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Capital vs. revenue
If you are not an accountant, there is one feature of the tax system which must seem particularly annoying. This is the way HM Revenue & Customs (HMRC) uses the phrase ‘capital expenditure’ to deny you tax relief for expenses you have incurred.
Let’s say that you are in a trading business, or have a property portfolio. In order to increase the efficiency of the business, or in order to enhance the amount of rent you can charge, as the case may be, you decide to make significant improvements to your property.
If you are not well advised, you will find, all of a sudden, that you now have to pay tax as if you hadn’t incurred the expenditure at all!
The reason for this is that HMRC regards improvement expenditure on properties, normally, as capital. The distinction between capital and revenue expenditure was devised by accountants a very long time ago to distinguish between expenditure which all got exhausted in the year and expenditure which gave an advantage over a much longer period. The true profit of a particular accounting period is calculated only after deducting the shorter-term, or revenue type, expenditure. Capital expenditure should not be deducted from current income.
The problem is that it often can’t be deducted against future income either. Improvement expenditure on a property is one good example of this. It is what is known as a ‘fiscal nothing’ (i.e. expenditure which gets no tax relief).
So, at the end of the day, you end up paying tax on profits you’ve never made.
Other examples of capital expenditure are things like legal fees in relation to the structure of the business, and payments to secure some kind of contractual right, which may go on for many years.
In the area of property works, this principle means that it is often effectively much cheaper to incur lower-level repair expenditure rather than do anything fundamental. It is also a good idea to spread expenditure thinly over as long a period as possible to avoid the Revenue claiming to add the payments back to your profit as capital.
Sometimes, HMRC can claim to disallow property works as capital expenditure, even where you are not extending or changing the building in any fundamental way. If the process of repair is extensive enough, Inspectors will try to argue against it, even if the result is simply to put the building back where it originally was.
If you are in this situation, it’s always worth trying to quote the Odeon Cinemas case at the Tax Inspector. The facts of the case were that a number of cinemas that had suffered dilapidations over a long period during the war were bought. Odeon Cinemas gradually went through a process of refurbishing and redecorating the cinemas, but continued to use them in the interim. Although the result was that the cinemas were better than when Odeon had bought them (because they were no longer dilapidated), the HMRC claim that this was capital expenditure was thrown out by the court. The key reason for the decision was that the cinemas were still usable, and expenditure was incurred over a long period.