A Not So Capital Investment

The landfill tax rising by £8 a year and the aggregates levy jumping from £1.60 a tonne to £1.95 from 2008 are only two of the bitter pills for those in aggregates to swallow. While large firms are riding high small firms face greater taxation under the lure of a new £50,000 annual investment allowance for new plant expenditure. But says JCB Finance’s Nigel Greenaway, the allowances are not the bonanza they first appear.

On Wednesday 21 March the Chancellor of the Exchequer, Gordon Brown, announced what will probably be his last budget and there were some big surprises such as the reduction in the basic rate of income tax from 22% to 20% – even thought it came hand-in-hand with the abolition of the 10% band, in effect increasing it to 20%.

Nearly all of the cost of reducing the basic rate will be paid for by abolishing the 10% initial rate and the remainder is paid for by aligning the upper-earnings threshold for national insurance with the higher-rate band of income tax, leaving the Treasury better off by £340million overall. The net result is that taxpayers will be out of pocket.

For businesses this is a salutory lesson in making sure you read the small print before drawing any conclusions about the net benefit or otherwise of the Chancellor’s Budget announcements. And with the aggregates levy rising from £1.60 to £1.95 from next year and landfill tax jumping from £3 a year hikes to £8 (reaching £48 a tonne by 2010), the quarrying and recycling sectors have reason to be increasingly cautious.

Sleight of hand this time around includes the headline rate of corporation tax being cut to 28% from 30%, from April 2008. The Chancellor said the rate was the most competitive “in the G7 and other major economies”. Obviously he doesn’t see Europe as a major economy.

Across the 27 European countries the rate averages 25.8% which places the UK 7th highest and far higher than the 12.5% rate that businesses in Dublin enjoy. Another victim in the budget was the small business, which, like income tax payers, saw money given with one hand and taken away with the other.

The small firms’ rate of corporation tax will rise from 20% to 21% next year and then 22%. In reality, the small businesses who make up the majority of Corporation Tax payers in the UK will see an increase in their tax bills of 16%. Meanwhile, large companies with profits over £1million, will see a 4.8% reduction in their Corporation Tax bill.

Costing an estimated £820million to small businesses, the tax hike will in theory be fully offset by a new £50,000 annual investment allowance for expenditure on new plant and machinery from next April. The problem here is that HM Revenue & Customs has released scant information about it: “The detailed design and scope of this allowance will be the subject of consultation,” it said.

Some have interpreted this to mean that the first £50,000 of expenditure will be 100% allowable against tax, while others are awaiting the results of the consultation. The existing 50% first year allowances for investment in plant and machinery will last a further year to ease the transition.

But the real sting in the tail of the changes in the capital allowances system is the reduction in the Capital Allowance annual writing down allowance rate from 25% to 20%, also from 2008/09, for plant and equipment in the general pool.

This is unprecedented. In the 60-year history of capital allowances, there has never been a change to the main writing down allowance rate. First year allowance (FYA) rates have appeared, altered and gone again, but the main rate has, until now, remained constant.
Many businesses overestimate the perceived benefits of the FYAs and successive

Chancellors have milked this to the full when the reality is very different. In order to calculate the value of any monetary advantage gained you have to calculate the benefit of being able to write off the asset quicker in the first year.

If this benefit was then banked in a deposit account it would earn interest over a typical three-year replacement cycle. The whole argument hinges around time and money. The answers will be different depending on your business’ rate of taxation.

Let’s assume that an asset is purchased for £50,000 and that the highest rate of income tax is applied (40% for a partnership making high enough profits). This represents a best case scenario because the higher income tax rate presents the greatest opportunity for tax savings (see box).

The two different rates of writing down allowances are then applied and the net tax savings are calculated and placed in a deposit account earning 3% a year net of tax. It soon becomes clear that the net tax saving really only applies in the first year when the 50% v 25% FYA results in a tax saving of £10,000 compared to £5,000 – a net tax saving of £5,000.

In the second year this position is reversed because the 50% FYA results in a lower remaining balance of £25,000 which then has to be written off at the lower rate of 25%. Using the 25% annual writing down allowances from the outset results in a higher balance of £37,500 in the second year.

This means that there is no net saving in the 2nd and 3rd years when using the 50% FYA and this waters down the saving enjoyed in the first year. To cut a long story short, the net benefit of writing down the asset harder in the first year is an overall difference in tax savings of £2,813 or actual interest gained after tax over the period of £346.89. This represents a “massive” increase in profits of £346.89 over a three year period for a capital outlay of £50,000.

If the business is a small limited company making profits of £50,001-£300,000 it would be taxed at the lower rate of 20% from April last year so this saving would be watered down by half to £173.44. These represent the high and low taxation points so other businesses can pick their own tax rates that fall between these two points. The new lower 20% writing down allowances will reduce these savings further.

When the machine is sold, depending on its sale value compared with its tax written down value, either a tax charge or a balancing allowance is made. This will effectively negate any differences caused by using the different tax writing down allowances.

The key point to remember is that capital allowances only defer the payment of the tax. They do not reduce the total amount of tax payable over the working life of the asset. This is why the only net benefit earned is the deposit interest gained over the three-year period or the working life of the machine in the business.

Many would be shocked at just how small these interest gains are. If you have plant worth millions then these interest gains were worth having but from April 2008 the new £50,000 annual investment allowance for expenditure on new plant and machinery will make this whole argument academic.

In short, small businesses have suffered the double whammy of increased corporation tax coupled with a reduction in the ability to offset plant and machinery investment against tax. For larger companies renewing their plant on a regular basis, the smaller capital allowances are offset by lower corporation tax. It is easy to conclude who has been caught between a rock and a hard place.

The old capital allowance rules meant that cash buyers or users of loans or hire purchase would take eight years to write-off 90% of the value of their plant and equipment against tax. The new rules add two years to achieve the same 90% tax write-off.

Alternative methods of funding that can increase the speed of tax write-off, allowing 100% of the costs to be written off against taxable profits in as little as three years are contract hire and operating leases.

Nigel: 01889 594126