Capital Cost Allowance vs Depreciation Deduction From Profits. How Does It Differ?

mentorkeithmentorkeith Feels At HomePosts: 74Registered
Hi Everyone

I have just completed my Level 3 exams successfully and am now mulling over if I should immediately start studying for my level 4. I have been reading through this forum, giving help to those still struggling through their level 3. I noticed that "capital cost allowance" seems to come up often in discussion. I just now read up about it on:

http://www.hmrc.gov.uk/capital-allowances/basics.htm

However, it does seem to be discussing the tax relief on depreciation expenses. From my understanding, most expenses of a business are deducted as part of the taxable profits. Does that not include depreciation? If so, then surely if the taxable profits will be taxed at 20%, then depreciation (as part of that figure) effectively has already been given tax relief from that 20%.

Therefore, I ask, what is the difference from what I have described about depreciation tax relief and what HMRC describe about capital cost allowance. I am confused.

Can anybody explain the difference to me?

Thanks

Comments

  • CeeJaySixCeeJaySix Well-Known Posts: 645Registered
    In a nutshell:

    Capital allowances reduce the Corporation Tax/Income Tax liability when purchasing fixed assets (as these aren't included as an expense).

    Depreciation IS an expense and as you say, reduces your taxable profit. Capital allowances have no bearing there. Not sure if you mis-read the content of your link:
    The amount you can claim also won't usually be the same as the 'depreciation' in your commercial accounts, which is calculated differently and is not allowable for tax.

    I'm sure someone with more in-depth knowledge can give you more detail, but that's my understanding of it - any good?
  • SandyHoodSandyHood Font Of All Knowledge Posts: 2,034Registered, Moderator
    Mentorkeith

    You have found a single topic, but you need to understand a couple of stepping stones first.
    This is an area which requires a course of study but I hope I can address your point:
    1. Taxable profits and accounting profits are different
    2. To find taxable profit you deduct the tax depreciation (or capital allowance) figure from the operating profit (there are other differences from accounting profits) but accounting depreciation is not an allowable expense.
    3. Tax is then calculated on the profit after the capital allowances have been deducted.

    Tax depreciation is more commonly used in the states, the term capital (cost) allowance is more commonly used in the UK. Both mean the same thing.
    Sandy
    [email protected]
    www.sandyhood.com
  • mentorkeithmentorkeith Feels At Home Posts: 74Registered
    CeeJaySix wrote: »
    Depreciation IS an expense and as you say, reduces your taxable profit. Capital allowances have no bearing there. Not sure if you mis-read the content of your link:



    I'm sure someone with more in-depth knowledge can give you more detail, but that's my understanding of it - any good?

    Thanks for trying. The statement from HMRC is what confuses me:

    "The amount you can claim also won't usually be the same as the 'depreciation' in your commercial accounts, which is calculated differently and is not allowable for tax."

    I am confused because that doesn't clearly tell you in what way it is not the same, because it seems to me that the final result is exactly the same, unless capital cost allowance is at a different tax rate and shown separately after "tax on profits" has been deducted. Isn't depreciation tax relief part of that profit before tax figure?

    HMRC also state:
    "The aim is to give tax relief for the reduction in value of qualifying assets that you buy and own for business use by letting you write off their cost against the taxable income of your business"

    This is as related to capital cost allowance. Doesn't that sound the same to you as accounting for depreciation in the profits?
  • mentorkeithmentorkeith Feels At Home Posts: 74Registered
    SandyHood wrote: »
    Mentorkeith

    You have found a single topic, but you need to understand a couple of stepping stones first.
    This is an area which requires a course of study but I hope I can address your point:
    1. Taxable profits and accounting profits are different
    2. To find taxable profit you deduct the tax depreciation (or capital allowance) figure from the operating profit (there are other differences from accounting profits) but accounting depreciation is not an allowable expense.
    3. Tax is then calculated on the profit after the capital allowances have been deducted.

    Tax depreciation is more commonly used in the states, the term capital (cost) allowance is more commonly used in the UK. Both mean the same thing.

    Ahh, I should have waited a few minutes. That makes more sense. I will just re-word it to see if I understand what you have said.

    First we have Gross profit (or operating profit), then the other net expenses (expenses less income) are deducted to give us the profit for the year before capital cost allowance. Then the capital cost allowance (total allowable depreciation) is deducted to give us the profit before tax figure. Is that correct?
  • mentorkeithmentorkeith Feels At Home Posts: 74Registered
    Sandy

    I think I may still have it wrong. The best way that I learn is by looking at examples. Would you please show an example of how the capital cost allowance differs in tax relief from depreciation.

    For example, could you show me what it looks like on the income statement and then on the statement of financial position by using say "plant and machinery £100,000, accumulated depreciation £60,000 at £15000 per year. The profit for the year BEFORE depeciation (total of ALL depn for the year £40,000) was £1000,000. How would it all be listed and what would be the tax?
  • SandyHoodSandyHood Font Of All Knowledge Posts: 2,034Registered, Moderator
    The Income Statement and the Statement of Financial Position are not tax accounts.

    If your Income Statement States:

    Profit for the year (before tax) but after depreciation of £40,000: £1,000,000

    The tax authority then requires you to increase the reported profit by adding back the accounting depreciation.
    £1,000,000 + £40,000 = £1,040,000

    The tax authority may then allow say 25% capital allowance on capital assets based on the tax carrying value.

    If you have plant and machinery that originally cost £100,000 and this is the first year, then £25,000 would be the capital allowance for plant and machinery. You may have other assets, if I assume all of these have tax carrying values of nil (quite possible as many assets have 100% allowances in year 1) then your total capital allowance would be £25,000

    £1,040,000 - £25,000 = Taxable profit £1,015,000
    And if tax is 20% tax would be £203,000

    There is a lot more to tax. You will calculate the tax due, your value might be different to the tax authority so you have to adjust for this in the following year.
    Your assets have 2 carrying values, one for accounting treatment of depreciation, one for tax carrying values. This gives rise to deferred tax.

    And you have costs that the company will charge to the accounts which are not allowed for tax.
    Sandy
    [email protected]
    www.sandyhood.com
  • CeeJaySixCeeJaySix Well-Known Posts: 645Registered
    And this is where I learn to keep my mouth shut rather than trying to apply what I do know to what I don't! Thanks for correcting me Sandy, I had no idea that taxable profit was quite so different to 'regular' profit, I must admit a computer program does the tax comps for me which are then checked by the tax dept! I won't try to explain further my line of thinking in my original post as clearly I was barking up the wrong tree.

    I do learn more reading the MIP section than the study forums though, things make more sense in the real world even if they won't directly help me pass an exam - and it's a bit more interesting than 'forced' textbook examples.
  • mentorkeithmentorkeith Feels At Home Posts: 74Registered
    Thanks MentorSandy (mentor of higher level students), from mentorkeith (mentor of lower level students).

    This is very interesting. I have worked in financial accounting for 30 years but never touched corporation tax on profits. I am fully aware that there is a final "taxed" profit (after tax is deducted) which is then added to the capital funds, but never knew how it was calculated. The rules probably changes from year to year? How long has capital cost allowance been in operation? Over these 30 years has it always existed or am I right to believe that at one time depreciation was deducted from the profits before tax was calculated?

    Anyway, back to my questions. You state "tax carrying value". Is that different from Net Book Value of the Fixed asset? If it is the same then are we saying that the tax allowance of 25% £25,000 per year, gives us a different net book value to our carrying value after the depreciation of £15000 has been deducted, per year.

    In the scenario I mentioned it would mean a higher tax relief for that first year. Would it also mean that the tax carrying value would be £75000 for the second year as opposed to the depreciated NBV of £85000 (using £15000 for the depreciation method)?

    If so, eventually the machine (if scrapped at zero value) will be fully accounted for (as depreciation) as an expense of £100,000 and the same with capital cost allowance, ie the same tax overall (all comes out in the wash) although it may take a different time span. Is that correct? If so, then the total tax at 20% would eventually be the same for both methods once the item has reached a zero value, wouldn't it?

    Is this all covered in level 4 Business tax or are we discussing something at an even higher level? If it is covered at level 4, it is possible the book will not explain it as well as you do or as specifically as we are, here. Therefore, I would still be very grateful of a clear explanation; as (I am almost certain) would everybody else reading this.
    Thanks
  • coojeecoojee Experienced Mentor Posts: 794Registered
    Thanks MentorSandy of higher level, from mentorkeith of lower level students.

    This is very interesting. I have worked in financial accounting for 30 years but never touched tax on profit. I am fully aware that there is a final "taxed" profit after tax is deducted, but never knew how it was calculated. The rules probably changes from year to year? How long has capital cost allowance been in operation? Over these 30 years has it always existed or am I right to believe that at one time depreciation was deducted before tax was calculated?

    Anyway, back to my questions. You state "tax carrying value". Is that different from Net Book Value of the Fixed asset? If it is the same then are we saying that the tax allowance of 25% £25,000 per year, gives us a different value to our depn of £15000 per year. In the scenario I mentioned it would mean a higher tax relief for that first year. Would it also mean that the tax carrying value would be £75000 for the second year as opposed to the NBV of £85000 using £15000 for the depreciation method?

    If so, eventually the machine (if scrapped at zero value) will be fully accounted for (as depn) as an expense of £100,000 and the same with capital cost allowance, ie the same tax overall (all comes out in the wash) although it may take a different time span. Is that correct? If so, then the total tax at 20% would eventually be the same for both methods once the item has reached a zero value, wouldn't it?

    Is this all covered in level 4 or are we discussing something at a higher level?

    It's all covered in Level 4.
  • mentorkeithmentorkeith Feels At Home Posts: 74Registered
    Hi Coojee

    Thanks for replying. Would you please check my last comment again, because I have just made quite a lot of modifications. The quote you gave was BEFORE I made the changes. Most specifically:

    " Is this all covered in level 4 Business tax or are we discussing something at an even higher level? If it is covered at level 4, it is possible the book will not explain it as well as you do or as specifically as we are, here. Therefore, I would still be very grateful of a clear explanation; as (I am almost certain) would everybody else reading this."
  • SandyHoodSandyHood Font Of All Knowledge Posts: 2,034Registered, Moderator
    You state "tax carrying value". Is that different from Net Book Value of the Fixed asset?
    Yes

    You may be about to cause yourself more problems than you solve.
    There are stepping stones in the study of tax, if you jump in without these foundations you'll not necessarily understand the subject thoroughly.
    As you indicate, you can spend 30 years without any involvement in tax.

    I suggest that you modify your enthusiasm by looking at tax and the principles and build up from there, rather than picking the capital allowance v accounting depreciation and the two different carrying values of assets and working backwards.

    Most public libraries have tax books, Osborne BPP Kaplan and the Wiley Dummies series all have introductory books.

    You have awarded me a rather inflated title. I certainly encounter new topics from time to time. When I do I look for the "ladybird book" rather than anything too advanced. Ladybird used to produce brilliant children's books where explanations were clear and simple and clear and simple is what I need to get the gist. As far as I know, there isn't a Ladybird book of Tax!
    Sandy
    [email protected]
    www.sandyhood.com
  • coojeecoojee Experienced Mentor Posts: 794Registered
    SandyHood wrote: »
    Ladybird used to produce brilliant children's books where explanations were clear and simple[/i] and clear and simple is what I need to get the gist. As far as I know, there isn't a Ladybird book of Tax!

    I wish there was a Ladybird book of tax as well, what a great idea. Maybe you could write it Sandy ;-)
  • SandyHoodSandyHood Font Of All Knowledge Posts: 2,034Registered, Moderator
    Coojee
    I wish there was one already. It may be your turn?
    And now I have no shame! a plug for Management and Cost Accounting For Dummies
    According to the publishers it is out in July
    But the Guardian website has changed the publication date to September

    I had to update the Transfer Pricing chapter last weekend in the light of the G8 and the government plans, I hope that won't push the date back as far as September and miss the new college year.
    Sandy
    [email protected]
    www.sandyhood.com
  • coojeecoojee Experienced Mentor Posts: 794Registered
    SandyHood wrote: »
    Coojee
    I wish there was one already. It may be your turn?
    And now I have no shame! a plug for Management and Cost Accounting For Dummies
    According to the publishers it is out in July
    But the Guardian website has changed the publication date to September

    I had to update the Transfer Pricing chapter last weekend in the light of the G8 and the government plans, I hope that won't push the date back as far as September and miss the new college year.


    Noooo, tax is not my thing at all. I suffer it because I have to but that's as far as it goes.
  • mentorkeithmentorkeith Feels At Home Posts: 74Registered
    SandyHood wrote: »
    You state "tax carrying value". Is that different from Net Book Value of the Fixed asset?
    Yes

    You may be about to cause yourself more problems than you solve.
    There are stepping stones in the study of tax, if you jump in without these foundations you'll not necessarily understand the subject thoroughly.
    As you indicate, you can spend 30 years without any involvement in tax.

    I suggest that you modify your enthusiasm by looking at tax and the principles and build up from there, rather than picking the capital allowance v accounting depreciation and the two different carrying values of assets and working backwards.

    Most public libraries have tax books, Osborne BPP Kaplan and the Wiley Dummies series all have introductory books.

    You have awarded me a rather inflated title. I certainly encounter new topics from time to time. When I do I look for the "ladybird book" rather than anything too advanced. Ladybird used to produce brilliant children's books where explanations were clear and simple and clear and simple is what I need to get the gist. As far as I know, there isn't a Ladybird book of Tax!

    Hi Sandyhood

    I ask these questions because "business tax" is an option not compulsory for level 4. I would like to learn it, but am wondering if I have the acumen to understand it enough to pass the unit. This is why I am labouring it here (as a feeler) to test whether it is a unit I should take. If you can manage to explain the answers to my questions in a way that I can AT LEAST get somewhere nearer understanding it, then that tells me that I may be okay with the unit. However, if I cannot understand the "ladybird for dummies" explanation then maybe I should just accept that tax is not my specialty. What do you think.

    Therefore would you please suffer me one more time on these specific questions.

    Thanks
  • coojeecoojee Experienced Mentor Posts: 794Registered
    The basics of tax are that you have profit for accounting purposes and this gets adjusted to make taxable profits. So the profits in the accounts aren't the profits that are taxed. This is one of the reasons why the water companies (amongst others) are being harangued in the media. They've made profits in the accounts but because they've invested in infrastructure they've got 100% capital allowances which have wiped out their profits so there's no tax to pay. All the media see are the accounting profits so they're giving them grief about not paying tax.
  • BarryBarry Well-Known Posts: 101Registered
    Sandy

    I have put an order in for your book to help with my ACCA studies! I bought IFRS For Dummies book by Steve Collins and that was really good so I'm sure yours will be! You and Steve give such good advice on here :)

    Baz
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