Business Taxation, Understanding Revenue and Capital Expenditures - Essay Example

? Business Taxation Capital and revenue expenditure divide has been a major topic of discussion among business people, tax advisors, and judges for quite a long time. There is no simple test that can help decide on the issue in all the circumstances. At times, various judicial judgments lead to conflicting conclusions, too. The paper attempts to understand how complex or simple it is to segregate between revenue and capital expenditures in the given business circumstances and whether applying annual capital allowance (AIA) to the various classes of assets under the head ‘plant and machinery’ needs a great deal of understanding of the various statutes, legislation and numerous cases that clarify the treatment of expenditure. Understanding Revenue and Capital Expenditures Revenue expenditures such as rent of premises for conducting business, employee wages, raw materials and many such items are ongoing expenditures that are necessary to generate business profits. Revenue expenditure is also known as circulating capital that means capital changes hands to produce profit and loss. On the other hand, capital expenditures such as purchasing land or building, plant and machinery or goodwill form a long-term expenditure that accrue benefits until its useful life. The Statute ICTA88/S74 (1) (a) provides that only those expenditures are allowed for deductions that are "incurred wholly and exclusively for the purpose of trade" (BIM37035). However, capital expenditures are not allowed for deductions fully, and its treatment is governed by different statutes, as incorporated by the governing office from time to time. Capital Expenditures – Differential Treatment in GAAP and Income Tax It is important to note that accountancy and income tax laws are not fully in alignment as far as treatment of capital expenditure is concerned. It would be appropriate to know where accountancy and income tax laws differ in their consideration for capital expenditures as this is the major area which separates them in calculation of taxable profits. Depreciation is one of the areas where UK GAAP and income tax laws differ considerably (BIM35030). It should be noted that only those deductions are allowed that are clearly enumerated in the Taxes Acts; moreover, all deductions are restricted by statute ICTA88/S817 (1) while calculating taxable profits (BIM37020). All revenue expenditures are allowed for deduction to profit and loss statement. All capital expenditures are not allowed for deductions unless allowed by statute. For example, ITTOIA/S58 and S59 are the statues that allow deductions for the incidental costs incurred while raising a loan for business purposes (BIM45800, 2012). The statutes deal with the costs incurred while raising loans or issuing loan stock. These statutes do not provide relief for the costs incurred while raising finance through other methods such as bills of exchange, leasing assets, hire purchase, buying assets on credit or any form of equity financing. The incidental costs to obtain finance have been defined in ITTOIA/S58 (2). The allowable costs include commissions, fees, advertising, printing and related matters. It is required that the costs must be incurred, wholly and exclusively, for the purpose of acquiring or repaying the finance including its security. Some of the costs that are included under this statute can be described as per the following (BIM45815). a. Introduction fees, underwriting commissions, brokerage. b. Professional and legal expenses for negotiating the loan and getting the document ready. c. Valuer's fees, land registry fees incurred towards the security of the loan. d. Commitment fees. e. The costs of issuing a prospectus, postage, and the costs of advertising etc (BIM45815). Statute ITTOIA/S59 (1) provides that expenditure incurred while obtaining loan is not allowed for any deduction if it has provisions of conversion into shares or if any other securities or conversion takes place before three years from the date of loan obtaining (BIM45810). There are several deductions that require a specific mention. For example, legislation ICTA88/S401 deals with pre-trading business expenditures –expense that incurred before the start of a business (BIM46355). Statute ICTA88/S74 (1) (a) does not allow deduction of professional fees. The statute also provides that the circumstances and the nature of the services provided are important for ascertaining whether such deductions need to be allowed or not (BIM46405). Newth (2003) emphasises that repairing and maintenance are the most contentious heads of expenditure in any business. He brings forth the view "unless statute law and case law provides otherwise, then the accountancy treatment of an item is the tax treatment" (p. 2). This has more relevance with respect to expenditure pertaining to repairs. The philosophy has been accepted by the courts in the cases of Willingale v International Commercial Bank Ltd [1978] STC 75, Heather v P-E Consulting Group Ltd 48 TC 293 and Threlfall v Jones [1993] STC 537 (Newth, 2003). In the year 2001 and 2002, Special Commissioners heard the case of Transco plc v Dyall SpC 310. The company spent substantial sum on inserting polyethylene pipes into the cast iron pipes as the cast iron pipes were getting cracked and needed repairing. It is worth noting that the tribunal declared the expenditure as a revenue expenditure accepting the principle of commercial accountancy (Newth, 2003). Contrary to the above, the case of Auckland Gas Co Ltd v CIR [2000] STC 527 was decided against the company by the Privy Council not considering the expenditure as revenue though it involved a similar kind of work (Newth, 2003). Having gone through various statutes and case laws describing and differentiating revenue and capital expenditure, it is likely that many kinds of expenditures may get wrong identification (revenue in place of capital). For example, any expense on computer hardware, or fixtures and fittings towards repairs and renewals are included in IT costs and considered arevenue expenditure in the profit and loss account; however, their basic applicability reveals that these expenditures are of a capital nature and should not be treated as a revenue expenditure. In fact, a capital allowance claim can be made on these items (Capital v Revenue Expenditure Toolkit, 2012). Capital Allowances on Plant and Machinery It is important to note that capital allowance legislation does not clearly define plant and machinery. Any expenditure done on the items stated in S23 (2) is to be treated as a part of plant and machinery to apply capital allowance on thereof. The items include thermal insulation done in a building, expenditure on fire safety in buildings, expenditure on any safety measures due to a special kind of threat and many other items (CA21010). Investments or expenditures in machines, equipment, tools, furniture, fixtures fall in the category of plant and machinery, and they are eligible to deduct capital allowance while computing profit or loss figures. These are the long-term assets, and one cannot deduct the expenditure made on creating those assets while calculating the profit or loss in business. Instead, one can deduct capital allowance to arrive at correct profit or loss figures. This is applicable to everyone regardless of whether it is a proprietary business or a large organisation operating under the company's act (CA23081). Examples of the items that qualify as plant and machinery are: cars, vans, furniture, tools, computers, equipment, and machinery. It is important to note here that different assets attract different allowances. Further, certain fixtures or integral features in buildings do qualify for deduction as capital allowances. It is important to note that though one can claim capital allowance for most items of plant and machinery but in some of the circumstances, the allowance is not permitted because it is not considered as plant. The point is that matters are never so simple and straightforward, as evident from the case of Attwood vs. Anduff car Wash Limited (1997). Here the company claimed capital allowances on the full expenditure of each site be considered as a single item of plant. The Inland Revenue did not agree and rejected the claim and considered some of the facilities as plant but not the site in its entirety because part of the building was used to trade the business. There are certain qualifying rules for eligibility as plant and machinery allowances, and those can be listed as per the following. 1. It is necessary that all expenditure incurred as plant and machinery are done solely for the purpose of business, and the entity must own the said asset by virtue of incurring that expenditure. 2. The asset must last for more than two years and must not get used up in trading operations. 3. The asset is not treated as a circulating capital or a buying and selling transaction giving indication of a trade. Even if it is sold for some other reason, necessary adjustment to capital allowances is then necessary in the books. However, it is to be noted here that one cannot claim capital allowances on leased assets; however, it is possible to claim capital allowances on assets that are owned and leased to other users as business activity (CA23081). Annual Investment Allowance (AIA) Annual investment allowance is available against expenditure on most plant and machinery. Currently, it is capped at ?25,000 a year (CA23081). It should be noted that for expenditure on specific types of asset, a 100 percent first-year allowance is also available. The assets covered for first-year allowances are: a) New zero-emission vehicles, for example, electric vans. b) Specific energy-efficient equipment. c) Water efficient and environmentally beneficial equipment. d) Cars with emission levels of less than 110 grams of CO2 per kilometer. e) Also, equipments that are used for refueling of vehicles with biogas, natural gas, or hydrogen fuel. Writing-Down Allowances Writing-down allowances are available on those assets that one has not been able to claim either as a first-year allowance or as an annual investment allowance. Two kinds of rates are available as writing-down allowances for plant and machinery. Main Pool Items: Rates available for main pool of items (expenditure on most items) are 18 percent applicable from 6 April 2012. Special Rate Pool Items: The rate applicable to special rate pool items such as integral features, thermal insulation, long-life assets, and some cars is 8 percent from 6 April 2012. Entirety Issue and Capital Allowances Newth (2003) argues that even if the capital allowances have been granted on the asset, one can still claim a revenue deduction for a repair to that asset. The case of Samuel Jones & Co (Devondale) Ltd v CIR 32 TC 513 is worth mentioning here; the replacement of a chimney was taken in it as repairs and allowed as a revenue expenditure considering it as a part of entirety and not the entirety itself; however, contrary to above, in the case of O'Grady v Bullcroft Main Collieries Ltd 17 TC 93, a chimney replacement was considered in its entirety and not as repair because the chimney was separate from the main colliery (Newth, 2003). What can be deduced from above cases is that replacing same part is considered as repairing in one instance but altogether rejected in the other; it all depends upon the real facts of the case. This implies that it is not simple or straightforward every time to make a decision on the nature of expenditure from the tax point of view. Conclusion From the above, it is quite clear that ample numbers of legislations govern and define the capital expenditure and revenue expenditure. Many of them have been modified time to time. Though it may seem a simple common sense approach to distinguish between capital expenditure and revenue expenditure, it is a fact that there is no single simple test that can be employed to decipher between revenue and capital expenditure. This can be decided only after going through the facts that necessitated the expenditure in the given circumstances. Acquisition, improvement or alteration of assets is one such area where the grave risk is associated with the allocation of expenditure as revenue rather than capital. Business circumstances and the exact nature of trade usually decide whether the expenditure should be treated as revenue or capital. There can be ample evidence that the same item can be classified as trading stock (revenue expense) in one instance but as capital in another. Similarly, GAAP accounting practices take into account the depreciation rules applicable to plant and machinery to prepare for profit and loss statement; however, depreciation calculations are not allowed for income tax purposes while calculating profit and loss figures. Understanding capital allowances as applied to different classes of assets within the head of plant and machinery becomes, all the same, more important for computing correct profit or loss figures. In view of the continuous modification and changes in the rules, either through budgetary reforms or otherwise, one needs to keep abreast with the information and knowledge all the time. Jenny's contention is not acceptable in the sense that it is not straightforward and simple enough to determine the revenue versus capital expenditure in all the circumstances. Even one cannot take inference from the past court judgments as circumstances and nature of business keep on changing and one needs to delve into the actual business circumstances and nature of business to come to any firm conclusion. Moreover, what items constitute plant and machinery is a matter of detailed understanding and study and cannot be dismissed by a superfluous comment as made by Jenny while discussing the matter with her friend. Bibliography Attwood v Anduff Car Wash Ltd, CA (1997). ACCA. uk.accaglobal.com [Online] Available from: [Accessed 18 January 2013] BIM35030 - Capital/revenue divide: introduction: is distinction relevant today (n. d). hmrc.gov.uk. [Online] Available from: [Accessed 16 January 2013] BIM37020 - Wholly & exclusively: statutory background: legislative starting point (n. d). [Online] Available from: [Accessed 16 January 2013] BIM37035 - Wholly & exclusively: statutory background: the statutory prohibition (n. d). [Online] Available from: [Accessed 16 January 2013] BIM45800 - Specific deductions - incidental costs of loan finance: Contents (n. d). hmrc.gov.uk. [Online] Available from: [Accessed 16 January 2013] BIM45810 - Specific deductions - incidental costs of loan finance: Convertible loan or loan Stock (n. d). hmrc.gov.uk. [Online] Available from: [Accessed 16 January 2013] BIM45815 - Specific deductions - incidental costs of loan finance: Expenses allowable (n. d). hmrc.gov.uk. [Online] Available from: [Accessed 16 January 2013] BIM46355 - Specific deductions: pre-trading expenditure . hmrc.gov.uk. [Online] Available from: [Accessed 16 January 2013] BIM46405 - Specific deductions: professional fees: general principles (n. d). hmrc.gov.uk. [Online] Available from: [Accessed 16 January 2013] CA21010 - Plant and Machinery Allowances (PMA): meaning of plant and machinery: general approach to claims (n. d). hmrc.gov.uk. [Online] Available from: [Accessed 16 January 2013] CA23081 - PMA: Qualifying Expenditure: Annual Investment Allowance (AIA) qualifying expenditure: outline. Capital allowances on plant and machinery (n. d). hmrc.gov.uk. [Online] Available from: [Accessed 16 January 2013] Capital v Revenue Expenditure Toolkit. HM Revenue & Customs (n. d). hmrc.gov.uk. [Online] Available from: [Accessed 16 January 2013] Newth, J. T. (2003). Newthwire. accountingweb.co.uk. [Online] Available from: [Accessed 19 January 2013] Read More