The basic rules for allowable expenditure by sole traders and partnerships (or companies) appear straightforward, at least on the face of it. Profits of the trade are calculated in accordance with generally accepted accounting practice, subject to any adjustment required or authorised by law.
Is it allowable?
For the purposes of calculating profits for tax purposes, the main requirements for a deduction in calculating the profits of a trade are: firstly, that the expenditure is incurred ‘wholly and exclusively’ for the purposes of the trade; and secondly, that it must not be capital in nature (there is an exception for certain capital expenditure by ‘cash basis’ businesses, which are not considered here).
What is ‘capital’ expenditure? Unhelpfully, there is no definition in the tax legislation. This has resulted in extensive case law involving taxpayers and HM Revenue and Customs (HMRC).
Repair or replacement?
One of the potential areas of dispute is whether expenditure was on repairing an asset (i.e., normally an allowable revenue cost) or replacing it (i.e., normally non-allowable capital expenditure).
The basic approach taken by HMRC (see its Business Income manual at BIM35430) is that the cost of:
- repairing an asset is normally allowable revenue expenditure;
- replacing an asset is normally capital expenditure (so not allowable);
- altering an asset to do something else is normally capital expenditure and not an allowable deduction;
- improving an asset is normally capital expenditure and not an allowable deduction.
However, as with most things in tax, the distinction between revenue and capital expenditure will generally depend on the particular facts.
For example, in Steadfast Manufacturing & Storage v Revenue and Customs  UKFTT 286 (TC), a site included a factory and yard. The whole yard was used to unload articulated lorries, move those lorries, and provide trailer storage. Prior to the expenditure, the yard had not been resurfaced for some time, and the surface was in poor condition. The yard was previously repaired twice a year by patching with gravel, but the patching was becoming less effective.
Expenditure was incurred on work such as removing the surface area, levelling it, re-surfacing with reinforced concrete, and adding a drainage channel. There was no increase in size of the useable area and no increase in the loadbearing capacity of the yard. HMRC sought to disallow the company’s expenditure on the yard as being capital in nature.
However, the First-tier Tribunal considered that there was no improvement in the yard compared to its original condition, and that the works only returned the yard to its previous standard. Nor was there any increase in the useable area compared to the original. The reduced need for repairs did not of itself make the expenditure capital in the tribunal’s view; it would be an inevitable result of repairing the yard properly, rather than in patches. The expenditure was revenue in nature.
Steadfast Manufacturing & Storage underlines the principle established in case law that, for expenditure to be capital, the reduced need for repairs would have to result from the bringing into existence of something new with an ‘enduring benefit’ to the business. Restoring an asset to its original state should not, of itself, bring something new into existence.
The above article was first published in Property Tax Insider (January 2021) (www.taxinsider.co.uk).