Sarah Bradford considers how to differentiate between capital and revenue expenditure, and why it matters.
Expenditure may be capital or revenue in nature. The distinction is important as it will determine how the expense is treated for tax purposes and the relief (if any) which is available.
While it will often be the case that an item of expenditure will be wholly capital or wholly revenue, there may be occasions where capital improvement work and revenue repairs are undertaken at the same time. This will necessitate splitting the expenditure between capital and revenue.
Capital expenditure
Capital expenditure is expenditure on items that are retained within the property business and which either form part of the land or structure or which are used to generate revenue. In the context of a property business, items of capital expenditure will include the land and property itself, fixtures and fittings, furnishings and domestic appliances.
Relief for capital expenditure may be given in various ways, depending on the nature of the expenditure, the type of property business and whether the accounts are prepared under the cash basis or the accruals basis.
Unless accounts are prepared under the cash basis (which is the default basis in most cases where rental receipts are £150,000 or less), capital expenditure cannot be deducted in calculating taxable profits. Instead, relief is given either through the capital allowances system or in calculating any capital gain or loss on the eventual disposal of the property.
Where accounts are prepared on the cash basis, the expenditure can be deducted in computing profits unless the expenditure is of a type for which such a deduction is expressly prohibited (as is the case for land, buildings, and cars).
Revenue expenditure
Broadly, revenue expenditure is expenditure incurred in the day-to-day running costs of the business, such as staff wages and salaries, accountancy fees, administration expenses, advertising costs, cleaning costs, travel expenses, maintenance costs, repairs and suchlike.
Regardless of whether the accounts are prepared under the accruals basis or the cash basis, revenue expenses can be deducted in computing the taxable profits of the business, as long as they are incurred wholly and exclusively for business purposes.
Splitting expenditure
Capital and revenue expenditure may be incurred at the same time. Where this is the case, the expenditure will need to be split between the capital component and the revenue component so that each part can be treated correctly for tax purposes.
The need to split expenditure is most likely to arise where a property is being renovated or extended. Where this is the case, the project may include elements of repair and maintenance as well as capital improvement.
When undertaking repair and improvement work, the line between capital expenditure and revenue expenditure can become blurred. At what point does something stop being a repair and become an improvement?
Repair or improvement?
A ‘repair’ is defined by HMRC as the restoration of an asset by replacing parts of the whole asset. Replacing roof tiles blown off in a storm, repointing brickwork, undertaking interior and exterior decoration, and mending broken windows would be repairs. The nature of the work is to put the property back in its original condition rather than making it into something better.
Expenditure on repairs is revenue expenditure. As long as the repairs are undertaken wholly and exclusively for the purposes of the property business, the expenditure can be deducted in full when calculating the taxable profit.
Expenditure on improving the property is capital expenditure rather than revenue expenditure. An example here would be the addition of an extension or a loft conversion.
Drawing the line
However, in practice, it will not always be clear whether there has been improvement or where the line should be drawn.
HMRC recognises the difficulty in determining, at the margin, whether work constitutes a repair or an improvement. They acknowledge that ‘sometimes the improvement may be so small as to count as incidental to the repair’. Where there are no other indicators of capital expenditure, they allow the full amount of the expenditure to be deducted as revenue expenditure.
A further problem can arise where there is an element of improvement because the repair has been carried out using modern materials which give the appearance of an improvement simply because the materials are of a superior quality, give a better finish or are more durable than those which they replaced. As long as the materials are, taking account of developments over time, broadly equivalent to the old materials, the expenditure will be treated as revenue expenditure and deductible in full.
HMRC also accepts that replacing wooden beams with steel girders and lead pipes with copper or plastic pipes are repairs (and allowable as a deduction) rather than improvements, in the absence of other indicators that the expenditure is capital in nature. However, the boundary is crossed if the wooden beams are replaced with steel girders to enable the building to take heavier loads, or the new pipes are designed to take greater pressure or more heat. It is, therefore, necessary to consider the wider picture in determining whether the expenditure is capital or revenue.
In deciding whether the revenue or capital boundary has been crossed, the degree of improvement also needs to be considered. Where there is only a trivial increase in performance or capacity resulting from the use of newer, but broadly equivalent, materials, the expenditure remains revenue. But if the improvement arising from the change of materials is significant, the full amount of the expenditure is capital, including the cost of any work that is needed to ‘make good’, such as redecorating after the improvements have been carried out (even though redecoration work would, on its own, be revenue expenditure).
Any improvements that arise solely as a result of improvements in technology (e.g., the replacement of single glazing with double glazing) are generally treated as repairs, such that the costs are deductible rather than an improvement, as long as the functionality and character remain broadly the same.
It may also be necessary to consider whether an apportionment of expenditure is needed where extensive alterations are undertaken. However, if these are so significant as to amount to the reconstruction of the property, the full amount of the associated expenditure will be capital expenditure. Expenditure will only be allowable as repair expenditure in relation to any parts of the old building that are preserved.
Basis of apportionment
Work undertaken on a property may include both capital and revenue expenditure at the same time. Expenditure on repairs remains allowable, subject to the condition that it is incurred wholly and exclusively for the purposes of the business. To identify the deduction for repairs, the costs must be split.
If the contractor provides one bill covering both capital and revenue expenditure, the costs will need to be apportioned. To do this, it is necessary to identify what work counts as repair work and what work counts as improvement work.
HMRC allows expenditure to be ‘apportioned on a reasonable basis to estimate the amount attributable to the repair element’. Where the bill is itemised, splitting the total between capital and revenue should be fairly straightforward. However, HMRC stresses that any split ‘must be done fairly and the figures will be open to review’.
To back up the split, it is helpful to keep any relevant documentation, such as evidence of initial discussions and initial estimates, plans and suchlike. For example, emails discussing how part of the building may be repaired may be useful to support the contention that the associated expenditure is deductible revenue expenditure rather than capital improvement expenditure.
Practical tip
Where an extensive building project is undertaken by a property business or a landlord, the project may involve both repairs and alterations to the building, and consequently, both capital and revenue expenditure will be incurred. To ensure that the costs are treated correctly for tax purposes, and importantly, deductions for revenue expenses are not overlooked, it is vital to understand the nature of the work undertaken and the costs attributable to each, making any necessary apportionments in a fair and sensible manner which is open to scrutiny.
