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Show your depreciation

Continuing with my theme of advising private limited companies established by the over-50s, the essence of the role of the financial adviser is to help these late starters to really focus on their objectives. The shorter the time available for the achievement of financial objectives, the smaller is the margin for error.

Broadly, the choices which exist with regard to the investment of corporate wealth are:

To retain funds in the company on deposit.

To retain funds in the company for investment.

To retain funds in the company to purchase equipment.

To distribute funds to owner/employees to spend or invest.

To invest funds on behalf of owner/employees in pensions or pension substitutes.

With any form of corporate investment, the adviser needs to take into account the possible loss of business assets taper relief if the trading status of the company is put at risk by the investment or if the company is seen to commence a business of holding investments.

When it comes to retaining funds for equipment purchase, it is essential that advisers are aware of the way in which capital expenditure is treated for tax purposes. This is especially so as the desire for tax saving may be so strong as to disproportionately influence the decision as to whether to invest in capital equipment. The investment case for a purchase of capital equipment must always be made first.

Let us remind ourselves of the tax/accounting position with regard to the purchase of capital equipment. In the accounts, an amount usually equal to 25 per cent of the value of the remaining (as yet unrelieved) capital expenditure will be deducted from profit in the profit and loss account and from the value of the capital equipment in the books.

This is known as depreciation. Simply put, it is a way of the accountants being prudent about keeping back some profit to provide eventually for the replacement of the capital in the profit and loss account. Assuming that the value of capital assets reduces, so a prudent view of the asset value of the company is shown in the balance sheet. Depreciation is not tax-deductible. When working out a company&#39s taxable profits, it is necessary to add back the amount of any depreciation for the year.

Capital expenditure may qualify for a capital allowance. This is a tax deduction in respect of otherwise unallowed capital expenditure. Often, the rate of capital allowance for tax purposes matches the rate of (in effect, cancels out) the added-back depreciation. Where depreciation is not matched by the tax allowance, it will be seen that the tax liability cannot be reconciled properly with the company&#39s accounting profits.

Most capital allowances (company cars are generally the exception) are calculated based on the unallowed expenditure pool for the year. The pool on which the allowance is given is, in effect, increased every time a qualifying purchase is made and reduced every time a capital asset is sold. A balancing allowance will be given if, on termination of the trade, there is an amount of unallowed expenditure. In these circumstances, the whole of the unallowed expenditure will be allowed. A balancing charge will be made if, on sale of all the assets in the pool, more allowances have been given than real depreciation has taken place.

There are special first-year capital allowances for plant and machinery. The rules apply to expenditure by small and medium-sized businesses on machinery and plant but not expenditure on machinery and plant for leasing, cars, sea-going ships and railway assets.

The general rule is that capital allowances are given on machinery and plant at 25 per cent a year on the reducing balance basis. This means that relief of 25 per cent of the cost is given for the year in which equipment is bought, 25 per cent of the balance remaining is given for the following year and so on. Currently, expenditure on machinery or plant by small and medium-sized businesses will qualify for a first-year allowance at 40 per cent. The enhanced rate will apply to the first year for which allowances are due. For subsequent years, allowances will be due on the balance remaining at 25 per cent.

Under the Companies Act, small or medium-sized businesses must satisfy two of the following conditions:

Turnover must not be more than £11.2m.

Assets must not be more than £5.6million.

There must be no more than 250 employees.

The business was defined as small or medium-sized in the previous year.

In the case of companies, the company must be small or medium-sized for the year in which expenditure is incurred to qualify for the enhanced rate. If the company is a member of a group, the group must be small or medium-sized.

The enhanced rate also applies to businesses carried on by individuals and partnerships made up of individuals, provided the business would qualify if it were carried on by a company.

A special enhanced rate applies for capital expenditure on information and communication technology incurred by small enterprises. This special first-year allowance in respect of expenditure by small businesses gives a 100 per cent first-year allowance for expenditure on computers and associated equipment.

Small for this purpose means that turnover must be less than £2.8m, assets must be less than £1.4m and the business must have fewer than 50 employees.

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