## **Learning Outcomes**

After reading this article, you will be able to identify, incorporate, and explain the effects of tax, capital allowances, and tax shields in project cash flows. You will understand how to calculate the relevant post-tax cash flows, timing for tax payments and relief, and apply capital allowances including balancing adjustments. You will be able to correctly adjust investment appraisals for these issues as required in the ACCA FM exam.

## **ACCA Financial Management (FM) Syllabus**

For ACCA Financial Management (FM), you are required to understand how taxation and capital allowances impact investment appraisal. In particular, you should be comfortable with:

- Identifying which project cash flows are subject to tax
- Calculating the effect of tax on project profits and cash flows
- Including the benefits of tax-allowable depreciation (capital allowances) in investment appraisals
- Applying the timing rules for tax payments and capital allowances, including balancing allowances and charges on asset disposal
- Recognising the use and impact of tax shields in project evaluation

## **Test Your Knowledge**

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision._

1. Why are depreciation charges usually ignored in investment appraisal, but capital allowances must be included in taxed NPV calculations?
2. Which of these statements about tax-allowable depreciation (capital allowances) is correct?
   a) It is included in project cash flows as a direct cash payment.
   b) It is a non-cash item but leads to a tax saving, so the tax benefit is a relevant cash flow.
   c) It increases the taxable profit but is ignored for NPV purposes.
3. In what year is a balancing allowance or balancing charge calculated, and what does it represent?
4. Briefly explain the purpose of a 'tax shield' in project appraisal.

## **Introduction**

When appraising projects, it is essential to use the correct after-tax cash flows. Most businesses pay corporation tax, which affects not only trading cash flows but also brings potential benefits from claiming capital allowances—sometimes called tax-allowable depreciation. Understanding how to compute and incorporate these tax effects, including tax shields from capital allowances, is key to accurate NPV analysis for the ACCA FM exam.

> **Key Term: capital allowances**
> Tax-deductible amounts allowed on qualifying capital expenditure (usually plant, equipment, or machinery). Claimed by businesses to reduce taxable profits in place of accounting depreciation.
>
> **Key Term: tax shield**
> The reduction in tax resulting from deductible expenses, such as capital allowances, which reduces the firm's tax liability and improves cash flows.

## The Impact of Tax on Project Cash Flows

Tax affects projects by reducing the net benefit from operating profits but can also improve project cash flows through the tax relief associated with capital allowances.

### Taxation of Operating Cash Flows

- Corporation tax is charged on taxable profit, normally calculated as project revenue minus allowable cash expenses and capital allowances.
- Project appraisals should use post-tax cash flows, as only cash available after tax can be paid to owners.

### Timing of Tax Payments

- Unless the exam states otherwise, assume tax is paid one year after the cash flow or profit that gives rise to it.
- If a project generates a tax loss (negative taxable profit), assume full benefit is received as a cash inflow against future or group profits.

## Capital Allowances and Their Effect

- Most tax authorities do not allow accounting depreciation as a deductible expense. Instead, taxpayers claim capital allowances based on prescribed rates and methods.
- Capital allowances increase cash flows by reducing tax payable, even though they themselves are not cash flows—only the tax saving is relevant for NPV.

### Common Capital Allowance Methods

- **Straight-line:** Equal deductions over the asset’s tax life.
- **Reducing balance:** A fixed percentage applied to the asset's remaining value each year.
- The method and rates will be specified in exam questions.

> **Key Term: balancing allowance**
> A final deduction from taxable profits, claimed when an asset's written down value exceeds its disposal value at the end of a project.
>
> **Key Term: balancing charge**
> A taxable addition to profits, arising when the disposal value of an asset exceeds its tax written down value.

## Calculating Tax Relief from Capital Allowances

For each year, calculate:

1. The amount of capital allowance claimed in that tax year.
2. Multiply this figure by the corporation tax rate to get the tax saving (the tax shield for that year).
3. The timing: the tax benefit usually occurs one year after the allowance is claimed (unless stated otherwise).

On asset disposal, if the sale proceeds differ from the tax written down value, a balancing allowance (extra deduction) or balancing charge (extra taxable profit) arises.

### **Worked Example 1.1**

A company buys machinery for \$60,000, claiming 25% reducing balance capital allowances. The machine will be used for four years and then sold for \$10,000. Tax rate is 30%, with tax payable one year after profits arise.

**Calculate the annual capital allowance claims, the tax shield for each year, and any balancing allowance or charge.**

> **Answer:**
>
> - Year 0: Cost = \$60,000.
> - Year 1 CA: \$60,000 × 25% = \$15,000 → Tax shield: \$15,000 × 30% = \$4,500 (in Year 2).
> - Year 2 CA: (\$60,000 – \$15,000) × 25% = \$11,250 → Shield: \$3,375 (in Year 3).
> - Year 3 CA: (\$45,000 – \$11,250) × 25% = \$8,438 → Shield: \$2,531 (in Year 4).
> - Year 4 CA: (\$33,750 – \$8,438) × 25% = \$6,328 (before disposal).
> - Year 4: Sell for \$10,000. Written-down value after CA: \$25,312 – \$6,328 = \$18,984. Balancing allowance = \$18,984 – \$10,000 = \$8,984. Tax shield from balancing allowance: \$8,984 × 30% = \$2,695 (in Year 5).

### Tax Shields and their Benefits

The tax shield is the tax saving on capital allowances, leading to lower tax payments in future and improving a project's NPV.

### **Worked Example 1.2**

A project generates annual profits before depreciation and tax of \$100,000 for three years. Equipment costing \$90,000 is depreciated over three years, but capital allowances are 33.3% per year straight-line. Corporation tax rate is 25%, tax is paid in arrears.

**Calculate the after-tax cash flows considering capital allowances.**

> **Answer:**
>
> - Each year: Capital allowance = \$90,000 / 3 = \$30,000.
> - Taxable profit = \$100,000 – \$30,000 = \$70,000.
> - Tax paid = \$70,000 × 25% = \$17,500 (paid 1 year later).
> - Annual after-tax cash flow: \$100,000 – \$17,500 (from previous year) = \$82,500 per year starting in Year 2.
> - In Year 1, only spend on equipment: (\$90,000).
> - In Year 4: No operating cash flows; claim any balancing adjustment if sale proceeds differ from written-down value.

## Disposal of Assets: Balancing Allowance/Charge

- If the sale proceeds are less than the tax written down value at the end, claim a balancing allowance—extra tax relief.
- If proceeds exceed written down value, record a balancing charge—extra taxable income, taxed at the normal rate.

### Treatment in NPV

- Include the tax shield cash flows in the project NPV as inflows in the year they are received.
- Ensure correct timing—delays in tax benefit must be reflected.

### **Revision Tip**

In the exam, always calculate capital allowances, tax clouds, and any balancing adjustment separately. Check timings for all tax-related cash flows—tax is usually paid (or tax relief received) one year in arrears unless the question gives different instructions.

### **Exam Warning**

Include only the tax relief from capital allowances, not the allowance itself, in the project's cash flows. Never include accounting depreciation—capital allowances are the only relevant deduction for tax in NPV calculations.

## **Summary**

Taxation and capital allowances can significantly change a project's cash flows and financial viability. Incorporating the correct tax payments, tax shields, and the timing of these flows is essential for accurate investment appraisal in ACCA FM. Always follow the rules given in the question, especially regarding tax payment dates and capital allowance rates/methods.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- Recognise the impact of corporation tax on project appraisals
- Explain how capital allowances generate tax shields to improve project cash flows
- Calculate and time tax savings from capital allowances, including balancing adjustments
- Accurately adjust investment appraisals for tax and capital allowance effects

## **Key Terms and Concepts**

- capital allowances
- tax shield
- balancing allowance
- balancing charge

Project cash flows, tax, and inflation - Taxation, capital allowances, and tax shields