How Small Business Owners Can Use Capital Cost Allowance to Reduce Tax

Every business needs some form of asset, be it a vehicle, a computer, furniture, software, or real estate property. You may be a nomad graphic designer or a consultant, but you need a computer and software. An asset carries an initial cost and helps you earn money for several years. For instance, an oven can help a baker earn, a vehicle can help a taxi driver earn, and an apartment can help a landlord earn rent for many years. All these assets are expensive to buy. If you were to show the asset’s cost as an expense, your business profits might look lopsided, and it may not even help you save enough tax. Hence, the Canada Revenue Agency (CRA) offers capital cost allowance (CCA).

How Does Capital Cost Allowance Work?

CCA is a mechanism that allows businesses to deduct depreciation from their taxable business income. Depreciation helps you offset the cost of wear and tear, breakdown, and replacement that reduce an asset’s value. Note that CCA is a great tool if the asset is something that loses value.

You cannot look at all assets from the same perspective. Some have a long, useful life, and some have a short life. Hence, the depreciation rate depends on how quickly the asset loses value. The CRA classifies all assets into different classes and sets a depreciation rate depending on their useful life. For instance, motor vehicles, some computer hardware and software, and network infrastructure equipment have a CCA of 30%, while that of a building is 4%.

The first step is to classify the asset in the right asset class. The next step is to calculate the CCA.

Calculating Capital Cost Allowance

The CCA is calculated using the declining balance method. There are three elements in CCA calculation.

• Asset Cost includes the asset’s price, GST, and any other cost associated with the acquisition of the asset.
• The CRA states the CCA rate.
• Unclaimed Capital Cost (UCC)

In the first year, you apply the CCA rate to the asset cost and deduct the depreciation to arrive at the UCC. Next year, you apply the CCA rate on the UCC and continue it every year till the asset value is zero or the asset is sold. Let’s understand this with an example.

A taxi driver buys a vehicle for $20,000. The CCA rate is 40% for the taxi.

Here’s how the CCA is calculated for each year:

• First year: $20,000 x 40% = $8,000
• Second year: $12,000 ($20,000 – $8,000) x 40% = $4,800
• Third year: $7,200 ($12,000 – $4,800) x 40% = $2,880

 The CCA can be deducted from the taxable income to reduce the tax bill.

However, the CCA is not that easy. It gets complicated with the transactions.

If you buy a new asset of the same class, the price of that asset is added to the UCC, and you can claim depreciation on that, too. Continuing the above example, the taxi driver buys a used taxi for $10,000 in the second year. His UCC will increase to $22,000 ($12,000 from the first taxi and $10,000 from the used taxi). He can claim up to $8,800 in CCA.

Capital Cost Allowance (CCA) Calculation During Sale of an Asset

If you sell an asset midway or at the end of its useful life, the asset’s sale price should be lower than the UCC. It often happens that the asset value doesn’t depreciate that fast, maybe because it was used less or maintained incorrectly. In such a scenario, you can get a higher value than the UCC when you sell the asset. At that point, the CRA requires you to recapture the CCA and add it to the taxable income.

Suppose the taxi driver decides to sell the taxi in the third year when its UCC is $7,200. He maintained the taxi well and was, therefore, able to secure $12,000 for the cab. The $4,800 difference has to be recaptured and added to the taxable income.

Note that this is not a gain on the sale. Hence, the entire $4,800 is added to the taxable income, and the marginal tax rate applies. Gain on the sale of assets is a separate concept where the asset is sold at a higher price than the purchase price.

Capital Cost Allowance (CCA) for Rental Property

Suppose you purchased an apartment for $500,000 and sold it after five years for $700,000. The $200,000 is the gain on the sale of the asset. In these five years, the property’s value (land) was appreciated. However, the apartment constructed on that land underwent wear and tear. The CCA is calculated on the apartment and not the land. Hence, you can only claim CCA on ready-to-use real estate property, which means that at least 90% of the property is being rented out and is not being renovated or closed for upgrades.

Take a scenario where you claimed $100,000 in CCA, and the apartment’s UCC is $400,000. Now you are selling it for $700,000. This transaction will have two parts:

• Recapture of CCA: Since the asset was sold at a higher price, you must recapture the entire $100,000 CCA deducted in these five years and add it to the taxable income.
• Capital gain on sale of assets: You must add 50% of the capital gain to the taxable income, which comes to $100,000.

The $700,000 sale will add $200,000 to the taxable income. At a 40% tax rate, your tax bill will come to $80,000. Hence, the CCA is great for depreciable assets.

How Small Business Owners Can Use Capital Cost Allowance (CCA) to Reduce Tax

The CCA calculations show that you can deduct significantly from your taxable income. There is no hard and fast rule to claim CCA in the year you purchased the asset. You can start claiming it whenever you want. This flexibility can be used to your advantage.

Year of high income: The first year of business may not generate enough income. You can preserve your CCA and use it in the year when your business income is high to reduce your taxable income, bringing significant tax savings.

Accelerated Investment Incentive: The CRA also offers an accelerated investment incentive for certain assets, wherein a business can claim CCA of up to 50% of the new purchases. It could be beneficial for companies that are considering expansion or revamping equipment. They can claim higher tax deductions and use that amount to make more investments.

Businesses can time their asset purchase and sale to get the maximum tax benefit, and a professional accountant can help you with the calculations.

Contact DNTW Toronto LLP in the GTA for Expert Tax Planning Advice

A skilled accountant is well versed with the changing CCA rules and can help you calculate tax savings under various scenarios. You can study the calculations and negotiate a better deal for your assets. At DNTW Toronto LLP, our accountants can provide services to support your capital decisions. To learn more about how DNTW Toronto LLP can provide you with accounting and tax planning expertise, contact us online or by telephone at 416.924.4900.