Looking at Capital Investment and Tax

The managers of companies have to make decisions all the time. Some of these decisions can be hugely beneficial for the company, but on the other hand some can bring a company to its knees.

For example, consider a manufacturing company that’s very plant-intensive, by which we mean one with lots of machines producing goods that eventually get sold on to their customer. Production often takes place 24 hours a day, seven days a week and the machinery used in the production process is often highly expensive and replaced on an infrequent basis.

Generally, companies are extremely careful about how much they spend on large amounts of machinery for three reasons. First, a company wants to obtain the best price for a machine, but second, it doesn’t want the machine to conk out a few months after it’s bought and installed; therefore, it needs to balance quality with cost.

Finally, and probably one of the most scrutinised things in the corporate world, there are the taxation benefits that the company obtains by buying the equipment. The timing of the purchase can be absolutely critical and result in the company optimising their tax benefits to the maximum, or losing out massively. As you’re probably aware, the UK government is very good at playing around with the tax system!

In financial accounting, capital expenditure appears in the profit and loss account by way of depreciation charges. Depreciation is the systematic writing off of the cost of an asset over its useful life. Management determines depreciation with a wide range of methods: for example, a company can write a machine off over three years, but write another machine off over 25 years.

Capital allowances are Her Majesty’s Revenue and Customs’ (HMRC’s) version of depreciation. For taxation purposes, capital expenditure is written off against taxable profits in a manner that’s prescribed by the government and enforced by HMRC. In the UK, the standard rate of capital allowances for plant and machinery costs for periods ending after 31 March 2012 is 18 per cent.

Sometimes, a company may decide to buy a machine that HMRC treats as eligible for enhanced capital allowances (capital allowances that are much greater than the standard rate, sometimes even as high as 100 per cent). This area is where the timing of the investment decision is crucial. Imagine that a manufacturing company decides to spend £80,000 on a new machine that qualifies for enhanced capital allowances.

In the UK, the maximum allowance available on qualifying machinery for accounting periods ending on or after 1 April 2010 but before 1 April 2012 was £100,000. For accounting periods ending on or after 1 April 2012 this figure was reduced significantly to £25,000. If the company with a 31 March 2012 year-end decides to buy the machine on 10 April 2012, it qualifies only for £25,000 worth of enhanced capital allowances instead of the maximum £100,000 if it had bought it before 1 April 2012.

This is an example of tax planning. A whole spectrum of tax strategy exists that ranges from tax planning (which is legitimate) through to tax avoidance (which people used to think of as being legitimate, but which now is undergoing a bit of a rethink) and tax evasion (which is certainly not OK).

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