Capital assets lose value during their use by a business and the loss in value of an asset is referred to as depreciation. Depreciation is an expense as far as accounting is concerned and businesses charge it to their trading and profit and loss account. This reduces their profits and the amount of tax payable.
However, depreciation is not allowed as an expense as far as taxation is concerned and it is added back to taxable income in tax computation. Taxation provides capital allowances for the loss of value of an asset instead of depreciation.
A capital allowance is an expenditure a business can claim against its taxable profit. A certain percentage of the cost of a capital asset is allowed as capital allowance during the accounting period in which it was purchased.
The basic principle of allowing capital allowances in the tax incentive regime is based on the understanding that capital items depreciate at the end of each year and the loss in value of capital items needs to be taken into account as a business expenditure.
There are three different types of capital allowances; Initial, Investment and Annual Allowances. Initial or Investment Allowances are only claimed once in the first year of use of the capital asset. A taxpayer cannot claim Investment Allowance when he has also claimed Initial Allowance. This entails that a business entity can only claim either Initial Allowance or Investment Allowance. A taxpayer can claim Annual allowance at the end of each year for the lifespan of the capital asset.
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