Capital or Revenue expenditure? That is the question
Should a client face an enquiry from HMRC into their tax return and accounts, a common area that is reviewed is any deduction that may have been claimed in the accounts for repairs and renewals. This arises because whilst a repair to an asset is an allowable item of expenditure for tax purposes, if the asset is altered, improved or replaced the expenditure is capital expenditure and is not allowable. Capital allowances may or may not be allowable on this capital expenditure.
Recently, HMRC have published revised guidance in their internal manuals about what they accept is a repair for tax purposes.
One point that the guidance focuses on is the concept of the entirety. Over many years there have been a number of court decisions on this area following disagreements between taxpayers and HMRC. In general terms if the entire asset has been replaced this will be treated as capital expenditure, whereas if less than the entire asset has been replaced this will be treated as revenue expenditure and is therefore tax deductible.
The guidance stipulates that what actually forms the asset or the entirety is a question of fact and that the question to decide is whether the asset is a separate distinct asset or if it is part of a bigger asset. For example:
- Does it look like a separate asset?
- Is it something that stands apart from other assets?
- Is it freestanding or is it something that is removable?
Another important test to consider, especially where there has been a lot of work undertaken, is to consider if the character of the asset has changed as a result of the work. In simple terms, is it the same object both before and after the work is undertaken? If it is like for like in that the asset simply does the same job as before then this is an indication that the work is a repair, but if the function or capacity of the asset is altered or improved then it is capital.
The following examples which are based on HMRC updated guidance illustrate these points.
Pat is a dairy farmer and the driveway leading to her farm is in a very poor state of repair having been initially created some 30 years ago.
The Dairy Company advise Pat that the driveway is causing damage to their milk tanker vehicles and refuse to call at the farm until it is repaired.
Pat has the driveway repaired at a cost of some £25,000. The tarmac is removed and the sub-surface repaired. It is then re-surfaced with new kerbing added to bring the driveway up to modern standards.
Even if the driveway is an asset in its own right the entirety has not been replaced. It has been re-surfaced and the expenditure is allowable for tax purposes as a repair.
The drive was not widened nor was its load bearing capacity increased, so no improvement was involved.
Pedro runs a farm near Clacton-on-Sea and has diversified so that he has a number of chalets that are used as a furnished holiday lettings business. One of the chalets is damaged beyond repair and Pedro replaces it with a new chalet of the same model. As most of the cost is covered by insurance, Pedro only has to spend £3,500.
For tax purposes the chalet is an identifiable asset in its own right. Pedro has replaced the asset in its entirety and the expenditure is therefore capital expenditure and is not tax deductible as a repair.
This is an area where the incorrect tax treatment can cause potential difficulties with HMRC and key to a successful outcome is planning in advance and documentary evidence so please do contact us if you are considering carrying out this type of substantial expenditure.