Depreciation or capital allowances: Which should be tax deductible?
By Donald Drysdale for ICAS
27 August 2018
The suggestion that a tax deduction might be allowed for depreciation is not new, and Donald Drysdale has been looking at recent OTS reports on possibilities for reform.
The corporation tax computation
Back in July 2017, the Office of Tax Simplification (OTS) published a report on simplifying the corporation tax computation. Within that report, the subject to which it devoted most space was whether the tax treatment of capital expenditure ought to be reformed to align corporation tax more closely with accounting treatment.
Given the long-established distinction between ‘capital’ and ‘revenue’, depreciation charged in the accounts is not tax-deductible. For many years, relief for some capital costs of tangible fixed assets has been provided in accordance with differing rules and at a variety of rates by complex capital allowances legislation, clarified in numerous tribunal and court cases.
The OTS questioned whether capital allowances achieved their aim by relieving capital expenditure and supporting capital investment in a way that recognises the commercial reality under which businesses make decisions and prepare accounts and whether this might be accomplished more simply. The regime was criticised for the frequency of change, the scope of (and boundaries between) qualifying and non-qualifying assets, and the write-off rates.
Following that report, the OTS was charged with the task of exploring fully the potential impact of replacing capital allowances with accounts depreciation, looking at the impact on the Exchequer and on different industries and sectors. Questions to be addressed would include whether there would be noticeable national or regional impacts, how the impact might vary between companies of different sizes, and what the impact would be on unincorporated taxpayers.
The OTS was to consider whether accounts depreciation was a flexible concept and whether the role of judgement and the potential for changes in accounting standards might introduce unacceptable risk. It would address how accounting revaluations and impairments would be dealt with, what transitional mechanisms would be needed, how annual investment allowance (AIA) might best be accommodated into the system, and what the impacts on the UK’s international competitiveness might be.
Simplifying relief for fixed assets
This June the OTS published its report on simplifying tax relief for fixed assets.
The OTS has received many representations about the excessive complexities of the existing capital allowances regime. It admits that a depreciation-based approach has attractions, but considers that simply using the accounts figure would present many difficulties and require alterations to other parts of the tax system.
While the AIA is not perfectly simple, its existence means that the greatest difficulties with capital allowances are confined to around 30,000 of the largest taxpayers. Those businesses are best equipped to deal with the complexities of capital allowances and generally don’t support a change to using depreciation instead.
Even if such a change were to be made, the OTS believes that the fairest transition to a depreciation-based approach would take a long time to complete, during which the Exchequer would be exposed to revenue losses as a result of arbitrage risks.
Unsurprisingly, therefore, the OTS doesn’t recommend the use of depreciation now. However, it identifies two reasons why it can’t be dismissed. First, the challenges of using depreciation may be overcome while current problems with capital allowances remain unaddressed, making the use of depreciation more attractive. Second, if a more far-reaching simplification of the corporation tax computation were considered, perhaps for a subset of taxpayers such as very small companies, then it would be natural to consider using depreciation.
The OTS approach in detail
The June 2018 report establishes three broad principles:
- Reform should focus on areas which can positively impact the greatest number of taxpayers on the largest number of occasions; since 1.2 million businesses taxpayers have to calculate capital allowances, the use of depreciation instead has the potential to simplify compliance.
- Quick wins should be sought where opportunities arise. As an example, the scope of AIA might be widened to cover all assets used in a business (including assets presently excluded from the AIA such as cars, but still excluding land and dwellings). This would simplify calculations for 98% of those who calculate capital allowances – relieving them of the need to consider a raft of obscure distinctions as to what are and what are not qualifying assets.
- Difficult areas should be addressed only where the case for change is compelling; moving to a depreciation approach is challenging and the case for quick change is not compelling, so alternative possibilities for reform need to be considered.
While building on the earlier OTS work, the report includes new recommendations on simplifications which could be delivered in a cost-neutral way by adjusting other reliefs, though not without gainers and losers. Three possible approaches receive particular attention.
First, the scope of the AIA might be widened, as described above.
Second, the scope of capital allowances generally might be widened in a similar way to realise significant compliance benefits. This could be achieved by creating a new pool for new business assets (but not land or dwellings) which do not qualify under any of the existing provisions, to be written down at a prescribed rate.
Third, a more radical reform of the structure of capital allowances might be considered, leveraging information already used in accounts. This might provide an allowance for depreciation that would be as close as possible to the annual charge in the accounts, with a minimum of adjustments. In other words, not quite a full shift to using the accounts charge, but very close to it.
Conclusions
The OTS concludes that depreciation should not replace capital allowances and no further work should be done pursuing it at this time. However, it acknowledges that using depreciation instead remains an attractive idea in principle and that at some future point the problems which impede it now may be overcome.
The report identifies one change alone which could put a stop to interest in using depreciation: the radical simplification of capital allowances. In its absence, the use of depreciation will always be raised as a potential means of overcoming the shortcomings of the existing capital allowances regime.
The latest OTS report won’t necessarily satisfy those who would like to see depreciation deductible instead of capital allowances, as it may discourage the Government from early and substantive reforms. However, it seems unlikely to make the idea go away.
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