When a company buys a major piece of equipment, a vehicle, or any other long-term asset, the company doesn’t just list the entire cost of the asset as an expense in its income statement for that year.
Instead, the cost is spread over several years. This is because the long-term assets purchased by the company, known as capital assets, are expected to help the company generate revenue over many years, not just in the year they are purchased.
This approach is based on the matching concept in accounting.
The matching concept ensures that expenses are recorded in the same period as the revenue they help generate.
Imagine you buy a machine for ₦1,000,000, and this machine is expected to help produce goods for 5 years. According to the matching concept, the cost of the machine should be spread over the 5 years, as it will contribute to generating revenue for each of the 5 years.
Note: If you expense the entire ₦1,000,000 in the year you buy the machine, your financial statements will show a big expense in that year, even though the machine will benefit the company for 5 years.
{getToc} $title={Table of Contents}
Understanding Capital Assets
Capital assets are big, long-term items a business buys to use over several years. These could be things like:
- Machinery: Equipment used in production.
- Vehicles: Company cars, trucks, or delivery vans.
- Buildings: Offices, factories, or warehouses.
- Office Equipment: Computers, furniture, etc.
Depreciation in Financial Statements
To better match the cost of the asset with the revenue it helps generate, companies use depreciation.
Depreciation is an accounting method that spreads the cost of the asset over its useful life. For example, if a company buys a machine for ₦1,000,000 and expects to use it for 10 years, it might depreciate the machine at ₦100,000 per year. This way, the cost is allocated over the years the machine is in use.
However, depreciation is just for accounting purposes—it shows up on the company’s financial statements, but it doesn’t directly affect the company’s taxable income.
Transition to Tax Purposes: Capital Allowance
When it comes to calculating taxes, the tax authorities have a different set of rules. They don’t just accept the company’s depreciation figures, because they have no control over the method of depreciation used by the company. Instead, they use something called capital allowance to determine how much of the cost of a capital asset can be deducted from taxable income each year.
Capital allowance is similar to depreciation, but it’s specifically used for tax purposes. It allows companies to deduct a portion of the cost of their capital assets from their taxable income over several years. The key difference is that capital allowance rates and rules are set by tax laws, not by the company’s accounting policies.
How Capital Allowance Works
Capital allowance spreads the cost of a capital asset over time, but it does so according to specific rules set by the tax authority. Here’s how it typically works:
Initial Allowance
Initial Allowance is a one-time deduction applied in the first year an asset is put into use. It’s typically a significant percentage of the asset's cost and is meant to provide immediate tax relief when the asset is first acquired. This allowance encourages investment by reducing the taxable income more sharply in the year the asset is purchased.
- Example: If Aliko Limited purchases machinery for ₦10,000,000 on January 1, 2024. The machinery qualifies for capital allowances. Assume the initial allowance rate for the machinery is 50% according to the local tax laws, then ABC Limited can claim initial allowance of ₦5,000,000 on the machinery (i.e., 50% x ₦5,000,000). What this means is that ABC Limited can deduct ₦5,000,000 from its taxable income in that year of assessment.
- The remaining balance is therefore ₦10,000,000 - ₦5,000,000 = ₦5,000,000. This is called the Tax Written Down Value (TWDV).
- TWDV is the remaining value of an asset for tax purposes after capital allowances (initial and annual allowances) have been deducted. It represents the book value of the asset in the company's tax records.
Annual Allowance
Annual Allowance is an ongoing deduction applied after the initial allowance. It’s calculated as a percentage of the remaining value of the asset (after deducting the initial allowance) and is spread over the asset's useful life. This allowance continues each year until the total cost of the asset has been deducted.
- Example: Following the initial allowance example, if the annual allowance rate for the machinery is 25% according to the local tax laws, then Aliko Limited can claim annual allowance of ₦1,250,000 on the machinery (i.e., 25% of the TWDV after calculating initial allowance, ₦5,000,000).
- In some countries, like Nigeria, you can claim both initial and annual allowance in the same year the asset was purchased. What this means is that ABC Limited can deduct ₦6,250,000 (₦5,000,000 + ₦1,250,000) from its taxable income in the year of assessment in which the asset was purchased.
- Then the TWDV becomes ₦10,000,000 - ₦6,250,000 = ₦3,750,000
- Note that in subsequent years, the annual allowance value is deducted from the TWDV for that year until the TWDV is exhausted.
Investment Allowance
Investment Allowance is an additional deduction offered to businesses that invest in specific types of capital assets. This allowance is often given as an extra incentive on top of the initial allowance and encourages investment in certain sectors or types of equipment. Unlike the initial and annual allowances, the investment allowance does not reduce the value of the asset for subsequent calculations.
- Example: Assume the government offers an investment allowance of 10% for companies investing in green energy technologies. If a company purchases solar panels for ₦5,000,000, they can claim an additional ₦500,000 deduction immediately.
- Note that the investment allowance should not be taken into account when calculating the TWDV. Only the initial and annual allowances can be deducted from the value of the asset to obtain TWDV.
Balancing Allowance
Balancing Allowance occurs when an asset is disposed of (e.g., sold or scrapped) before it has been fully written off through annual allowances. If the sale proceeds are LESS THAN the tax written down value (TWDV) of the asset, the difference is treated as a balancing allowance and is deducted from taxable income.
- Example: If a machine with a TWDV of ₦3,000,000 is sold for ₦2,000,000, the company can claim a balancing allowance of ₦1,000,000 (i.e., ₦3,000,000 - ₦2,000,000). The balancing allowance can be deducted from the taxable income.
Balancing Charge
Balancing Charge is the opposite of the balancing allowance. If an asset is sold for more than its TWDV, the difference is ADDED BACK to the company’s taxable income. This charge ensures that businesses do not profit from tax allowances when disposing of assets.
- Example: Using the previous scenario, if the machine with a TWDV of ₦3,000,000 is sold for ₦3,500,000, the company must add a balancing charge of ₦500,000 (₦3,500,000 - ₦3,000,000) to its taxable income.
Why Capital Allowance Matters
Capital allowance is crucial because it directly affects a company’s taxable income, and therefore, how much tax it pays. By carefully calculating and applying capital allowance, companies can reduce their tax burden over time, freeing up more cash to reinvest in their business.
Capital Allowance in the Nigerian Tax Space
Investment allowance and rural investment allowance in Nigeria
- Investment allowance is an incentive granted where a company has incurred expenditure in property, plant and equipment (PPE) at the rate of 10% of the purchase amount. However, please note that the investment allowance shall not be taken into account in ascertaining the TWDV of the PPE.
- Rural investment allowance incentive was available to companies located in rural areas, and provided additional tax deduction at varying rates on eligible capital expenditure incurred for companies located at least 20km away from available utilities.
- Investment allowance and Rural investment allowance have been expunged by Finance Act 2023 (FA'23).
Conditions for Granting Capital Allowance in Nigeria
- The company must have incurred capital expenditure.
- The claimant (i.e., the company) must remain the beneficial owner of the asset at the end of the basis period of the company.
- The asset must be wholly, reasonably, exclusively, and necessarily (WREN) used for the purpose of trade or business carried on by the company at the end of its basis period
Capital allowance rates in Nigeria
- Building / Industrial building expenditure: Initial allowance (15%); Annual allowance (10%)
- Furniture and fittings: Initial allowance (25%); Annual allowance (20%)
- Motor vehicle: Initial allowance (50%); Annual allowance (25%)
- Public transport motor vehicle: Initial allowance (95%); Annual allowance (0%)
- Plantation equipment: Initial allowance (95%); Annual allowance (0%)
- Agric plant: Initial allowance (95%); Annual allowance (0%)
- Research and development: Initial allowance (95%); Annual allowance (0%)
- Mining: Initial allowance (95%); Annual allowance (0%)
- Construction plant: Initial allowance (50%); Annual allowance (25%)
Restrictions of Capital Allowance in Nigeria
- In Nigeria, capital allowance to be deducted from the assessable profit of companies in any year is restricted to 66.667% of such assessable profit, except for agro-allied industries and manufacturing industries. The remainder of the capital allowance is carried forward to the following year.
- Capital allowance is also restricted when there is private use of the asset in question. The amount on which capital allowance is calculated on the amount allocated to its official use.
- When the basis period is less than 12 months, capital allowance calculation is restricted to the number of months in the basis period.
Capital Allowance on cessation of trade or business in Nigeria
- On cessation of trade/business, unabsorbed capital allowance arising in the year of assessment in which trade/business permanently ceases, may be carried back for relief against the remainder of profits of the five years of assessment preceding the final year of trading/business.
- The remainder of profits discussed above is determined using a proforma as follows: Deduct each of the total profits of the company for the last five years from the unabsorbed capital allowance amount. Then apply the income tax rate on each of the amount deducted; that's the amount to be refunded by the tax authority. OR if the company still has outstanding tax liabilities from prior years, the relief from the unabsorbed capital allowance would first be used to offset these liabilities. OR the relief may also be applied during the final tax computation upon cessation. This means the company's final tax obligations could be reduced by the amount of relief. See below scenario for clarity:
Scenario:
Aliko Limited, a Nigerian company, ceased its business operations permanently in 2024. In the year of cessation, ABC Limited had an unabsorbed capital allowance of ₦10,000,000. The company seeks to carry back this unabsorbed capital allowance to get relief against the remainder of profits for the five years preceding its cessation.
Step 1: Determine the Total Profits for the Last Five Years
Let's assume that below are the total profits of ABC Limited for the last five years:
- 2019: ₦15,000,000
- 2020: ₦12,000,000
- 2021: ₦8,000,000
- 2022: ₦10,000,000
- 2023: ₦7,000,000
Step 2: Determine the Remainder of Profits
To calculate the remainder of profits, the unabsorbed capital allowance of ₦10,000,000 will be deducted from each of the total profits of the last five years, starting with the most recent year.
Proforma Calculation:
2023:
- Total Profit: ₦7,000,000
- Remainder: ₦10,000,000 (unabsorbed capital allowance) - ₦7,000,000 (total profit) = ₦3,000,000
- Tax Relief: ₦7,000,000 * 30% (tax rate) = ₦2,100,000
2022:
- Total Profit: ₦10,000,000
- Remainder: ₦3,000,000 (remaining unabsorbed capital allowance) - ₦10,000,000 (total profit) = ₦0 (remaining unabsorbed capital allowance is fully utilized)
- Tax Relief: ₦3,000,000 * 30% (tax rate) = ₦900,000
2021:
- Total Profit: ₦8,000,000
- No remaining unabsorbed capital allowance to be applied.
- No additional tax relief.
2020:
- Total Profit: ₦12,000,000
- No remaining unabsorbed capital allowance to be applied.
- No additional tax relief.
2019:
- Total Profit: ₦15,000,000
- No remaining unabsorbed capital allowance to be applied.
- No additional tax relief.
Step 3: Summary of Tax Relief:
- 2023: ₦2,100,000
- 2022: ₦900,000
- Total Tax Relief: ₦3,000,000
In summary, Aliko Limited was able to carry back and apply the unabsorbed capital allowance of ₦10,000,000 against the total profits of 2023 and 2022, resulting in a total tax relief of ₦3,000,000. After applying the allowance, no unabsorbed capital allowance remains to be carried back to the earlier years. ABC Limited may seek a refund of this tax relief if it doesn't have outstanding tax liabilities to offset it with.