When a business buys a long term fixed asset it is normal to depreciate that capital asset over a number of years to smooth out the effect on net profit. Depreciation being a management decision is not allowed as a deductible taxable expense and while being deducted to arrive at the management net profit is written back in the accounts for the calculation of tax.

Capital allowances are set by the government at fixed rates at which a business can claim the expenditure on fixed assets against the taxable profit. Prior to the financial year commencing 1 April 2008 capital allowances included a first year allowance at the rate of 50 per cent of the original cost for self employed and small limited companies plus a writing down allowance in subsequent years of 25 per cent of the reducing balance. The rate of first year allowance for medium and large limited companies was 40 percent of the original capital cost.

From the 1 April 2008 for small limited companies and from the 6 April for self employed business the 50 per cent first year capital allowance is replaced by an annual investment allowance at the rate of 100 per cent of the investment subject to maximum expenditure of 50,000 pounds in the financial year and an amount pro rata to that if for a small limited company financial year straggles the 1 April 2008.

The writing down allowance is also changed from April 2008 being reduced from 25 per cent of the reduced balance to 20 per cent of the reduced balance.

The annual investment allowance applies to all assets categorised as plant and machinery which includes most fixed assets including plant, equipment, fixtures and fittings, computer equipment and commercial vehicles. As first year allowances could not be claimed on motor vehicles not classed as commercial vehicles the annual investment allowance also do not apply to motor vehicles which are now subject to a reduced writing down allowance in the first year of 20 per cent.

A self employed business operating a standard financial year of 6 April to 5 April 2008 is entitled to the full 50,000 annual investment allowance. If, as is the case of many small limited companies the financial year straggles the 1 April 2008 then prior to this date the first year allowance can be claimed and in respect of expenditure on fixed assets after the 1 April 2008 the annual investment allowance can be claimed with the maximum claim limited on a time based pro rata basis.

Where the financial year for example is 1 January 2008 to 31 December 2008 the capital allowance claim in the first 3 months would be the first year allowance at 50 per cent of capital expenditure. After the 1 April 2008 the annual investment allowance of 100 per cent of the capital expenditure can be claimed subject to a maximum claim of 9/12ths of the 50,000 being 37,500 pounds.

Where capital expenditure exceeds the annual investment allowance maximum limit the additional expenditure will added to the existing unwritten down value of the assets and the reduced writing down allowance of 20 per cent may be claimed against the net taxable profit.

The annual investment allowance does not replace the 100 per cent first year allowance schemes currently applicable to various green and environmental schemes and approved research and development projects. The annual investment allowance is complimentary to these schemes.

In addition for the financial year starting April 2008 small businesses which have a written down balance for tax purposes of under 1,000 pounds will be entitled to write off the total written down value as a capital allowance.