Tax depreciation is the deduction allowed under an income tax system for recovering the cost of assets used in a business or for producing income. Most income tax systems permit individuals and companies to claim a tax deduction for the cost of qualifying business assets.
The tax treatment of an asset depends on whether the asset is consumed currently or provides benefits over a longer period. If an asset or cost is consumed in the current period, its cost may be deducted immediately as an expense or treated as part of the cost of goods sold. However, the cost of an asset that is not currently consumed is generally deferred and recovered over time through depreciation.
Therefore, tax depreciation allows the cost of long-term business assets to be deducted over a period according to the rules prescribed by the relevant tax system.
Recovery of Asset Cost for Tax Purposes
Assets used in business or for the production of income may provide economic benefits for several years. Therefore, their cost is generally not deducted completely as a current expense.
The cost is deferred and recovered over time through depreciation deductions. The depreciation allowed reduces the amount of income considered for tax purposes.
However, tax systems may follow different approaches. Some systems permit the full deduction of the cost, either wholly or partly, in the year in which the asset is acquired. Other systems require the cost to be recovered over the useful life of the asset by applying a prescribed depreciation method or percentage.
Thus, the timing and amount of the tax depreciation deduction depend on the applicable tax rules.
Variation in Tax Depreciation Rules
Tax depreciation rules vary significantly from one country to another. Rules may also differ within the same country according to the type of asset or the type of taxpayer.
Some tax systems prescribe specific useful lives and depreciation methods for assets. In certain systems, the lives and methods used for financial reporting may also be required for tax purposes.
Most tax systems provide different depreciation rules for real property, such as buildings, and personal property, such as equipment.
Therefore, tax depreciation is governed by the tax laws and regulations applicable to the asset and the taxpayer.
Capital Allowances
A common tax depreciation system allows a fixed percentage of the cost of depreciable assets to be deducted each year. Such a deduction is often known as a capital allowance.
The term capital allowance is used in the United Kingdom. Capital allowance deductions may be available to individuals and businesses for qualifying assets placed in service during or before the relevant assessment year.
Under this system, the tax law or regulations specify fixed depreciation percentages according to the type or class of asset.
The fixed percentage is multiplied by the tax basis of the assets in service to determine the amount of capital allowance deduction.
The basic calculation may be expressed as:
Capital Allowance = Tax Basis of Assets × Prescribed Fixed Percentage
The applicable percentage is determined by the relevant tax law or regulations.
Capital Cost Allowance
Canada uses a system known as Capital Cost Allowance. Under this system, fixed percentages are applied to assets belonging to a particular class or type of asset.
Assets are classified according to their nature, and a fixed percentage rate is prescribed for each class.
The applicable percentage is multiplied by the tax basis of the assets in service to determine the depreciation or capital cost allowance deduction.
Capital allowance calculations may be based on individual assets, the total set of assets, or pools of assets classified according to year or asset class.
Tax Lives and Depreciation Methods
Some tax systems specify the useful lives of assets according to classes of property defined by the tax authority.
For example, the Canada Revenue Agency specifies different classes according to the type of property and the manner in which it is used.
Under the United States depreciation system, the Internal Revenue Service provides guidance containing tables of asset lives and applicable depreciation conventions.
The prescribed tables may specify useful lives for commonly used assets such as office furniture, computers and automobiles. These prescribed lives may override the useful lives determined according to actual business use.
Therefore, for tax purposes, depreciation may be based on the useful life specified by the tax authority rather than the life estimated by the business.
Depreciation Methods for Tax Purposes
Tax authorities may prescribe the depreciation methods that taxpayers are permitted to use.
Under the United States tax depreciation system, depreciation may be calculated using the Double-Declining-Balance Method with a switch to the Straight Line Method or the Straight Line Method itself, depending on the permitted option.
Tax depreciation tables may specify percentages that are applied to the tax basis of an asset for each year during which the asset remains in service.
An important point is that depreciation becomes deductible when the asset is placed in service.
Thus, the acquisition of an asset alone may not be sufficient. The asset must be placed in service before depreciation becomes deductible under the applicable tax rules.
Additional Depreciation
Many tax systems permit an additional deduction for a portion of the cost of depreciable assets acquired during the current tax year.
Such additional depreciation or accelerated allowance provides a larger deduction in the initial year of asset acquisition.
For example, certain tax systems may permit a first-year capital allowance or a deduction for a substantial portion of the cost of qualifying depreciable tangible property.
The United States system has provided deductions for the cost of qualifying depreciable tangible personal property and additional first-year depreciation for certain assets.
Other tax systems may also provide similar first-year or accelerated depreciation allowances.
The purpose of such provisions is to permit a faster recovery of asset cost for tax purposes.
Real Property and Tax Depreciation
Many tax systems prescribe longer depreciable lives for buildings and land improvements.
The depreciation period may differ according to the type and use of the real property.
Many tax systems permit depreciation of real property only under the Straight Line Method or by applying a small fixed percentage of cost.
In the United States, different depreciation periods are prescribed for residential rental buildings, other buildings and land improvements. These assets are depreciated using the Straight Line Method.
Therefore, real property is generally depreciated over a longer period than many types of equipment or personal property.
No Depreciation on Bare Land
Generally, no tax depreciation deduction is allowed for bare land.
Land itself is not normally treated as a depreciable asset for tax purposes. However, land improvements may have prescribed depreciable lives and may qualify for depreciation.
Therefore, an important distinction exists between bare land and land improvements. Bare land is generally not depreciated, while qualifying land improvements may be depreciable according to prescribed tax rules.
Averaging Conventions
Calculating depreciation separately for every asset may require extensive record-keeping, especially when a business acquires or disposes of many assets.
To simplify depreciation calculations, many tax systems allow assets of a similar type acquired in the same year to be combined into a pool.
Depreciation is then calculated for the entire pool as a single calculation instead of calculating depreciation separately for each individual asset.
However, pooled depreciation requires assumptions regarding the date on which assets were acquired.
For this purpose, tax systems may use averaging conventions.
Half-Year Convention
Under the Half-Year Convention, property of a particular type is treated as if it were acquired at the midpoint of the acquisition period.
As a result, one-half of a full period’s depreciation is generally allowed during the acquisition period.
If the asset’s useful life consists of a whole number of years, one-half of a full period’s depreciation may also be allowed in the final depreciation period.
The Half-Year Convention therefore simplifies depreciation calculations by using an assumed acquisition date.
Mid-Month and Mid-Quarter Conventions
The United States system may apply a Mid-Month Convention to real property. Under this convention, the property is treated as if it were acquired at the midpoint of the month.
A Mid-Quarter Convention may be required for certain property when more than 40% of the acquisitions for the year occur during the final quarter.
These conventions determine the assumed timing of asset acquisition for calculating the amount of depreciation allowed during the relevant tax period.
Fixed Rate of Depreciation
In many countries, tax laws prescribe a fixed rate of depreciation for a particular class of assets.
The depreciation is charged at the prescribed rate and claimed as an expense for determining the tax expense allowance.
Under this approach, assets are classified into different categories or classes. A fixed depreciation rate is prescribed for each class.
The taxpayer applies the prescribed rate to the relevant asset value or tax basis to calculate the depreciation deduction.
Therefore, the depreciation rate for tax purposes may be determined by tax law rather than independently selected by the business.
Tax Depreciation and Financial Reporting
Tax depreciation is calculated according to the requirements of the applicable income tax system.
Financial reporting depreciation is used to allocate the cost of an asset over its useful life for accounting purposes. Tax depreciation, on the other hand, determines the deduction permitted for tax purposes.
Some systems require the same depreciation lives and methods to be used for financial reporting and taxation. However, other systems may prescribe different depreciation methods, useful lives, percentages or allowances for tax purposes.
Therefore, the amount of depreciation calculated for tax purposes may depend on specific statutory rules.
Exam Focus
Tax depreciation is a tax deduction allowed for recovering the cost of assets used in business or for producing income.
The cost of assets consumed currently may be deducted immediately as an expense or included in the cost of goods sold. The cost of long-term assets is generally deferred and recovered over time through depreciation.
Tax depreciation rules vary by country, type of asset and type of taxpayer.
A Capital Allowance is a deduction based on a fixed percentage of the cost or tax basis of depreciable assets. The applicable percentage is prescribed by tax law or regulations.
Depreciation generally becomes deductible when the asset is placed in service.
Many tax systems provide additional first-year or accelerated depreciation allowances for qualifying assets.
Real property such as buildings generally has a longer depreciable life, while bare land is generally not depreciable.
Averaging conventions such as the Half-Year Convention, Mid-Month Convention and Mid-Quarter Convention may be used to simplify the calculation of tax depreciation.
In many countries, a fixed depreciation rate is prescribed for a particular class of assets for tax purposes.