Limited company contractors who invest in major company assets such as IT equipment and vehicles can benefit from tax breaks known as capital allowances, and certain assets qualify for a special type of capital allowance known as the Annual Investment Allowance (AIA).
AIA gives tax relief for expenditure all in year one, whereas normal capital allowances give a proportion of the cost of taxable profits each year.
“Capital allowances enable contractors to gain tax relief when they make a large purchase of an enduring asset, such as a computer,” explains James Abbott, owner and head of tax at contractor accountant Abbott Moore.
The AIA provides contractors with the full tax break in year one
“Normally, HMRC’s rules say that capital allowances are allocated at 18% on a reducing balance basis each year, but the AIA allows capital purchases to receive tax relief all in year one, up to a certain cap rather than on a drip-feed basis over several years.”
The most common purchases made by contractors and covered by the AIA include desktop PCs, laptops, tablets, smartphones, servers and office equipment and furniture. Cars are not covered by AIA but are covered by the normal capital allowances rules. However, commercial vehicles and motorbikes do qualify for the AIA.
“It is can also make good financial sense for some contractors to buy commercial vehicles that qualify for the AIA, which can significantly lower a contractor’s corporation tax bill,” adds Abbott.
Why does HMRC allow these capital allowances?
HMRC is not generally known for its generosity, but according to Abbott in a roundabout way the taxman still benefits from the arrangement: “HMRC allows contractor limited companies to benefit from tax relief on revenue expenses, such as stationery, services and the like – things that don’t last very long. The cost of these items is written-off against tax in the year that they are incurred.
Normally, HMRC's rules say that capital allowances are allocated at 18% on a reducing balance basis each year, but the AIA allows capital purchases to receive tax relief all in year one, up to a certain cap rather than on a drip-feed basis over several years
James Abbott, Abbott Moore
“Then contractors have so-called capital items with more of an enduring nature, such as computers, furniture and so on. These can’t be treated as expenses in a contractor limited company’s accounts all in one go. Accountancy rules say that you have to think about how long the asset is going to last and then write off the cost against profit over that period.”
The taxman knows that if tax relief was based purely on this principle of writing-off assets over their useful lives, then it is likely that business owners would ensure that most of their assets would not last very long to accelerate the tax relief.
The taxman and the government also know that they can use the tax system to incentivise the way businesses behave when they buy things.
“The conclusion was that there needs to be different rules for tax on capital items than the accounting rules on capital items allow,” continues Abbott. “That’s how the capital allowances regime, and the Annual Investment Allowance (AIA), came about.”
How the AIA works
By definition, as principally service businesses, contractor limited companies are not particularly capital intensive, and capital costs represent a small amount of the average contacting business’s costs.
“The low capital intensity of contractor businesses means that the vast majority of contractors will never get close to the allowance limit, so can write-off asset purchases against tax in the year that they are bought,” says Abbott.
“The AIA limit has fluctuated hugely, from £25,000 to its current level of £250,000, but either of these has been generally more than enough to allow 100% corporation tax relief in the year of purchase.”
What contractors will see in their end of year accounts prepared by their accountant is the value of the asset dropping by only a percentage of its purchase value. But the corporation tax return will show 100% of the purchase price as a capital allowance, if the asset qualifies for AIA.
Capital allowances can also apply to older pre-AIA purchases
According to Abbott, older assets that still need tax relief will normally be written off against tax at 18% (sometimes 8% in rare cases) per year: “Because AIA is relatively recent, some contractors may have older purchases that have not been fully written off against tax. They can use 18% of the pool that is left.”
Abbott provides an example: “Let’s say some years ago an IT contractor bought an expensive server and there is a balance of £1,500 of the purchase price left to claim against tax.
“The contractor’s accountant will take 18% of the balance, £270, to offset against corporation taxable profits. The remaining £1,230 will form the basis of the capital allowance claim the following year.”
And, to simplify matters, if the pool is worth less than £1,000, then it can all be written off against tax in one go, to save the hassle of calculating the 18% in ever -decreasing amounts.
Why only commercial vehicles, why not cars?
Although property is also not covered by capital allowances at all, capital allowances tend to apply to most other asset purchases. The AIA, where 100% is obtained in year one, applies to commercial vehicles but not most cars.
Abbott says that a common question he receives from contractors is whether the AIA can be used for cars: “It’s not that cars don’t qualify for capital allowances, just not the AIA and that means it can only write the cost against tax at 18 or 8% in most cases. The key point is that the vast majority of contractors don’t gain any tax or financial advantage from putting a car through their business – quite the opposite in most cases. For those contractors where a company car does make financial sense, leasing is generally the best option.”
Commercial vehicles are not cars and have a specific tax definition, which is that they have a one tonne payload.
But under certain circumstances Abbott says they may also be a viable option: “Contractors spending a lot of time on construction sites, or even those keen on outdoor pursuits, will find commercial vehicles such as extended cab pickups make financial sense and can utilise the AIA.”