New regulations around septic tanks, to reduce and control the level of pollution from sewage into the watercourses of England and Wales, had a deadline of 1 January 2020.
This means that anyone with a septic tank discharging into a watercourse must have replaced or upgraded their existing system. For properties being sold, the work had to be completed in advance of the property sale.
The options available to meet the requirements of the regulations included:
- Installing a septic tank conversion unit to treat the sewage;
- Replacing of the septic tank with a small sewage treatment plant;
- Connecting to a mains sewer; or
- Installing of an infiltration system to discharge into the ground.
It was also possible in exceptional circumstances, to apply for a permit to discharge to surface water.
As a result, many of our rural clients spent significant sums in 2019-20 to ensure compliance with these regulations.
As we approach the 31 January 2021 tax return filing deadline, thoughts turn to how this, and similar expenditure, should be treated for tax purposes.
The precise treatment for tax will depend on whether the expenditure is revenue or capital in nature.
What is revenue expenditure?
Expenditure will generally be revenue expenditure where it is one of the following:
- A repair to an existing asset;
- Restoration of an existing asset to its former condition;
- Replacement of a component of a larger overall asset; or
- Replacement of a component part of an asset with a better component, so long as that better component is just the modern-day equivalent of the component it replaced. The classic example is replacing old single-glazed windows in a property with new double-glazed windows. Today’s norm is the installation of double-glazed windows, to ensure energy efficiency.
How is revenue expenditure treated in accounts and for tax?
If the expenditure is revenue expenditure, it is deducted in full in the profit and loss account in the year it is incurred. That 100% deduction of the cost is generally allowed for tax purposes.
What is capital expenditure?
Expenditure will be capital expenditure, generally, where it is one of the following:
- Purchase of a new asset (including any incidentals of acquisition, such as delivery and legal or professional fees);
- Replacing an old asset in its entirety; or
- Improvement/alteration of an existing asset.
How is capital expenditure treated in accounts and for tax?
Capital expenditure is considered to provide a benefit to a business over a longer period. As a result, rather than deducting the cost of the asset in the profit and loss account in a single hit, it is capitalised on the balance sheet. The cost of the asset is released to the profit and loss account over the ‘useful economic life’ of the asset, by applying a suitable depreciation policy. However, depreciation is disallowed for tax purposes. Instead, if an asset qualifies, it will be afforded capital allowances for tax purposes.
If capital expenditure doesn’t qualify for capital allowances, that capital expenditure will not receive any tax relief against income.
What are capital allowances?
Capital allowances are the tax equivalent of depreciation and provide an annual writing down allowance that is a tax-deductible and available at approved standard rates.
The same rates apply for income tax and corporation tax and it is therefore irrelevant whether business is conducted through a limited company, a partnership, a sole trade or a trust.
In broad terms, capital expenditure will qualify for capital allowances if that expenditure is on qualifying plant and machinery, but not if it is on land, buildings or structures.
Annual Investment Allowance
A business can spend up to £1 million on qualifying plant and machinery in its financial year and receive a 100% deduction of that cost for tax, under the Annual Investment Allowance (AIA). This annual limit, which was temporarily raised for two years to encourage investment in new equipment, had been set to revert to its lower level of £200,000 per annum from 1 January 2021.
However, it was recently announced that this elevated annual limit would be extended through to 31 December 2021. It’s therefore expected that the annual limit will now revert to the lower level of £200,000 per annum from 1 January 2022.Trustees and mixed partnerships (those with individual and limited company partners) do not qualify for the AIA.
Where a financial year is shorter than 12 months, or where it spans an AIA limit change date, the available annual limit is apportioned accordingly.
Capital allowance rates
Where expenditure on qualifying plant and machinery exceeds the AIA in a financial period, the excess will attract capital allowances at the following approved rates:
New electric or low emission cars will also qualify for a 100% deduction for tax in the year the expenditure is incurred.
Integral features are systems that are ordinarily incorporated into the fabric of a building that then become part of the building and which you wouldn’t normally take with you if you moved premises. They include, for example, cold water systems, water or space heating or cooling systems and electrical or lighting systems.
The AIA applies to all these assets, except cars. With a bit of careful planning to ensure the maximum benefit, the AIA can be used to cover assets that would normally only get 6% writing down allowances, in preference to those that get 18% per annum, thereby accelerating tax relief.
Residential property and capital allowances
Where the business is that of letting residential property, capital allowances are only relevant where either a Furnished Holiday Letting (FHL)election has been made, or where the item(s) in question are in common parts of a building, for example a hallway table in a block of flats.
Structures and Buildings Allowance
Structures and buildings are not qualifying plant and machinery for capital allowances. However, a Structures and Buildings Allowance (SBA) provides a flat 2% per annum writing down allowance for tax – effectively writing off the expenditure over 50 years. That flat rate was increased to 3% from April 2020.
Commercial or agricultural buildings, fencing, bridges, tunnels, retail and other qualifying non-residential uses will qualify. FHLs do not quality.
Although certain capital costs will not qualify for tax relief when incurred, they may qualify as deductible enhancement expenditure for capital gains or corporation tax purposes, should that asset be sold in the future.
What about my septic tank?
That’s a very good question!
Replacing a septic tank with a small sewage treatment plant, installing a septic tank conversion kit to treat sewage, or modification of an existing system to either connect to a mains sewer or to discharge to ground, will all qualify as capital improvements, rather than repairs or revenue expenditure.
As a result, the expenditure should be capitalised on the balance sheet of the business, and depreciated over an appropriate estimated useful economic life for the asset.
For income or corporation tax purposes, that depreciation will be disallowed.
Generally, expenditure on plant and machinery associated with residential property will not qualify for capital allowances and there will therefore be no income or corporation tax relief. That is, unless it is plant and machinery in, say, a common area of a block of flats, or plant and machinery associated with a residential property over which an FHL election has been made.
On a subsequent sale of the property serviced by the tank, however, the septic tank expenditure should be an allowable deduction for capital gains or corporation tax, as a capital improvement.
The Capital Allowances Act 2001 defines ‘sewerage or drainage systems’ as ‘buildings’, and therefore not qualifying expenditure for capital allowances. However, the Act then goes on to state that where ‘sewerage systems are provided mainly to meet the particular requirements of the qualifying activity, or to serve the particular plant and machinery used for the purposes of the qualifying activity’ then they will not fall under the definition of a building and will qualify for allowances!
So, if the system is needed, for example, due to provision of customer toilet facilities, then it could be argued that the expenditure qualifies for capital allowances. Similarly, there could also be an argument where such facilities are required for staff employed in the business. Each scenario would need to be carefully considered on its individual merits.
If it is decided that the expenditure does qualify for capital allowances, it could be covered by any available AIA, and afford a 100% deduction for income or corporation tax in the year of acquisition, or for the 18% annual writing down allowance.
Where the expenditure does not qualify for capital allowances, it may alternatively qualify for the 2%/3% annual writing down allowance for non-residential structures and buildings.