What tax implications can come with depreciation?

For business owners, understanding depreciation is not just about accounting practices but also about handling their taxes efficiently.  

Depreciation represents the reduction in the value of an asset over time, primarily due to wear and tear.  

Businesses use various methods to calculate depreciation, such as the straight-line method or the reducing balance method.  

The chosen method can impact a company’s financial statements and, consequently, its tax liabilities. 

Tax implications of depreciation 

Depreciation plays a crucial role in determining a business’s taxable income. As assets depreciate, businesses can deduct this value from their profits, thereby reducing their taxable income.  

However, the tax system does not allow businesses to deduct depreciation directly. Instead, businesses claim capital allowances. 

Capital allowances 

Capital allowances are deductions that businesses can claim for certain capital expenditures, effectively serving as a substitute for depreciation in tax calculations.  

These allowances come in various forms, including: 

• Annual Investment Allowance (AIA) – A type of capital allowance that lets businesses deduct the total value of qualifying assets from their profits before tax 
• Writing Down Allowances (WDA): Allowances claimed on assets that don’t qualify for AIA, spread over several years 

By claiming these allowances, businesses can significantly reduce their tax liabilities, emphasising the importance of understanding and correctly calculating depreciation. 

Common scenarios in taxation and depreciation 

Several scenarios can affect how businesses calculate depreciation and claim capital allowances. 

When a business acquires a new asset, it is important to work out if the asset qualifies for AIA or if it should be depreciated using WDA. 

If a business sells an asset for more than its written-down value, it may need to pay tax on the difference, known as a balancing charge. 

Switching between depreciation methods can have tax implications, requiring businesses to adjust their capital allowance claims accordingly. 

Challenges and considerations 

While there are benefits to using depreciation against a business’s tax obligations, there can also be downsides too.  

These include incorrectly classifying assets, leading to missed AIA opportunities, failing to update depreciation calculations in line with changing tax laws and regulations, and overlooking international operations and their impact on depreciation and taxation. 

Depreciation is more than just an accounting concept for business owners and is a critical component of tax planning and strategy.  

If you would like more advice about depreciation and how it can benefit your tax responsibilities, please contact us today.