March of technology moves capital allowances to frontline

Posted on 6 Apr 2010 by The Manufacturer

Capital allowances are critically important to manufacturers who need to invest regularly in top end equipment to stay competitive. And technology is shortening the “tax life” of machines, meaning it takes longer for the machine to pay for itself, making the allowance even more important. Will Stirling reports.

Manufacturers, especially those who use precision machine tools for advanced manufacturing applications, know better than anyone the importance of capital allowances.

Higher allowances make investing in machinery more affordable and companies can compete more effectively.

Recent government policy has not been kind to capital allowances. Although in last year’s April Budget, capital allowances on purchases over £50,000 – a bracket relevant to most high value-add manufacturers – was doubled to 40%, this was only applied for one year and as expected, was reversed with this year’s Budget. There have been several small taxation gains for business in recent years, like the creation of R&D tax relief and the attempt to reduce administration for businesses. However, as Steve Radley, policy director at the manufacturer’s organisation EEF says, “These benefits are piecemeal, and for manufacturers, the tax system is close to breaking” (see Steve’s column on page 15).

In February, the Conservative Party claimed if it won the election it would reduce the headline corporation tax rate from 28p to 25p, which would be partly funded by scrapping capital allowances and tax reliefs that help companies invest. EEF claimed this would be madness, as capital allowances are so crucial to the investment decisions made by businesses at key moments in the financial year, in order to remain competitive.

Why? Why can’t companies like machine tool engineers continue producing components with their legacy equipment? Manufacturers, including the members of EEF and the Manufacturing Technologies Association, whose president Bob Hunt highlighted this hot issue at the MTA’s annual dinner last month, are very keen to explain this to politicians if they are willing come to their factories and see why.

Best equipment is not optional
Damon de Laszlo and Andrew Churchill sit on EEF’s Business Tax Panel. Long term campaigners for a pro-industry tax regime, they spelled out to TM why either main political party needs to try to understand manufacturing better to make claims about their commitment to manufacturing growth.

“The UK manufacturing base is mainly mid-sized companies, £5m up to £100m turnover,” says de Laszlo, whose company Harwin makes a wide range of electrical interconnectors. “The high tech, long term, capital intensive suppliers to our big industries and primes need long term planning and employee training that takes 3+ years. Cash flow is our biggest problem.

Borrowing is one issue, as the real problem now is that companies can’t repay, and you’re having to turn high end machinery over in two to three years.” Here is the rub: with the onward march of technology the top end equipment that keeps the UK’s SME base competitive in advanced manufacturing has a much shorter asset life today. To keep up with the demands of competitive markets like parts for aerospace engines and electrical interconnectors, companies have little choice but to invest in the very best kit. It is not optional.

“New equipment is a fascinating cost calculation. I’ve just bought two new Japanese lathes, made by Star, and were installed over Christmas,” says de Laszlo. “They are 30 per cent faster than the same model that’s three years old. That’s eye-watering.”

Speed of obsolescence pushes tax agenda Few politicians or non-manufacturers would miss the sense in investing in the best equipment.

What some fail to grasp is how quickly advanced machines become obsolete, adding to the relative cost of a machine as the time it takes to repay the investment – its working life – falls. Andrew Churchill, MD of JJ Churchill Engineering and an advisor to government on manufacturing policy, provides a clear example.

“Today, if you want to occupy that high end niche where high labour cost is of proportionally less importance in the total cost, you need to invest in the high end technologies, that is a simultaneous 5-axis milling machine. Instead of the £30k capital cost of 15 years ago, these cost between £750k and £1m. And instead of it lasting – in terms of being competitive – five to ten years, you’re now looking at between two to five years. If I’m using it beyond five years, then I won’t be competitive against somebody else who has bought the next generation. So I have to depreciate that equipment very quickly if I want it to reflect reality, to remain competitive.” The problem, then, is the disconnect between the capital allowances depreciation that your books have to reflect and reality. “And that gap is cash,” says Churchill.

EEF and MTA have analysed the effect of capital allowances and depreciation rates, and have campaigned for politicians to better understand the process. On March 29, EEF published a new taxation paper recommending a tax regime more favourable to industry, part of which focuses on the “tax life” of modern equipment — that is, how long it takes the tax system to reflect the cost of a new machine.

Jeegar Kakkad, senior economist at EEF, says: “While studies like the Statistics Canada report suggest that manufacturers are replacing their equipment, on average, every seven to eight years, the current 20% rate implies a 30-year tax life, and a 12.5% rate [which has been proposed] a 53-year tax life“.

In the US, the vast majority of manufacturing investments have a tax life of seven years. The table shows many of the UK’s competitors have tax systems with much more realistic treatments of investment, reflected in shorter equipment tax lives.

Window of opportunity
To complicate the issue, investing in the best equipment cannot just be deferred to a future time slot when cash flow may be higher. When a customer puts out a big tender, based on the number of units of product to be delivered over the long term, a company may need to buy a better machine immediately to compete. “In my industry, there is a variety of, for example, Rolls-Royce engine platforms that are developed for specific air frames. If you’re not in the game by already having the requisite high-tech kit installed when Rolls- Royce puts details out to tender you’re off the list.

Returning a year later with the right kit will be too late.” Churchill emphasises the key point of the risk element that these medium-sized businesses are taking. Waiting for that opportunity to arrive is not a given because of the long lead time on this equipment. “The manufacturing sector is dealing with this big element of uncertainty. We have to invest in high capital cost equipment in advance of that window of opportunity in the anticipation that having it will enable us to develop that niche.

If you haven’t invested, you’re not in the game; if you have invested you have a chance.” Such an illustration gets to the root of support for manufacturing – knowing what support is coming needs to be planned in and, as EEF and MTA point out, so often the constant shifting of the tax system has not permitted easy financial planning.

Damon de Laszlo adds: “Advanced manufacturing is intensely competitive. Companies who use products we supply are getting pressure from their financial people to source outside the UK because “it’s cheaper”. In fact, it isn’t always cheaper because now we see some production returning from Asia, but there is all sorts of pressure, and uncertainty over the tax structure adds to the burden.” Accountants, too, are familiar with the problem.

Andy Brook is director at Deloitte in Birmingham. He has firsthand experience of the pain of uncertain tax relief rates. “I am working with a client on a £250 million investment in an expansion to a plant,” he says. “The tax relief available is hugely important as prior investment was marginal and depended on the availability of capital allowances. However coupled with this is the uncertainty over where the rate of capital allowances is heading. We are now modelling different scenarios to understand their impact, which provides a greater degree of uncertainty. Long term investment requires long term certainty.”

Misguided corporation tax policy
As EEF’s Steve Radley says in his column this month, the Conservative Party seems set on reducing headline corporation tax rates, paying for this by scrapping allowances and tax reliefs. In March, Shadow Treasury minister David Gauke reiterated the Tories commitment to cutting capital allowances, but offered a fig leaf of cover by recommending the party would extend the period for short life assets, giving companies more time to write-off capital assets for tax purposes.

Small and medium-sized businesses, the manufacturing bedrock, are much more interested in cash management than simply just profits. “And they need to be encouraged that the profits they make can be reinvested in the business,” says Andrew Churchill. “Capital allowances are key here. My argument would be balance the higher corporation tax rate with the larger companies, and enhance the smaller mid-sized companies’ capital allowances..” As the election looms, the duty of EEF and the Ministerial Advisory Group for Manufacturing to explain the effect of tax on business will increase. Damon de Laszlo considers another approach to conveying this message. “Perhaps the chink in the armour for politicians is that both parties say they want to encourage manufacturing — we’ve now discovered it’s a good thing to have an industrial society. If you want jobs in manufacturing you have to have the capital equipment to go with it. Putting a person on a machine today requires more capital than it did 10 years ago, that’s your high end technical skill, which encourages your apprentice level to come in…And they want to come into manufacturing because they look at the technology and say wow! It’s a symbiotic relationship – people and quality equipment.”

David Guake recently reiterated the Conservative Party’s commitment to, in all likelihood, scrapping (or cutting) capital allowances to help pay for a lower rate of corporation tax. But all is not lost – he also gave a firm indication that the Tories would consider extending the qualification of short life assets to eight years, effectively extending the period an asset has to be written off for tax purposes. This is not a direct offset of capital allowances, but for many capital-intensive, high-value manufacturers will be critical in mitigating the cashflow consequences.

Ultimately, there is no substitute for MPs, and indeed HM Treasury, HMRC and Dept for BIS officials, to visit factories and talk to people to better understand how machines link to people, if politicians wish to claim to support industry with genuine conviction.