as plant. These items created an atmosphere conducive to the comfort and well being of the customers.
On the other hand in Wimpy International Ltd v Warland the company owned and managed a chain of fast food restaurants and wanted to claim capital allowances in respect of a number of items of expenditure.
The court held that in order to decide what is allowable and what is not it is important to apply two tests: the premises test and the business use test in this case. Accordingly, under the first test, those things which become part of the building cannot be considered as plant unless of course the premises themselves are plant. Therefore, an attractive floor provided in a restaurant which has a main purpose of making the restaurant attractive to its customers is not enough to make it a plant. It functions as premises and its cost does not, therefore, qualify for capital allowance. On the other hand, if we apply the second test to the items which are not part of the building then, it qualifies as a plant provided that item is used in the course of the business and is not part of business's stock in trade.
The light fittings are classed as general chattels and therefore these did not become part of the premises. In addition to this, it was held that the light fittings had a specific function which was unique to the trade as it was important to have certain volume of light in a fast food restaurant and therefore Wimpy being fast food restaurant it had a same importance.
In Cole Brothers Ltd v Phillips general lighting in a department store was distinguished from special display lighting and held that general lighting is not plant but it is merely a setting. However, special display lighting was held to qualify as a plant.
Leeds Permanent Building Society v Proctor had Free-standing decorative screens installed in the windows of their premises. The Inland Revenue allowed these as plant for capital allowances purposes. The reason was the main function of these decorative screens was to attract more customers and had nothing to do with the setting in which the society's business was carried on.
In Carr v Sayer it was held that a building which is built for a particular trade do not qualify as plant, hence quarantine kennels which were immovable did not qualify.
It was held vitally important what the taxpayer did, and not how he funded that transaction and bought those assets, so was the decision in Barclays Mercantile Business Finance Limited v John Mawson
The analysis and discussion of variety of case law demonstrates how Inland Revenue distinguishes what does and what does not qualify as plant. It seems obvious that if the asset is used in business on a day to day basis then it is more than likely to qualify as plant and hence would qualify for capital allowances. Inland Revenue have stated that expenditure on the provision of mains services to buildings such as electrical wiring, cold water piping and gas piping are part of the cost of the buildings and therefore qualify for capital allowances. Similarly, expenditure on apparatus and alterations to existing buildings which could be classed as incidental to the installation of plant or machinery also qualifies for capital allowances.
Fred will not have any problems claiming capital allowance on industrial building which is specifically designed for environmentally friendly launderette. The energy saving and water efficient equipment would qualify as plant for capital allowance. On the basis of case law it may be possible to add the cost of electrical wiring, cold water and gas piping etc to the cost as they would be apparatus which are used in the day to day activity of the business. It may be that the Inland Revenue would apply a function test to these items to see which ones qualify. The case law analysis shows that Fred would be allowed to claim capital allowance on light fittings and perhaps drying racks and all such other items which do not become part of the building because light fittings are chattels and not part of the building. The reason being they fulfilled the specific function of the business as drying racks and lighting are essential to the launderette.
- 1. BPP Study text 'Advanced Taxation (FAs 92)' pages 94 to 97
- 2. Tolleys Tax Guide by Arnold Homer and Rita Burrows published by Tolley pages 380 to 396
- 3. Business law by Scott Slorach and Jason Ellis published by Blackstone press pages 171 to 175
- 4. Lawtel. For Case law
- 5. Inland Revenue web site-www.inlandrevenue.gov.uk
- 6. page 33 to 38 The Taxation of unincorporated businesses, Tax planning ACCA open learning Resource book published by ACCA