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Enterprise Investment Scheme (EIS) for Companies

18 January 2021 by 1ndexate Leave a Comment

The Enterprise Investment Scheme (or EIS) is a tax incentive that helps companies to raise capital by offering tax relief to individual investors who buy new shares the company. The benefit of EIS to companies is that their shares are more attractive to investors because of the tax relief.

Under EIS, the company can raise up to £5 million per year, up to a total of £12 million (across all venture capital schemes, not just EIS) over the company’s lifetime. And the first investment under a venture capital scheme claim must be within 7 years of its first commercial sale.

There are different rules for knowledge-intensive companies that carry out a significant amount of research and development or innovation. (These rules are not covered in this post)

The company needs to follow the EIS rules for 3 years following investment for the investors to retain their tax relief. If the company does not follow the rules, the tax relief is withdrawn from the investors.

EIS Conditions for the Company.

The company cannot raise more than £12 million from a combination of EIS, VCT (Venture Capital Trusts), SEIS (Seed enterprise investment scheme), SITR (social investment tax relief)
EIS investment must be within 7 years of the company’s first commercial sale unless the company can show that it wants to raise money for a different activity or a new geographical market and the company is seeking at least 50% of the company’s average annual turnover for the last 5 years.
The company must not have more than £15million of gross assets and less than 250 full-time equivalent employees.
The company must carry out a qualifying trade.
The company must use the money for growth and development – to grow things like revenue, customers, employees.
The shares must be newly issued and paid for in cash.
The company has to have a way to accept payment before shares are issued.

“Risk to capital” condition.

The investment must meet the critical “risk to capital” condition – that there is a genuine risk that the investor will lose more capital than they are likely to gain as a net return (the net return includes dividends, interest, fees, capital growth and tax relief). HMRC will decline applications where it does not believe that there is a genuine risk to capital.

When looking at the “risk to capital”, HMRC will look at things like the company’s sources of income, assets, structure, use of subcontractors, marketing of the investment opportunity, relationship with other companies.

The shares must be full-risk ordinary shares, they must not be redeemable and they cannot carry special rights to a company’s assets if it closes down. Investors cannot have priority or protection over other investors.

Applying for EIS

An EIS1 application must be made either within 2 years of carrying out a qualifying business activity for 4 months or 2 years of the end of the tax year in which the shares were issued.

It is possible to apply for advance assurance, in advance of the investment being made but an EIS1 application must still be made after the shares have been issued.

Advance assurance might be a condition set by a company’s prospective investors. Allow at least 30 days (but preferably more) for advance assurance. Often it can be given in a quicker time-frame but there are peak times of the year where it can take longer.

If the EIS1 application is successful, HMRC will issue a form EIS2 which will contain a Unique Investment Reference (UIR) number for the particular share issue, to the company. The EIS2 authorises the company to issue the EIS3 forms to individual investors. (The company must not issue EIS3 forms without having received this authorisation.) The company must complete all the relevant information in the EIS3 form and then issue them to each investor (each EIS3 form is personal to each investor.)

The investors use the EIS3 to claim their tax relief as part of their personal self-assessment tax return – assuming that the investors themselves are eligible. Possession of an EIS3 certificate doesn’t automatically mean that an investor is eligible for tax relief. It isn’t the company’s responsibility to apply for the individual investor’s tax relief.

Enterprise Investment Scheme (EIS) for Companies (pin). Photo credit © L Rowe 2016

Enterprise Investment Scheme (EIS) for Investors

23 November 2020 by 1ndexate Leave a Comment

For those investing in new companies, perhaps as part of a Seed investment round, there are a number of tax schemes to make such investment more attractive to investors. One such scheme is the Enterprise Investment Scheme.

As part of the EIS, the investor receives income tax relief, personal capital gains tax relief, inheritance tax relief and there is also tax relief in the event of a loss.

Income Tax Relief

The income tax relief for the investors is that they can claim back up to 30% of the value of their investment in the form of income tax relief. For example, if you invest £1,000, then you can save £300 in income tax.

Capital gains relief

If the investor holds the shares for at least three years (or three years from trading, if the company didn’t start trading until after the shares were issued), then the shares are exempt from capital gains tax when the investor sells them – if the income tax relief wasn’t restricted (unless the only reason why it was restricted was because income tax was was reduced to zero)

And if the investor has made a capital gain on an asset and uses that gain to invest in EIS shares, then the Capital Gains Tax can be deferred (delayed) until the EIS shares are disposed of.

Loss Relief

If the company fails or performs poorly and the investor loses money on their investment, then they can claim loss relief on the amount lost.
For example, if the investor had invested £1000 and the shares are now worth nothing, the investor would have already received £300 in tax relief, leaving £700 of loss. If the investor pays income tax at 40% then they would claim 40% of £700 (which is £280), so the investors actual loss would only be £420. The loss relief can also be claimed in the previous tax year that the shares were sold/disposed of.

Inheritance Tax Relief

Investors can claim inheritance tax relief on EIS share purchases after 2 years. This does not apply to shares listed on a recognised stock exchange.

EIS Conditions

There is a maximum of £1,000,000 than any investor can invest in qualifying shares.
The shares must be held for at least three years. If they are held for less than 3 years, the tax relief can be clawed back (or withdrawn)
EIS tax relief cannot be carried forward but investors can treat some of their EIS shares as being purchased in the previous year (effectively “carrying back” the EIS income tax relief to the previous year), if they have not reached their limit for EIS shared purchased (which is £1,000,000 check this) An investor would do this if they had not reached the EIS limit in the previous tax year but expects to reach the limit in the current tax year.
The investor must be a UK taxpayer.
The investor (or their associates – generally relatives, business partners, cannot be connected to the EIS company (can’t be an employee, a partner, a paid director, hold more than 30% of the company’s shares, rights to assets if the company is wound-up, voting rights, loan capital for SITR.
The shares must be newly issued and paid for in cash.

“Risk to Capital” Condition

There must be genuine “risk to capital” – the EIS scheme must not simply be a tax avoidance exercise without commercial risk. This is a critical condition of the scheme.

The “risk to capital” condition will not be met if there are risk-reducing arrangements in place that result in an investor having priority over other investors, being able to withdraw their money as soon as possible, protecting their money so that other investors’ money is used first, or having special rights to the company’s assets if it closes down.

EIS3 Form

If the company has made a successful EIS application, then the company will issue EIS3 forms to the investors. The company does not apply for your personal tax relief. You claim the EIS tax relief on your personal tax return. Most of the details that you will need (for example, the name of the company invested in, the amount, the date of issue of the shares and so on) are shown on the EIS3 form. You are not required to send the EIS3 into HMRC unless requested but you cannot claim tax relief without having been issued with the EIS3 form from the company.

However, receipt of an EIS3 form does not automatically entitle the investor to tax relief. There may be personal circumstances why you cannot claim all of the EIS tax relief – for example, you may have invested more than £1,000,000 in qualifying shares. or your tax liability is not high enough to be able to claim all the EIS tax relief – so you may have to forgo some of the unused EIS tax relief.

Enterprise Investment Scheme (EIS) for Investors (pin). Photo credit © L Rowe 2017

Contractor Loan Charges and Settlements – When Tax Avoidance Goes Wrong

26 October 2020 by 1ndexate Leave a Comment

Contractor Loans Charges and Settlements (wide). Photo credit © L Rowe 2016

Sometimes, if something sounds too good to be true, that is often because it is too good to be true. This is definitely the case in contractor off-shore loan schemes, as some contractors are now realising.

Even more unfortunately, many contractors are also discovering that the operators and promoters of such schemes have ceased to exist – leaving them (the contractor) with no “come back” and personally open to tax liabilities going back years.

Loan schemes are usually (but not always) based off-shore, using a non-UK trust – however, some are operated by UK umbrella companies. They “work” by paying the contractor a minimum salary and the remainder is paid to the contractor by way of a “loan” (minus an admin fee levied by the scheme provider). Income tax and national insurance are not payable on loan income – hence the tax avoidance. However, in practice, these loans are not expected to be repaid – which is why HMRC views such loan payments as disguised remuneration.

HMRC introduced anti-avoidance measures which means that any such loan taken out since 1999 and that is still outstanding on 5 April 2019 becomes taxable, all in one go, on that date (5 April 2019).

The loan income is considered employment income by HMRC and in theory, the employer is liable for PAYE. However, where the employer is offshore (which includes the Channel Islands and the Isle of Man) or the employer has dissolved (ceased to exist) or HMRC thinks that the individual knew that the employer failed to make the correct PAYE deductions or the employer is unable to pay, the tax liability can pass to the individual.

If you are affected, you essentially have two options available to you:

Reach a settlement with HMRC – which essentially means calculating and paying tax on the historic tax years, as if the loans were taxable in the year(s) the loans were received (eg, if you had a £5,000 salary and a £20,000 loan in 2016/17 you pay tax on £25,000 income for 2016/17 plus the historical interest on the tax from 2016/17 to date. This calculation is made for every tax year that you had loan income.
Pay the loan charge as at 5 April 2019. So the total of all your loans is added to your 2018/19 income (on 5 April 2019) and you’re taxed accordingly in 2018/19. This may push some people into the higher rate or even the additional rate tax band. You may also have to repay any child benefit you received (if you end up over the threshold in 2018/19)

In either case, you may also reach an instalment arrangement, in which case HMRC will charge “forward interest” on the outstanding amounts. (Forward interest just means they calculate all the interest that would apply over the period of time it will take you to pay the tax in instalments)

The loan charge is not without controversy. It is a retroactive charge with a “look back” period of 20 years (because HMRC can go back and tax loans dating from 1999) – which is further back than a tax enquiry can usually be opened. This means that some contractors owe substantial amounts of tax and interest.

Ignorance is not a defence, so any freelancer, consultant or contractor should be very wary of any scheme promising to net 80%+ of income and HMRC are investigating thousands of contractors. It is also worth noting that contractors are not the only people caught by the loan charge – such schemes have also affected celebrities and other high-net-worth individuals.

Contractor Loans Charges and Settlements (pin). Photo credit © L Rowe 2016

Comparing Business Structures

21 August 2020 by 1ndexate Leave a Comment

When you start a business, there are a variety of different business structures that you can choose. Below is a comparison of the different options. It has to be said that it is rare for a start up to proceed directly to plc

Sole Trader/Proprietor

Single person in business
Who to tell/register with: Notify HMRC that you are self-employed. It is straightforward, inexpensive and fast to set up.
Legal Structure and Liability: No legal separation between the person (as a private individual) and the business. The proprietor is liable for the business debts and obligations
Owners, managers and capital: The sole proprietor is the owner and manager. The sole trader puts the capital into the business.
Profits & Taxation: Profits are taxed as they arise and as part of the sole-trader’s personal taxable income. Class 2 & Class 4 NICs may also be payable if profits are high enough.

Partnership

Two or more people in business together
Who to tell/register with: Notify HMRC and choose a nominated partner who is responsible for the partnership tax return. No legal separation between the people (as a private individuals) and the business partnership. It is still fairly straightforward to set up.
Legal Structure and Liability:The partners are jointly (and severally) liable for the business debts and obligations. (ie each partner can be held liable for debts.). It is a good idea to have a partnership agreement.
Owners, managers and capital: The partners are the owners and managers. The partners put the capital into the business.
Profits & Taxation: The partnership must complete a tax return. But each partner is taxed as a self-employed individual on their share of the partnership profits. Profits are also subject to Class 2 & Class 4 NICs.

Limited Liability Partnership (LLP)

Two or more people in business together with limited liability
Who to tell/register with: Must be registered at Companies House.
Legal Structure and Liability: An LLP is a separate legal entity from the partners. The ordinary partners are jointly and severally liable for business debts and obligations. The limited partner is only liable up to their capital investment. It is still a good idea to have a partnership agreement.
Owners, managers and capital: The partners are the owners and managers. The partners put the capital into the business.
Profits & Taxation: The partnership must complete a tax return. But each partner is taxed as a self-employed individual on their share of the partnership profits. Profits are also subject to Class 2 & Class 4 NICs.

Limited Partnership

Two or more people in business together, some partners are “ordinary”/”general” partners and some partners are “limited partners”
Who to tell/register with: Must be registered at Companies House
Legal Structure and Liability: The general partners are in the same position as a standard general partnership. The limited partners have limited liability and cannot take a management responsibility and cannot make binding agreements on behalf of the partnership. You will still need a partnership agreement.
Owners, managers and capital: The partners are the owners and managers. The partners put capital into the business.
Profits & Taxation: The partnership must complete a tax return. But each partner is taxed as a self-employed individual on their share of the partnership profits. Profits are also subject to Class 2 & Class 4 NICs.

Private Limited Company (“Ltd” or “Limited”)

Limited company whose shares are held privately
Who to tell/register with: Must be registered at Companies House
Legal Structure and Liability: The company is a separate legal entity from the directors and shareholders (owners). If you are forming a limited company with more than one shareholder, do make sure you have a shareholders’ agreement in place.
Owners, managers and capital: The shareholders are the owners of a company and put the capital into the company. Directors manage the company (and may also be shareholders)
Profits & Taxation: The company pays corporation tax on its profits. Directors may draw a salary, which counts as a business expense (salaries count as personal taxable income and NICs may also be payable). Shareholders can receive dividends on after tax profits. There is an annual tax free dividend allowance and further dividends are taxable. Directors may also reclaim busines expenses (which may also reduce corporation tax).

Public Limited Company (“Plc”)

Limited company whose shares may be freely traded to the public
Who to tell/register with: Must be registered at Companies House (and must have a minimum of £50,000 share capital)
Legal Structure and Liability: The company is a separate legal entity from the directors and shareholders (owners)
Owners, managers and capital: The shareholders are the owners of a company and put the capital into the company. Directors manage the company (and may also be shareholders). Accounts must be audited.
Profits & Taxation: The company pays corporation tax on its profits. Directors may draw a salary, which counts as a business expense (salaries count as personal taxable income and NICs may also be payable). Shareholders can receive dividends on after tax profits. There is an annual tax free dividend allowance and further dividends are taxable. Directors may also reclaim busines expenses (which may also reduce corporation tax).

Partnership and shareholder agreements perform a similar function – they set out the entry/exit terms for new partners or shareholders, respectively. For partnerships, it will layout the capital contribution of each partner. In limited companies, the capital contribution is given by the shares and payment for the shares.

Comparing Business Structures (pin). Photo credit © L Rowe 2020

10 Great Apps for Consultants

7 June 2020 by 1ndexate Leave a Comment

This is a collection of apps and software that consultants, contractors and coaches might find useful in running their business.

1) Skedpal

This is my current favourite task management / time management app. If you are a fan of “timeblocking” to get things done, you might find it useful, too. First, add all your tasks (allocated to different projects or areas of your life). You can colour code your projects, too.

You set a deadline, a time duration that you think the task will take to complete. Optionally, also a time frame for start/finish. You also set when you would like to do each task (as in what time map)

Optionally, you also set up time maps (again, think time-blocking) of your week, so you could designate Mondays – Wednesday office hours to a specific project, Thursdays to admin, Friday to marketing and Saturday morning to domestic things.

After doing the above, the really clever thing is that Skedpal will then arrange your weekly tasks depending on what deadlines and timeblocks you have assigned into your SkedPal schedule.

If you have got too many deadlines, SkedPal will flag what it cannot assign. It only goes up to 3 weeks ahead for the daily scheduling (on a rolling basis). It would be better if it was 4-5 weeks or a calendar month. However, you can manually set tasks in skedpal beyond the 3-week horizon.

It will sync up with your calendar, so that it will not schedule tasks when you have fixed appointments.
You can also override things and set tasks to be done at a specific time.

Skedpal costs $9.95 per month if you sign up for the year. There is no free plan.

2) Trello

If you like lists, then this is the app for you because it is literally lists of lists. You have project boards and cards within each board, arranged in lists. Each card represents a task. You can add deadlines, colour-codes and attachments. It is possible to drag and drop the cards between lists, boards and even re-order them within lists; For some reason, dragging those cards around the screen is very pleasing. Trello also lends itself particularly well to the kind of organisation that involves sequencing and discrete stages.

Trello integrates with an impressive number other apps, that are too numerous to mention.

I have only used the free version, which still has unlimited personal boards, unlimited cards, unlimited lists and the ability to attach files up to 10MB, 10 team boards. The paid version includes more storage (for attachments), unlimited team boards, more facility to arrange boards, team board templates, power ups.

Business class is $9.99 per month if you sign up for a year but there is also a free plan and an enterprise version.

3) OneNote

The note-making app. It synchronises across desktop, tablet and mobile and you can use it to make and organise your notes on everything from work to your home-life.

You can also use a stylus – although I prefer not to.
You can have several notebooks and assign each one a colour-code. You can also colour-code individual sections within each notebook a bit like having different coloured subject dividers in a physical folder. You can drop notes anywhere on the page and move them around. You can also use icons or tags (think bullet journalling, only electronically) in these notes.
You can send links directly to OneNote and you can email OneNote pages.
You can format text (similar to Word) but the formatting capabilities are more limited.

The interface is familiar to anyone who has ever used a Microsoft Office product and it integrates with Outlook so you can track “to do” items along with accompanying information.
It is particularly suitable if you are already using Microsoft products. With that said, OneNote is now free across all platforms and it can be used as a standalone produce.

4) Zoom

The use of Zoom’s audio-video conferencing app has rocketed since March. You can also share your screen and a whiteboard (which you can use a stylus or type on).
There are dozens of specific settings to control whether people are muted or not, whether they can share screens, join the meeting or are held in a waiting room or can join the meeting before the host. You can change your background for those occasions when you don’t want to project your background.
It is also possible to set up a second camera. I’ve used this app to project my “real life” whiteboard. It would also work well for demonstrations and product promotions.
It is the second camera function that gives it the slight edge over its competition.

The paid (Pro) version has a 24hour meeting (the free version meeting limit is 40 minutes) for up to 100 participants. The business tier includes 300 participants, vanity URLs and company branding. There is also an enterprise version. Extras such as virtual conference rooms, webinar settings, voip phone and audio plans have an additional cost.

5) Canva

Canva helps you to create gorgeous graphics even if you are design-challenged.
The free version is fantastic. There are templates and designs for everything from posters to social media graphics to brochures.
Upload your own photos and design anything from posters to social media graphics (you can define custom sizes). It is really easy to learn and it is much more intuitive than most graphic design software.
The pro version allows you to arrange things in folders and save things like logos, brand colours and upload fonts, resize your design and make custom templates and have transparent images. There are also a lot more free templates and literally millions of premium stock images. You can also set download quality and make animated gifs with the pro version
The only thing I wish it would let you do is arrange your uploaded photographs in some way.

The free plan is perfectly adequate for casual and occasional use. The pro version is £8.99 per month, billed annually and there is also an enterprise version.

6) WordPress mobile app

With the WordPress mobile app for self-hosted websites, you can write, edit and publish posts from your phone. You can link more than one domain to the app.
There is a “no distraction” writing option. You can also take and upload photos, video and manage and reply to comments. You can manage and install plugins but you won’t be able to actually access a plugin’s settings or otherwise configure it. Unfortunately, you cannot install a new theme but you are able to switch between themes that are already installed. The app works with the block editor. In short, you can’t completely manage your WordPress website using the app and it is a bit fiddly to write a blog post on a mobile phone but it is fine for quick edits or in an emergency. It might also be useful for drafting posts offline and then publishing them once you are reconnected to the internet.

The WordPress app is free.

7) Time and Chaos

This is CRM software for managing your contacts, tasks, projects and calendar. You can use it as a customer database and link tasks and reminders to each customer. It is possible to group contacts together if that’s helpful, categorise contacts and also link two or more related contacts together. If needed, you can define custom fields to meet your particular business requirements.
Each client record also has a notes tab.
It is possible to drag and drop files and folders to individual records to enable you keep everything related to that customer in one place. Additionally, if you sign up for “Intellect” you can synchronise your email so that all communications for a customer are attached to their record.

As I mentioned, it is possible to link tasks to customers. Among other things, you can assign priorites, groups and colours to each task; plus you can add notes (with date-stamps if required) and also mark tasks as completed. This means that you can see a list of previous and upcoming tasks, like an activity log for each client.
The project function works with similar logic to tasks in terms of linking contacts, groups etc and is a way of creating a mini database within time and chaos.

The best bit for those that work “on the go” or from multiple locations is that there is both a desktop software and a cloud service and they sync up so that you can access the data from anywhere but also work on your laptop without an internet connection. I find this particularly handy for working on-site where it isn’t possible to get a mobile data signal and it isn’t always possible to hook into their onsite wifi.

It doesn’t sync directly with Outlook or Google but you can purchase Companion Link from a separate company that will keep Time and Chaos in sync with either.

8) Hootsuite

If social media is part of your business or marketing, then Hootsuite can help you to coordinate, manage and post to several social media platforms.
It allows scheduled posting to Twitter, Facebook, Instagram, YouTube, LinkedIn, Twitter and Pinterest.
You can set up different streams for your social media to make things far easier to visualise and follow.
However, know that Facebook prioritises posts made directly in its own platform over posts made on third-party platforms such as Hootsuite, and extras such as reporting or custom short links cost more.

Plans start from £25 per month with team, business and enterprise tiers.

9) Cushion

This is perfect for freelancers, consultants and those working in the “gig economy”
It is particularly suitable for those who work on a “project by project” basis, as opposed to recurring work.
You enter in your clients, projects, deadlines and time estimations. You also tell Cushion how many hours you have to allocate to work and which days are your workdays.
The app tells you the timeframe of when a project is estimated to finish but more than that, it shows you a visual overview of your calendar so that you can see when your busiest times are, when you are overbooked, and when you are available to start a new project. It doesn’t show you times of day – it isn’t a diary in that sense.
However, it does sync with your calendar and can also be used to track the time taken for each project. Cushion will handle client billing (it can pull the time tracking information to help with this) and card payments (for an extra fee) and expense tracking (you can allocate expenses to a particular project). You can chase up payments and forecast your income. You can also put in your financial goals in and it will track how close you are and what you need to bill to reach your target.

Cushions greatest strengths lies in its visual layout and reporting across, scheduling, budgeting and invoicing. It also integrates with Harvest, Freshbooks, FreeAgent and Xero
There are 3 tiers of pricing, starting from $8 per month (you get 2 months free if you sign up for the year). There is no free plan.

10) Xero

Xero is online Accounting software with a particularly satisfying bank reconciliation function which is one of its unique strengths.
Being accounting software, Xero will handle all of your accounting/bookkeeping requirements. It can be used for all your invoicing, expenses, purchases and payroll, as well as your VAT and EC sales lists (or US, AUS or NZ equivalents). As is standard for online accounting software, you can set up regular sales invoices to be emailed to customers and clients and also send out regular statements.
You can have your bank transactions feed into Xero automatically – this is not unique; however the way you subsequently deal with the transactions once they are in Xero is unique. You create bank transactions in Xero based on the imported transaction. Xero remembers previous transactions and will attempt to anticipate what you will want to do with similar transactions. You can also specify “rules” for how Xero should handle certain transactions.

It will also integrate with a wide range of apps including eCommerce, CRM, inventory, time-tracking and reporting tools

On the downside, the payroll functionality is particularly cumbersome, there are limitations on reporting limitations especially for payroll, the way it handles payments on account (for both customers and suppliers) is a little clunky, as is some aspects of VAT.

Xero starts at £10 per month (this option is only suitable for businesses with very low transaction numbers); the main offering is £24 per month and multicurrency is £30 per month. Payroll, expenses, CIS and projects are also extra.

Honourable mentions

ReceiptBank – OCR software for purchase invoices and receipts
ToDoIst – Productivity app
Tweetdeck (now owned by Twitter) – for managing your Twitter account
Slack – team collaboration
Capsule – CRM

10 Great Apps for Consultants (pin). Photo credit © L Rowe 2020

Explaining Capital Expenditure, Depreciation and Capital Allowances

5 May 2020 by 1ndexate Leave a Comment

When you buy stock or small or everyday things for your business, you can deduct the cost from your income before having to calculate the tax that is due. This is why it is called tax deductible (business) expenses.

In your accounts, you might categorise them as stock, materials or office supplies as appropriate… and they appear in your profit and loss account as business expenses.

Capital Expenditure

However, when you buy larger items such as equipment or machinery that you expect to last over a year, then these items are called business assets. Expenditure on assets is called capital expenditure.

Capital expenditure is handled differently in your accounts and in your tax return.

Depreciation

In your accounts, assets appear on your balance sheet not your profit and loss account.
Each year, a proportion of the cost of each asset is charged to your profit and loss account – this is what called “depreciation”. Effectively, this spreads the cost of the capital expenditure over several years of accounts.

There is a section in your balance sheet for assets. This shows the net amount of the asset. This is calculated as: the original price paid for each type of business asset that you have minus the accumulated depreciation has been charged to your profit and loss account. Accumulated depreciation is the total amount of depreciation charged over the years for each group of assets.

Straight Line Depreciation

Straight line depreciation means that an equal amount of depreciation is charged for each year of the asset’s useful life.

For example, say you purchased a piece of machinery for £10,000 and you expected it to last 4 years and the asset has no scrap value at the end of its life: The entire £10,000 would initially appear on your balance sheet as an asset. Each year, you would charge one quarter of £10,000 ie, £2,500 to your profit and loss account and reduce the amount on the balance sheet by the same amount, leaving £7,500 at the end of the first year.
This £2,500 is the annual depreciation amount and is a reflection of the “wearing out” (or wear and tear) of an item over its expected useful life.

In the second year, another £2,500 of depreciation is charged to your profit and loss account.
Your balance sheet asset would be £5,000 at the end of the second year.£10,000 for the original cost minus 2 x £2,500 for the 2 years of depreciation.

In the third year, another £2,500 of depreciation is charged to your profit and loss account and in the fourth year, a final £2,500 would be charged to your profit and loss account.

For items with a scrap value, you take this into account by not depreciating the full cost of the asset.

For example, if your £10,000 asset has a scrap value of £1,000 at the end of four years, then you would only depreciate £9,000 (£10,000-£1,000). The annual depreciation amount would be £9,000/4 = £2,250 every year for four years. After four years, the net value left would be £1,000.

Reducing Balance Depreciation

With reducing balance depreciation, the asset’s net balance is depreciated by a set rate every year.

For example, if the rate is 25% and the asset cost £10,000, the depreciation in year 1 is £2,500 (25% of £10,000) and the net value of the asset is £7,500.

In year 2, the depreciation is 25% of £7,500, which is £1,875, and the net value of the asset is £5,625 (£10,000 – £2,500 – £1,875)

In year 3, the depreciation is 25% of £5,625, which is £1,406.25 and the net value of the asset is £4,218.75 (£10,000 – £2,500 – £1,875 – £1,406.25)

In year 4, the depreciation is 25% of £4,218.75, which is £1,054.69 and the net value of the asset is £3,164.06 (£10,000 – £2,500 – £1,875 – £1,406.25 – £1,054.69)

Depreciation is NOT a tax deductible or allowable item for tax. So when you calculate your taxable profit, you have to literally “add back” the depreciation amount to the profit (or loss) figure from your accounts.

Capital Allowances

Instead of depreciation, you are potentially able to claim “capital allowances” for expenditure on “plant and machinery”

Annual Investment Allowance

You can deduct the full cost of the item up to the “annual investment allowance” for many items. The annual investment allowance has temporarily been increased to £1 million (between 1 January 2019 – 31 December 2020).

Annual Investment Allowance is a type of capital allowance where you are allowed to claim 100% of the cost of the asset.

Not all items are eligible for the annual investment allowance. Items that you cannot claim the annual investment allowance for:

Cars
Items you owned before the business started, that were purchased/used for another reason
Items given to you

Writing Down Allowance

You might be able to claim “Writing Down Allowance” for these items instead. This is a percentage of the item’s value. (Usually, the value is the price you paid for it unless you already owned it or it was a gift – in these cases, you would use the market value instead of the price paid)

The market value is what you would expect to sell it for to an “unconnected” person (ie to someone that you are not related to)

Unfortunately, it is not quite as simple as that because you have to “pool” assets (that aren’t eligible for Annual Investment Allowance) together and then work out the Writing Down Allowance for the whole pool.

If you have different assets that qualify for different rates (percentages) of Writing Down Allowance, you will need a different pool for each different rate. This is so that you can apply the 20% rate to one pool of assets and 6% to another pool, for example.

First Year Allowances

There are also “First Year Allowances” which can be anything up to 100% of the asset’s cost. The idea behind this is to encourage businesses to invest in certain areas/technologies.

Business Cars

For business cars, the writing down allowance depends on the car’s CO2 emissions. Some cars are eligible for First Year Allowances.
Cars are able to be used for private use.

Motorcycles (bought from 6 April 2009) lorries, vans and trucks qualify for Annual Investment Allowance. There are lots of rules about what counts as a van (rather than a car) for tax purposes.

When You Can Claim Capital Allowances

You can claim capital allowances for the period in which buy the asset. This means that if you buy the asset on the last day of your accounting year, you can claim the capital allowances in that year’s tax return.

Tax Adjustments

The profit that is in your accounts is not the same as your taxable profit.

When accountants talk about “add backs” these are literally the things (like depreciation) that are added back to the profit per the accounts to get to the taxable profit. These adjustments are common and are the reason why accounting profit and taxable profits are different.

So, in summary, capital expenditure is money spent on assets that last longer than one year. Depreciation is a spreading of that cost over several years. Capital allowances are what HMRC give instead of allowing depreciation as a tax-deduction.