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 UK 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 which arises and the income which 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 which 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. these include :
Main pool plant and machinery – 18% writing down allowances per annum on certain equipment, plant and machinery. (Temporary super deduction - see below) acquired for use in a trade or property rental business; thereafter, capital allowances are taken generally at 18% per annum on the reducing-balance basis.
Special rate pool plant and machinery – 6% WDAs 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 (UEL over 25 years).(Temporary 50% first year allowance - see below)
Research and development allowances – 100% first year allowances in respect assets, including buildings, used to carry out qualifying research and development.
Structures and buildings allowances - 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 tax relief is available on non-qualifying assets and expenditure.
Generous temporary reliefs were introduced in the 2021 Budget in respect of main pool and special rate pool expenditure:
The super-deduction will provide a 130% first year allowance for expenditure that qualifies for main pool plant and machinery
A 50% first year allowance will be available for expenditure incurred on assets qualifying for the special rate pool (normally at 6%
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 plant and machinery for use in Freeport tax sites. Further details to follow.
There appear to be a number of restrictions to the expenditure that will qualify, including plant and machinery used for leasing (excluding background Plant & Machinery). The above will apply to new expenditure incurred from 1 April 2021 only where contracts for the expenditure was entered into on or after Budget Day (3 March 2021)
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.
All businesses, regardless of size, can claim an annual investment allowance 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 annual investment allowance to GBP 1 million (from GBP 200,000) for a two year period from 1 January 2019. This has been further extended to 1 January 2022.
Structures and buildings allowance (SBA) was announced at Budget 2018, applies to qualifying expenditure incurred on or after 29 October 2018. The detailed legislation for the SBA took effect on 5 July 2019. 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 assets are leased, capital allowances are generally available to the lessor rather than the lessee. The rate of capital allowance of most plant or machinery leased to non-residents 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, and 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.
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).
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.
Many of the specific rules on the deduction of trading expenses also apply to management expenses. Many rules giving traders specific deductions for certain costs also apply, but this is not always the case.
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 (primarily fees and interest) are broadly deductible on an accounts basis, even if capital in nature, but subject to thin capitalisation constraints (with no explicit safe harbours), hybrid mismatch rules (see general rules for trading expenses) 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.
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.
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.