What is Capital Cost Allowance and How Does it Impact Your Business
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Frequently a client of mine will purchase a high ticket item such as a computer or a piece of furniture and will simply show it as an expense on their profit and loss. As far as they are concerned, if you spend money on acquiring something you should be able to write it off against your income. This makes logical sense from a certain point of view. Unfortunately, accountants and revenue agencies do not see it this way. From their perspective, an item that is purchased for a business, whose value extends beyond one year, is actually an asset that should be depreciated over the useful life of the asset. In other words, the expense that you can claim for the asset is only the portion of the asset that is used in the year that you claim it. While there are different accounting methods to reflect depreciation, Revenue Canada requires that you apply a percentage depending on the “class” in the asset is classified and is referred to as capital cost allowance or CCA.
What is Capital Cost Allowance (CCA) and how does it relate to depreciation?
According to CRA:
Since these properties may wear out or become obsolete over time, you can deduct their cost over a period of several years. This yearly deduction is called a capital cost allowance (CCA).
You cannot deduct the full cost of depreciable property when you calculate your net business or professional income for the year in which you acquired the property.
In other words, CCA is essentially a yearly deduction allowed by Revenue Canada (CRA) to expense a portion of an asset.
For example if you a purchase a computer, you are not permitted to expense it all in one year since the computer will likely last at least 3 years or longer. Therefore you can only technically “expense” (take depreciation) at a rate designated by CRA. The accounting term for the same concept is depreciation (or amortization). In both cases a useful life is assigned to an asset and a rate at which they should be expensed is applied. The difference between accounting and tax is that while there are many depreciation methods that can be used for accounting purposes, the calculation for CCA in Canada is generally based on what is referred to as the “declining balance method” (see below).
What are the different types of depreciation methods?
There are numerous depreciation methods of which the 3 below are the most popular:
Straight Line method
The straight line method is perhaps the most popular for accounting purposes, and the most direct. This method simply requires that you estimate the useful life of an asset and the salvage value ( i.e. the amount that the asset will be worth at the end of the depreciation period). You would then subtract the salvage value from the cost (purchase price) of the asset and depreciate the rest over the useful life.
For example if you were to purchase a camera that costs $2,000. You might expect it to last for about 5 years after which you will likely need a new camera either due to obsolescence (a newer, better version) or the one you bought will deteriorate due to use. Assuming the camera can be sold after 5 years for $400, your annual depreciation would be $2,000 (original cost) -$400 (salvage value) = $1,600/5 (estimated useful life) = $320
Unit of Production Method
The unit of production method can be a more precise measure of the usage of an asset particularly for machinery assuming you have good assumptions. Under this method you would determine the number of units a specific asset can produce over its lifetime which becomes the denominator in the depreciation calculation. The number of units actually produced is the numerator. For example if you estimate that a candy wrapper machine that you just purchased has the capacity to make 100,000 wrappers. If in the first year you make 10,000 wrappers your depreciation would be 10k/100k which is 10%
Declining Balance Method
The declining balance method is also the method used for CCA purposes for most assets (although there are exceptions such as leasehold improvements which uses the straight line method). Under this method, an asset is depreciated at a specific rate every year. It is different from the straight line method in that the rate of depreciation is applied to the ending balance of the previous period.
Example of Declining Balance (CCA) Method :
A car used for business is deductible, however the cost (usually) cannot be deducted all at once. Let’s assume the car costs $30k and is depreciated at 30% per year would look like the following (note that CRA applies the half year rule which requires that you take only 50% of the calculated depreciation in the first year):
Cost of Car Year 1 = $30,000
Depreciation in Year 1 = $30kX30% (CCA Rate)X50% (Half year rule) = $4, 500
Ending Balance at the end of Year 1 = $30,000-$4,500 = $25,500
Depreciation in Year 2 = $25,500 (Balance from end of year 1) X30% (CCA Rate) = $7,650k
Ending Balance at the end of Year 2 = $17,850
And so on…
See my blog post with more details on expense deductions relating to car expenses
This type of depreciation can continue infinitely until the asset is sold or disposed of as the balance never quite reaches $0
What is a CCA Class and what are the most common CCA classes?
To standardize the rates at which depreciation are taken, CRA has created a number of “classes” for specific types of property. These classes each have rates which are used to determine the depreciation expense. Some of the more common classes are:
Class 1 for property and buildings which has a CCA rate of 4%
Class 8 which is a catch all class for many items for which another category does not exist. Some examples included music and photography equipment
Class 10 and 10.1 are for motor and passenger vehicles. If the vehicle before GST/HST and QST costs $37,000 (starting January 1, 2024) or less it belongs in class 10 while vehicles that cost more than $37k (from January 1, 2024) belong in 10.1. One of the reasons for this is because only up to a maximum of $37k of automobiles are actually depreciable. It should be noted that while vehicles can be grouped together in Class 10, they have to be reflected separately in Class 10.1 i.e. each one is set up in a distinct class.
Class 12 including tools , medical/dental instruments that cost no more than $500
Class 13 is leasehold improvements which unlike the other classes uses the straight line method which is usually determined based on the term of the lease to which the improvements apply
Class 14 and 14.1 are intangible assets such as patents, franchises, quotas, customer lists. Class 14.1 used to be “eligible capital property”
Class 50 which is most computer hardware and systems software for that equipment. Items such as cell phones, tablets, ipads etc. would go into this class
More details on CCA classes can be found here
What is the half year rule ?
The half year rule with respect to depreciable property means that businesses can only claim 50% of depreciation calculated on assets using the declining balance in the first year. In our example about the car above, the depreciation allowed by CRA would only be 50% of $9k in year 1 which is $4.5k. (The ending balance would also be correspondingly higher). The half year rule applies regardless of whether the asset was purchased on January 1st or December 31st (assuming your year end is December 31st). As such many businesses benefit from buying assets in the final month of the year end to take advantage of the depreciation deduction, since the expense allowed is not prorated based on the purchase date.
What is recapture of CCA and terminal loss?
Sometimes you depreciate an asset based on the CCA rates and then end up selling it. There are two possibilities in this case:
Recapture of CCA
You claim depreciation of an asset, over time, so that when you decide to sell it, the undepreciated capital cost (i.e. the cost of the asset less the depreciation also referred to as UCC) is lower than its actual fair market value. Consequently, when you sell it, there is “ recapture” of CCA which means that you have to pay tax on the difference between the sale price of the asset and the undepreciated capital cost. Since you were able to claim the CCA as an expense on your tax return (either the T2125 for individuals or the T2 for corporations) , the recapture is taxed as business income rather than capital gains. It should be noted that the difference between the original cost of the asset (before it was depreciated) and selling price (proceeds of disposition) is then usually taxed as a capital gain. This is a common situation with rental properties.
Terminal Losses Relating to CCA
The reverse situation is when the undepreciated capital cost (UCC) of an asset is higher than the price for which you are able to sell it. If there are no longer any assets left in the pool in the class which you are depreciating and you sell the item for less than the UCC, you can take a terminal loss. For example, you might decide that you no longer need machines in your business (you might start outsourcing production) and you sell the machines that you already have at a loss. This loss would be claimed as a terminal business loss against your business income.
Note that recapture and terminal losses do not apply to Class 10.1 for cars that cost more than $37,000.
Do you have to claim CCA or can you Defer it to later years?
One of the benefits of CCA is that you have flexibility in how much you want to claim in a certain tax year from $0 up to the maximum amount allowed. This may happen if you already have losses and don’t want to increase them as there is a time limit on how long you can carry them forward. Or you might feel that the fair market value is higher than the depreciated value and you don’t want to be subject to recapture and have to pay tax in the future.
While there is no specific amount designated by CRA or RQ as to what constitutes an asset vs an expense, the business owner (or their accountant) can use their own judgement to determine the correct treatment of the item. Generally speaking an item that costs a couple of hundred dollars can usually be expensed unless is clear that it will last a long time. The advantage of CCA for small businesses is that it takes the guesswork out of depreciation. It is perfectly acceptable to use the CCA rate and declining balance method to calculate your accounting depreciation at the end of the year particularly if your business does not require an audit. This might not accurately capture the true depreciation of the asset, if one were to do a more thorough analysis, but the difference is often immaterial.
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