Severn Accounting
Tax & Accounting

Depreciation versus capital allowances

By Ali Jaw ·

Many business owners and accountants use the terms ‘depreciation’ and ‘capital allowances’ interchangeably, but they’re quite different in the eyes of HMRC and your accounts. Getting to grips with the distinction is crucial for accurate reporting and tax planning. This post explores how each works, why they matter, and how to handle them correctly.

Depreciation: An Accounting Concept

Depreciation is an accounting treatment required under UK Generally Accepted Accounting Practice (GAAP) and International Financial Reporting Standards (IFRS). It reflects the gradual wear and tear of fixed assets in your profit and loss account.

When you buy a van, computer, or piece of machinery, you don’t expense the full cost immediately. Instead, you spread it across the asset’s useful economic life. The amount you claim each year depends on the asset’s cost, expected residual value, and how long you expect to use it. Most businesses use the straight-line method: if a van costs £20,000 and will last five years, you’d depreciate £4,000 annually.

The key point: depreciation is a non-cash charge that reduces your reported profit. It’s essential for producing accurate financial statements, but it has no direct impact on your tax bill. HMRC doesn’t recognise it for corporation tax or income tax purposes.

Capital Allowances: The Tax Relief Alternative

Capital allowances are HMRC’s preferred method for giving tax relief on capital expenditure. They’re statutory reliefs defined in the Capital Allowances Act 2001 and subsequent tax legislation.

Rather than depreciation, businesses claim allowances on qualifying assets. The main types include:

  • Plant and machinery allowances – the broadest category, covering equipment and machinery used in the business
  • Annual Investment Allowance (AIA) – currently set at £1,000,000 per year, allowing 100% first-year relief on most plant and machinery
  • First Year Allowance (FYA) – 100% relief on certain green or energy-saving assets
  • Writing Down Allowance (WDA) – currently 18% per year on a reducing-balance basis for general plant and machinery

The significant difference: capital allowances directly reduce your taxable profit, cutting your tax liability. They’re far more generous than depreciation in the early years.

A Practical Example

Let’s say you buy office equipment for £50,000 in the current tax year. For accounts purposes, you might depreciate it at 20% annually, claiming £10,000 in year one.

For tax purposes, if the equipment qualifies, you can claim the full £50,000 as an AIA in year one, provided your total annual plant spending doesn’t exceed £1,000,000. This saves corporation tax on the entire amount immediately, rather than spreading relief over five years.

This timing difference is why capital allowances are so valuable for cash flow and tax planning.

Key Considerations and Pitfalls

Asset categorisation matters. Not all fixed assets qualify for capital allowances. Land, buildings, and most fixtures within buildings don’t qualify—though ‘integral features’ like lifts, air conditioning, and electrical systems have special relief under Structures and Buildings Allowance (SBA).

Balancing allowances. When you dispose of an asset, HMRC adjusts the pool. If you sell the equipment above the written-down value, you pay balancing charges (extra tax). If you sell below, you claim a balancing allowance (tax relief).

Record-keeping. Keep meticulous records: purchase invoices, dates of acquisition, and evidence that assets are used in your business. If HMRC questions your claims, poor documentation is costly.

Sole traders and partnerships claim capital allowances on self-assessment tax returns. Limited companies claim them in their corporation tax returns. Either way, consistency between your accounts and tax return is vital.

Bringing It Together

In summary: depreciation is for your financial statements; capital allowances are for your tax position. Many businesses claim depreciation in the accounts and separately calculate capital allowances for tax purposes, creating a timing difference that accountants manage through deferred tax provisions.

Getting this right requires understanding both the accounting rules and the tax rules—they don’t always align. That’s where professional guidance becomes invaluable, especially when you’re buying significant assets or restructuring your fixed asset base.

If you’re unsure whether your assets qualify, or you’d like to optimise your capital allowances strategy, we’re happy to help. A few hours of proper planning can save thousands in unnecessary tax.

For tailored advice, contact Severn Accounting — we’re here to help.