Authors: Alex Smith and Virginia Mariscal-Rios

Understanding capital expenditure versus revenue expenditure

A common pitfall is to classify revenue expenses as capital, or vice versa. Correct identification requires reviewing the purpose and long-term benefit of the expenditure at the time when it is incurred.

Capital expenditure refers to spend on acquiring, entirely replacing or enhancing assets such as plant and machinery, computers, fixtures and fittings, or vehicles. They are not day-to-day expenses but rather investments that provide an ‘enduring benefit’ to the business. These are added back when calculating taxable trading profits and the business can claim capital allowances instead.

There is no strict time limit that can be applied when considering whether expenditure is capital in nature.  However, HMRC generally accepts that expenditure on assets with a useful economic life of less than two years is revenue in nature, rather than capital, because such assets will not provide a lasting benefit to the business.

Conversely, expenses incurred to maintain rather than improve an asset, such as repairs, are typically considered to be revenue expenses and they are fully deductible from taxable profits in the year they occur.

The distinction between revenue and capital expenditure is therefore key for businesses to determine what costs can be immediately deducted from taxable profits and what costs are capital in nature and can be allocated capital allowances instead. Correctly classifying expenses not only avoids penalties for inaccurate tax returns but also helps maximise available tax reliefs whilst ensuring accurate financial reporting.

Key types of capital allowances currently available 

Businesses can claim different amounts for capital allowances based on the asset type and applicable tax rules:

• Annual Investment Allowance (AIA): Provides 100% tax relief on up to £1 million of qualifying plant and machinery expenditure per year. The AIA can also be allocated to integral features, which belong to the special rate pool. You cannot claim AIA on business cars, items you owned for another reason before you started using them in your business or items given to you or your business.
• Full Expensing: Allows companies to deduct 100% of the cost of qualifying ‘main rate’ plant or machinery from taxable profits in the year that expenditure is incurred. The plant and machinery must be new and unused, must not be a car, given to the company as a gift, or bought to lease to someone else. Full expensing is available to companies subject to Corporation Tax only. Therefore, unincorporated businesses cannot claim, but such businesses are entitled to claim the AIA which offers the same benefits as full expensing for the investments it covers (up to £1 million per year). 50% First-Year Allowance (FYA) allows companies to deduct 50% of the cost of new, unused ‘special rate’ assets (i.e. air conditioning, electrical systems) from their taxable profits in the year that expenditure is incurred. Capital allowances can be claimed on the balance of expenditure in subsequent accounting periods at the 6% rate of WDAs for special rate expenditure.
• 100% First-Year Allowances (FYA): Available for specific items, including new electric cars and cars with zero emissions, zero-emission goods vehicles, and equipment for gas refuelling or electric charging.
• Structures and Buildings Allowance (SBA): It provides tax relief on qualifying construction or renovation costs for non-residential buildings and structures. It can be claimed over 33 and one third years at a rate of 3% per annum.  The claimant company must hold a relevant interest in the land where the commercial building or structure is located, i.e. leasehold or freehold.
• Writing Down Allowances (WDA): They provide tax relief for capital expenditure on plant and machinery that is not fully covered by the Annual Investment Allowance (AIA) or First-Year Allowances (FYA). Unrelieved expenditure is added to pools, with most plant and machinery items falling into the main pool (currently in receipt of an 18% writing down allowance, but set to be 14% from 1 April 2026), while other assets, such as cars with emissions over 50g/km, go into the special rate pool (6% writing down allowance).
• New 40% First‑Year Allowance (FYA): From 1 January 2026, businesses can now deduct 40% of the cost of new, unused assets from taxable profits in the first year of purchase or lease. It will exclude second-hand assets, cars, and assets leased overseas. The introduction of the 40% FYA is particularly valuable for sole traders/partnerships, which were previously excluded from full expensing and may exceed their £1m Annual Investment Allowance (AIA). It will also allow the leasing sector, which could not claim full expensing, to benefit from some accelerated relief to support their investment.

You cannot claim Annual Investment Allowance (AIA), the super-deduction, full expensing, Special Rate (SR) allowances, or 50% first-year allowances on business cars. However, you may be able to claim a 100% first-year allowance on electric cars and cars with zero CO₂ emissions or writing down allowances based on its CO₂ emissions as explained above.

It is also worth noting that from 1 April 2025, most double cab and extended cab pick-up trucks have been reclassified as cars rather than commercial vehicles for capital allowances purposes.

Understanding the specific rules, eligibility criteria and the interaction between the different types of capital allowances available is crucial for businesses to ensure tax compliance whilst optimising their tax planning strategies.

Vehicle financing options: Tax considerations

Whether the business is buying outright, financing, or leasing a vehicle, the tax treatment and potential financial implications vary:

• Outright Purchase: Potential for full capital allowances for brand new electric vehicles, vans or other large commercial vehicles, but ties up cash. The rate of deduction for non-electric cars depends on the CO₂ emissions of the vehicle. Businesses cannot recover VAT on the purchase of cars unless the car is used exclusively for business purposes (which is rare).  Some examples of cars wholly used for business include taxis, driving schools and vans (which are kept on site and never used for e.g. commuting or personal travel) in which case VAT can be recoverable.  VAT on the purchase of commercial vehicles that fall outside the definition of a car is usually recoverable.
• Hire Purchase (HP): The company is treated as owning the car from the start, which means that capital allowances can usually be claimed, including the 100% relief for new electric cars, and the interest payments are typically tax-deductible. The VAT may be chargeable upfront on the total cost, and the same rules as above also apply here (i.e. VAT is typically blocked from recovery, unless the car is wholly for business use).
• Personal Contract Purchase (PCP): Despite described as a tax efficient option by most car dealerships, the reality is that this arrangement often fails to qualify for capital allowances. The final balloon payment and ownership structure affect how capital allowances apply and whether VAT is or not recoverable from a VAT point of view, it all depends on the level at which the final balloon payment is set. The proportion of VAT that is recoverable would also depend on the nature of the arrangement and use (i.e. business or personal) of the car. You should seek tax advice and provide a copy of the draft contract to your accountant before entering into this arrangement to check, based on the specified terms, if it would be eligible for capital allowances and upfront VAT recovery or not.
• Leasing / Contract hire: Lease payments are usually treated as an ongoing business expense, which means that there is no upfront tax deduction on the year of purchase, even for electric vehicles. Additionally, a flat rate disallowance of 15% of the leasing costs applies to cars with CO₂ emissions exceeding 50g/km (110g/km for expenditure incurred before 1 April 2021). Therefore, for high emission cars only 85% of the lease charge in the P&L account would be allowable for tax purposes. If your business leases a qualifying car for business purposes, you can normally reclaim 50% of the VAT charged for the actual car – vs 100% for a commercial vehicle.
• Ongoing maintenance / repair costs: Please note that ongoing maintenance and repair is often charged separately to any lease / HP arrangement.  Where this is the case, then the relevant VAT block (100% or 50%) would not apply to these costs, to the extent that they are still suffered by the business; however, it is important to check that these are supplied separately and do not form part of a single supply of a lease.

In all above cases, you should always obtain a VAT invoice (not a pro forma), and make sure this contains your supplier’s VAT registration number.  The actual level of VAT recovery may also depend on any partial exemption restriction, which may need to be applied by the business.

Environmental Considerations: CO₂ and Commercial Vehicles

Leased vehicles with CO₂ emissions above 50g / km suffer a 15% cost add back in tax calculation, reducing deductible expenses despite a cash outlay.

Before 1 April 2025 most double cab and extended cab pick-up trucks with a payload of one tonne or more were treated as commercial vehicles for capital allowances purposes. However, from that date onwards, they are now considered ‘cars’ which means if their CO₂ emissions are over 50g/km, then 15% of their lease cost will also need to be disallowed for tax purposes.

Electric vehicles no longer benefit from zero Vehicle Excise Duty (VED), which is now typically in line with petrol cars. Businesses relying on these advantages should reassess their fleet strategy to avoid unexpected surprises.

Income Extraction: What if I purchased in my own name?

Many new cars come with an expensive price tag, so often shareholders will become subject to higher and unexpected rates of personal tax in order to draw sufficient monies to fund a purchase, making personal ownership particularly expensive. This is either triggered by entering a higher tax band, or by earning above £100,000 in total and so losing all or part of the personal allowance.

However, making your next car purchase through your business may be a more tax efficient option as there is no income extraction required, which may lead to a significant tax saving. A drawback however will be that private use will lead to a taxable Benefit In Kind (BIK), based on the P11d value (even if second-hand) and payable every year. This is most expensive for petrol and diesel cars, but rates are still comparatively low for electric cars – currently 3% and set to rise to 9% by 2029/30.

Your frequency of car purchases, and how expensive they are anticipated to be, may lead to one option or another being preferential. So, you should seek advice before you buy!

Lease accounting changes: Effective now

Lease accounting rules under FRS102 have changed from 1 January 2026 to closely align to International Financial Reporting Standards (IFRS). One of the fundamental changes is the removal of the distinction between operating and finance leases for lessees, which means that they will need to bring their operating leases onto the balance sheet by recognising both the right of use asset and the corresponding lease liability. This could affect financial ratios and reporting, so it is crucial to start preparing your records now.

Transition adjustments are available to ease the shift to the new standard and do not permit a prior year adjustment. For any existing leases at the date of transition, a right-of-use asset and lease liability should be calculated for the remaining lease term and recognised accordingly. Any difference should be adjusted to the opening retained earnings.

Broadly from a tax point of view, the treatment of the right of use asset would be to allow the depreciation in line with the accounts and also allow the interest on the lease liability for tax purposes.  As corporation tax follows the accounts here, there will not normally be any change to deferred tax either.

Final thoughts

Capital expenditure decisions, especially around vehicles, are more than just operational choices. They are strategic tax planning opportunities. By understanding the nuances of capital versus revenue classifications, financing options, VAT rules, and regulatory changes, businesses can unlock significant savings.

At Shaw Gibbs, we help clients navigate these complexities with clarity and confidence to ensure compliance with the rules, whilst unlocking available tax savings. Contact our team today to ensure you are not missing out on available tax reliefs.