United Kingdom

As noted in the Income determination section, the UK tax system requires taxable profits to be calculated by aggregating (i) the company's net income from each source and (ii) the company's net chargeable gains arising from the sale of capital assets. This approach gives rise to a particularly complicated regime so far as deductions are concerned. Expenses are usually allocated to the source of income (or occasionally by reference to income generally) or to the particular gain to which they relate. The rules governing their deductibility differ according to whether the expense relates to a capital gain or to income, and, indeed, according to the particular source of income concerned. For example, there is a considerable difference in the manner in which tax relief is given for expenses incurred by companies trading in property as compared to those that invest in property. The regime also has a large number of specific rules dealing with particular types of deductions that take priority over the more general rules for each type of income.

We have therefore set out the general rule for trading expenses, being the most common category, and, following that analysis, considered some specific common exceptions.

General rules for trading expenses

A trading company is generally permitted to deduct expenses that are incurred wholly and exclusively for the purposes of the company's trade, provided those costs are not capital in nature and are charged to the profit and loss account. There is a significant amount of case law surrounding whether expenses have been incurred wholly and exclusively for the purposes of a company's trade and whether they are capital or not.

Relief is generally given in the period the expenses are accrued in the accounts, subject to some specific exceptions. In particular, contributions to a registered pension scheme are only allowed on a 'paid' basis, with some further provisions under which some contributions may be spread over a number of years; and if bonuses and other staff costs are paid out more than nine months after the end of the accounting period in which they are accrued, they are only allowed on a paid basis.

The general rule is made subject to a range of specific statutory provisions, some of which allow deductions and others of which limit them; some of the more important of these are discussed below, but there are many others. One example is that the costs of business entertainment cannot generally be deducted.

The United Kingdom has introduced rules dealing with hybrid mismatches, broadly intended to implement the recommendations in Action 2 of the OECD’s BEPS project, which took effect on 1 January 2017. They are complex, may apply to a broad spectrum of situations, and require careful consideration. At a high level, they effectively seek to address the situations where there is either: (i) a mismatch between the deduction that arises and the income that is taxed or (ii) a deduction taken into account in two jurisdictions. This could arise in situations involving a hybrid entity (such as a US company for which the check-the-box election has been made), a hybrid instrument (e.g. one that is treated as debt for one party but equity for the other), or dual resident companies, etc. Where a mismatch is caught by these rules, a disallowance may be required in the computation.

Depreciation and amortisation

Depreciation of fixed assets (other than certain assets within the intangible fixed asset regime, see below) is not allowable as a deduction from any source of income. However, traders, and most non-traders, are instead allowed specified rates of annual deduction in respect of specified classes of assets, together referred to as 'capital allowances', that are deducted in calculating trading income for traders and (broadly) against income derived from the use of the fixed assets for non-traders.

There are several different categories of capital allowances, each attracting a unique rate of tax relief, and fixed asset expenditure is allocated to one of these as follows:

• Main pool plant and machinery: 18% writing down allowances per annum on the reducing-balance basis on certain equipment, plant, and machinery acquired for use in a trade or property rental business. Note that a temporary super deduction regime (providing up to a 130% deduction) existed from 1 April 2021 to 31 March 2023; this was replaced by the Full Expensing First Year Allowance (FYA) (see below) providing a 100% first year deduction for relevant main pool plant and machinery (at the increased corporation tax rate of 25%).
• Following an announcement made at the 2023 Autumn Statement, Full Expensing is expected to be made permanent.
• Special rate pool plant and machinery: 6% writing down allowances on integral features in building (e.g. heating and ventilation), thermal insulation, expenditure incurred after 1 April 2018 on cars with carbon dioxide emissions that exceed 110 grams per kilometre driven, and long-life assets (over 25 years). Note that from 1 April 2021, a 50% first year allowance regime has existed (in different forms) for relevant special rate pool expenditure (exclusions include cars); following an announcement at the Autumn Statement this measure is expected to be made permanent.
• R&D allowances: 100% FYA in respect of assets, including buildings, used to carry out qualifying R&D.
• Structures and buildings allowances (SBAs): 3% per annum on a straight-line basis on structures and buildings not used in a residential capacity. 
• Cars: 100%, 18%, or 6%, depending on the CO2 emissions of the car.

No income tax relief is available on non-qualifying assets and expenditure which includes almost all expenditure on land.

Generous temporary reliefs were introduced in the 2021 Budget in respect of main pool and special rate pool expenditure, as follows: 

• The super-deduction provides up to 130% FYA for expenditure that qualifies for main pool plant and machinery (this percentage pro-rates down to 100% as the tax rate increases giving an continuous effective tax rate saving of c25%).
• A 50% FYA is available for expenditure incurred on assets qualifying for the special rate pool (normally at 6%).
• There are a number of restrictions to the expenditure that qualify for the super-deduction and 50% FYA, including plant and machinery used for leasing (excluding background plant and machinery). The above applies to new expenditure incurred from 1 April 2021 through to 31 March 2023 only where contracts for the expenditure were entered into on or after 3 March 2021.
• An enhanced 10% rate of SBA for constructing or renovating non-residential structures and buildings within Freeport tax sites. An enhanced capital allowance of 100% for companies investing in any plant and machinery for use in Freeport tax sites.

The above temporary reliefs were replaced by an accelerated UK tax relief for capital expenditure incurred by companies from 1 April 2023, essentially continuing the effective c.25% rate of tax relief offered by the existing super-deduction regime. Whilst originally expected to run until 31 March 2026, at the 2023 Autumn Statement the Government announced their intention to make this relief permanent.

Full expensing provides a 100% FYA in year 1 for main pool (MP) plant and machinery qualifying expenditure incurred by a company (with certain exclusions) as opposed to the prevailing 18% MP writing down allowance per annum.

Additionally, expenditure incurred by companies qualifying for special rate pool (SRP) plant and machinery allowances, ordinarily receiving 6% SRP writing down allowance per annum, now benefits from a 50% FYA in year 1 under full expensing; note that this regime operates in a slightly different way to the 50% SR allowance that accompanied the super-deduction.

As a First Year Allowance, full expensing on expenditure incurred in a given period must be claimed in the respective UK tax return. Claims must therefore be prepared on a timely basis and cannot be deferred to future periods.

There is no definitive list of assets that qualify for tax relief through capital allowances, and it is important to consider tax legislation, case law, and HMRC guidance when identifying qualifying expenditure.

Most businesses, regardless of size, can claim an annual investment allowance (AIA) of 100% on the first GBP 1 million per year of most qualifying expenditure. This is restricted to a single allowance for groups of companies or associated businesses. To stimulate business investment, the Finance Act 2019 increased the AIA to GBP 1 million (from GBP 200,000) from 1 January 2019, whilst originally expected to be a temporary measure, this AIA was set permanently at GBP 1 million from 1 April 2023. 

SBAs were announced at Budget 2018 and apply to qualifying expenditure incurred on or after 29 October 2018. In brief, relief is given at a 3% flat rate and is available for new commercial structures and buildings, including costs for new conversions or renovations, where a contract is entered into and works commence on or after 29 October 2018.

Capital allowances may also be available in respect of the cost of the acquisition of mineral assets and extraction, generally at the rates of 10% and 25%.

Excess capital allowances are generally recaptured on disposal. The recapture is calculated on a 'pool' basis for most machinery and equipment, in which case there is no recapture unless the sale proceeds exceeds the total tax written down value of the pooled assets or on cessation of a qualifying activity. Where claims for the super-deduction, full expensing, RDAs or either of the 50% FYAs have been made there will typically be a full clawback of the disposal proceeds in the period of disposal resulting in a tax charge arising at that point.

Where assets are leased, capital allowances are generally not available to the lessor and can sometimes be available to the lessee. The rate of capital allowance of most plant or machinery leased to non-residents businesses is generally restricted to 10%, but in some cases to nil.

Intangible fixed assets

A special regime applies to intangible assets, such as patent rights, know-how, trademarks, and goodwill. Royalties are generally deductible on an accounts basis, and, except in relation to 'grandfathered' assets owned by the group on 31 March 2002, the accounts' amortisation of intangible assets is also deductible (with an option to take a flat 4% deduction even if not amortised in the accounts). Traders will take the deductions in computing trading income; non-traders will create a 'non-trading loss on intangible fixed assets' that can be relieved as a loss against any profits of the year or carried forward indefinitely.

With effect for acquisition of goodwill and customer-related intangibles on or after 8 July 2015, amortisation, impairment, and certain other charges are not deductible for tax. Subsequent profits and losses on disposals of such goodwill remain taxable/deductible. However, from April 2019, there is relief for the cost of certain goodwill and customer-related intangibles when acquiring businesses with eligible IP.

Tax relief for expenditure on software that is capitalised as an intangible fixed asset can usually be received in line with the amortisation of the expenditure. Where such expenditure is capital in nature it is possible to exclude the expenditure from the intangibles regime and for it to be treated as qualifying for plant and machinery allowances under the capital allowances regime. In certain circumstances, where such an election is made, the expenditure may qualify for the super-deduction or full expensing. Expenditure that would be considered revenue for tax purposes is not eligible for such an election.

Income costs relating to R&D are normally deductible in any event, but there is a special incentive connected with R&D that generally allows additional tax relief (see the Tax credits and incentives section for more information).

Management expenses

Holding companies and companies with investment business can deduct expenses if they are expenses of managing the company's investment business and are not capital in nature. Such costs would typically include audit fees, directors' costs, rent, local rates, and office costs. These costs can be set against any sources of profit the company may have, including gains and financing income.

If the company has inadequate income, excess expenses can be surrendered as group relief or carried forward to set against future income, with no time limit.

Employee share schemes

The actual and deemed costs of an employing company for the deemed cost of providing shares or options to employees is usually deductible, depending on the nature of the share plan and the accounting. This will generally allow a deduction to a subsidiary company whose employees receive shares or options in the parent company.

Funding costs

Funding costs (primarily fees and interest) are broadly deductible on an accounts basis, even if capital in nature, but subject to transfer pricing and thin capitalisation constraints (with no explicit safe harbours), hybrid mismatch rules (see General rules for trading expenses above), and the corporate interest restriction (CIR) rules (see below). Some of these rules apply to foreign exchange deductions relating to debts owed and receivable.

Traders will generally take the deductions in computing trading income (which is also accounts based). Deductions relating to loans not used for trading purposes will give rise to 'non-trading deficits' that, if not group relieved, can be offset against profits of that year generally, carried back one year (against that year's funding profits), or carried forward indefinitely against non-trading profits (where the deficit arose before 1 April 2017) or against total profits (where the deficit arose on or after 1 April 2017).

There are complex and specific rules dealing with financial instruments, derivatives, cross-border transactions, etc.

From 1 April 2017, and subject to a GBP 2 million de-minimis per annum, the CIR rules impose a fixed ratio limiting corporation tax deductions for net interest expense to the higher of 30% of UK earnings before interest, taxes, depreciation, and amortisation (UK EBITDA) and the group ratio (for highly geared groups). In addition, the net interest deduction of the UK group cannot exceed the net interest shown in the worldwide group’s consolidated financial statements. These rules replace the previous worldwide debt cap rules and will often operate to reduce the amount of tax deductions achieved by UK taxpayers.

Bad debts, provisions, and reserves

Provisions for future costs can be deducted for tax purposes if they:

• are in respect of allowable revenue expenditure
• are made in accordance with acceptable accounting practice
• do not conflict with any statutory rule governing the timing of relief (e.g. in relation to payment of staff costs), and
• are estimated with sufficient accuracy.

This rule extends to bad debts on trading account. Generally, however, bad debts are dealt with under the 'loan relationships' rules for financing costs and financing income. The rules there, however, are broadly the same; if the bad debt can be identified specifically enough to allow a bad debt provision that satisfies UK accounting standards, it should be deductible.

Charitable donations

Most donations to charities by companies are deductible.

Fines, penalties, and bribes

Any payments that constitute a criminal offence (e.g. a bribe) are not deductible for tax. Fines and penalties imposed for breaking the law are also not deductible, although a deduction is usually available for legal costs incurred in defending such an action. Usually, there is no deduction for civil penalties, interest, and similar surcharges (e.g. relating to VAT). Fines for regulatory breaches are not allowed for tax, but the costs of compensating customers, etc. are usually deductible.

Damages that are compensatory rather than punitive (e.g. damages for defamation payable by a newspaper company) are often deductible, as are payments for breach of contract. Payments to employees for wrongful dismissal, etc. are usually deductible.

Taxes

Local municipal taxes (business rates) may be deducted from taxable income.

Net operating and capital losses

See Income losses in the Income determination section for a description of the treatment of income losses and capital losses.

Payments to foreign affiliates

There are no special rules for payments to foreign affiliates, so their tax treatment follows the basic rules for deductions set out above. The transfer pricing rules will impose an arm's-length price if the actual price is not arm’s length, provided that the resulting adjustment increases UK taxable profits or reduces UK taxable losses.