More Allowances

ROGER JONES looks at some problems with capital allowances on incorporation of a business and suggests a solution.

THIS YEAR'S BUDGET has added further incentives to the current fashion for incorporating businesses, of whatever size. It may therefore be useful to revisit an ancillary subject. This is the treatment of capital allowances on succession to a trade. In my experience, it is an area that seems to generate many problems.

Back to basics

Let us start with the basics. Though there are certain exceptions, notably expensive cars and short life assets, most expenditure on plant and machinery is pooled. In general, a writing down allowance of 25 per cent is available on the reducing balance of the pool. However, on the cessation of the business, section 55(4), Capital Allowances Act 2001 prevents a writing down allowance in the period of discontinuance. There is to be substituted a balancing allowance under section 54(4) or a balancing charge under section 55(3), Capital Allowances Act 2001. This needs a valuation of the assets to determine the correct position.

Similarly, small or medium sized businesses can generally get an enhanced (first year) allowance on expenditure incurred in the current period of account. Again, section 46(2), Capital Allowances Act 2001 precludes this in the period of cessation.

This can be demonstrated by Example 1 and this would be the result of an incorporation under section 162, Taxation of Chargeable Gains Act 1992. In that circumstance, new shares are issued by the company in exchange for all the assets of the unincorporated business. As a transaction between connected parties, the shares must be taken to have the market value of all the assets transferred. Thus, market value is imputed to the plant and machinery pool and a balancing allowance or charge arises.

Avoiding the charge?

To avoid the balancing allowance or charge, the transferor and transferee (the previous sole trader and the company) may make a joint election under section 266, Capital Allowances Act 2001 that the plant and machinery are transferred at a price which gives rise to neither a balancing allowance nor a balancing charge. So what does that really mean? I have seen it suggested (not least in the study notes for the associateship examination of The Chartered Institute of Taxation produced by a well-known firm of tutors) that the computation proceeds as in Example 2A. In other words, there has been an attempt to give a writing down allowance right up to the date of incorporation.

This is not the case, though. There is nothing in section 267, Capital Allowances Act 2001 to override the rules that prohibit a writing down or first year allowance in the period of discontinuance, and the trade of the former sole trader is discontinued at the point of incorporation. So, the plant and machinery is actually transferred at the tax written down value at the start of the final period of account of the sole trade. The true capital allowance position is thus as at Example 2B.

Naming the day

The absence of any capital allowances at all in the final period of account means that great care should be taken in selecting the date on which to incorporate. In my example, there is a nine-month period of account in which Mr Sole Trader gets no capital allowances. A tidy-minded adviser may favour incorporation at the traditional accounting date and make a section 266 election 'because it is easier'. So, Mr Sole Trader gets no capital allowances in the last period when, perhaps, there are substantial profits taxed at 40 per cent. The pay-off, of course, is that the company gets a higher writing down allowance in its first period of trade, but it pays tax at only 20 per cent (now 19 per cent). Is this good planning, especially if the client bought a large piece of equipment just before incorporation in anticipation of first year allowances to mitigate the tax on the profits?

Remember that capital allowances are given for a period of account (not a year of assessment). Where accounts have traditionally been drawn up to 31 March, incorporation on that date will mean the loss of first year allowances or writing down allowances for a full accounting period. How about incorporating at 30 April instead? The final period of account in which no capital allowances can be given is therefore only one month - a far more acceptable proposition.

The alternative route

All of the foregoing flows from incorporation by the section 162 route, but there is an alternative. This is to ignore the incorporation relief in that section and go for the alternative afforded by section 165, Taxation of Chargeable Gains Act 1992. This relates to a gift of business assets, though payment of some proceeds is possible and this route has been popular in the last few years with business proprietors keen to 'bank' retirement relief. An election under section 266 is still possible if this means of incorporation is preferred and it would leave us in the position demonstrated by Example 2B.

The payment option

To my mind, though, there is a far more favourable option. The company should actually pay the sole trader for the plant and machinery. Where there are actual proceeds, then they are taken as the disposal value under section 61(2), item 1, Capital Allowances Act 2001. Market value is not substituted even where the vendor and purchaser are connected. So, Mr Sole Trader could sell his plant and machinery to the company for, say, £200. This gives a large balancing allowance relievable against final year profits taxable at 40 per cent with an immediate reduction in the liability. (Note, however, that this does not work with expensive cars or short life assets - see sections 79 and 88, Capital Allowances Act 2001). The trade-off is that the company has precious little expenditure on which to claim allowances, but then its profits are taxed only at 20 per cent (19 per cent). So there is a permanent saving of 20 or 21 per cent of the balancing allowance as well as a cash flow advantage.

Not so peripheral

What is therefore often seen as a minor peripheral issue in incorporation can be a major source of tax savings, but it does require a thorough understanding of how the rules work.

Roger Jones is senior tax manager at Larking Gowen in Norwich. He may be contacted on 01603 624181 or by e-mail roger.jones@larking-gowen.co.uk.

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