Introduction
We start our study of taxation with a look at income tax, which is a tax on what
individuals make from their jobs, their businesses and their savings. We see
how to collect together all of an individual’s income in a personal tax
computation, and then work out the tax on that income.
We also look at the family aspects of income tax, how joint income of
spouses/civil partners is taxed and the anti-avoidance provisions for minor children.
In later chapters, we look at particular types of income in more detail.
Study Guide
| Intellectual level | ||
| A1 | Income and income tax liabilities in situations involving further overseas aspects and in relation to trusts, and the application of exemptions and reliefs | |
| (a) | The contents of the Paper F6 study guide for income tax and national insurance, under headings: | 2 |
| | B4 Property and investment income | |
| | B5 The comprehensive computation of taxable income and the income tax liability | |
| | B7 The use of exemptions and reliefs in deferring and minimising income tax liabilities | |
| (e) | Property and investment income: | 3 |
| (ii) | Advise on the tax implications of jointly held assets | |
| (f) | The comprehensive computation of taxable income and the income tax liability: | 3 |
| (i) | Advise on the income tax position of the income of minor children | |
| (g) | The use of exemptions and reliefs in deferring and minimising income tax liabilities: | 3 |
| (i) | Understand and apply the rules relating to investments in the seed enterprise investment scheme and the enterprise investment scheme | |
| (ii) | Understand and apply the rules relating to investments in venture capital trusts |
Exam guide
Although you are unlikely to have to perform a complete income tax computation in the exam, you need to understand how the computation is put together as, for example, you may be asked to calculate the after tax income that would be derived from a particular new source. Do not overlook the effect of an increase in income on the amount of the personal allowance.
The chapter also introduces tax planning concepts. Note the treatment of joint income of spouses/civil partners and the anti-avoidance rules that apply if a parent gives funds to a minor child.
This chapter revises the basic income tax computation that you will already have met in Paper F6. The examination team has identified essential underpinning knowledge from the F6 syllabus which is particularly important that you revise as part of your P6 studies. In this chapter, the relevant topics are:
| Intellectual level | ||
| B5 | The comprehensive computation of taxable income and income tax liability | |
| (b) | Calculate the amount of personal allowance available | 2 |
| (d) | Compute the amount of income tax payable | 2 |
The main changes in 2015/16 from 2014/15 in the material you have previously studied at F6 level are as follows. New Individual Savings Accounts (NISAs) are now referred to simply as Individual Savings Accounts (ISAs). The higher personal allowance is no longer examinable. The savings income starting rate limit has been increased to £5,000 and the rate of tax is now 0%. The personal allowance and the limit for the basic rate have changed but the basic rate, higher rate and additional rate percentages have not changed.
Topics that will be new to you in this chapter are tax reducers and the taxation of families.
1 Aggregation of income
| In a personal income tax computation, bring together income from all sources, splitting the sources into non-savings, savings and dividend income. |
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One of the competencies you require to fulfil Performance Objective 15 Tax computations and assessments of the PER is to extract and analyse data from financial records and filing information relevant to the preparation of tax computations and related supporting documents. You can apply the knowledge you obtain from this section of the text to help to demonstrate this competence.
As a general rule, income tax is charged on receipts which might be expected to recur (such as weekly wages or profits from running a business). An individual’s income from all sources is brought together (aggregated) in a personal tax computation for the tax year.
| Here is an example. All items are explained later in this Text. | ||||
| RICHARD: INCOME TAX COMPUTATION 2015/16 | ||||
| Non- | ||||
| savings | Savings | Dividend | ||
| income | income | income | Total | |
| £ | £ | £ | £ | |
| Income from employment | 50,520 | |||
| Building society interest | 1,000 | |||
| National savings & investments account interest | 360 | |||
| UK dividends | 1,000 | |||
| Total income | 50,520 | 1,360 | 1,000 | |
| Less interest paid | (2,000) | |||
| Net income | 48,520 | 1,360 | 1,000 | 50,880 |
| Less personal allowance | (10,600) | |||
| Taxable income | 37,920 | 1,360 | 1,000 | 40,280 |
Key terms The tax year, or fiscal year, or year of assessment runs from 6 April to 5 April. For example, the tax year 2015/16 runs from 6 April 2015 to 5 April 2016.
| £ | £ | |||
| Income tax on non savings income | ||||
| £31,785 20% | 6,357 | |||
| £6,135 40% | 2,454 | |||
| Tax on savings income | ||||
| £1,360 40% | 544 | |||
| Tax on dividend income | ||||
| £1,000 32.5% | 325 | |||
| 9,680 | ||||
| Less tax reducer | ||||
| Investment under the EIS £10,000 30% | (3,000) | |||
| Tax liability | 6,680 | |||
| £ | £ | |||
| Less tax suffered | ||||
| PAYE tax on salary (say) | 6,200 | |||
| Tax on building society interest | 200 | |||
| Tax credit on dividend income | 100 | |||
| (6,500) | ||||
| Tax payable | 180 | |||
Key terms
Total income is all income subject to income tax. Each of the amounts which make up total income is called a component. Net income is total income less deductible interest and trade losses. Taxable income is net income less the personal allowance. The tax liability is the amount charged on the individual’s income. Tax payable is the balance of the liability still to be settled in cash.
Income tax is charged on taxable income. Non-savings income is dealt with first, then savings income and then dividend income.
For non-savings income, income up to £31,785 (the basic rate limit) is taxed at the basic rate (20%), income between £31,785 and £150,000 (the higher rate limit) at the higher rate (40%) and any remaining income at the additional rate (45%). We will look at the taxation of the other types of income later in this chapter.
The remainder of this chapter gives more details of the income tax computation.
2 Various types of income 6/12, 6/15
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Don’t forget to gross up dividends by 100/90 and taxed interest by 100/80.
2.1 Classification of income
All income received must be classified according to the nature of the income. This is because different computational rules apply to different types of income. The main types of income are:
- Income from employment, pensions and some social security benefits
- Profits of trades, professions and vocations
- Profits of property businesses
- Savings and investment income, including interest and dividends Miscellaneous income.
The rules for computing employment income, profits from trades, professions and vocations and property letting income will be covered in later chapters. These types of income are non-savings income. Pension income is also non-savings income.
2.2 Savings income
2.2.1 What is savings income?
Savings income is interest. Interest is paid on bank and building society accounts, on Government securities, such as Treasury Stock, and on company loan stock.
Interest may be paid net of 20% tax or it may be paid gross.
2.2.2 Savings income received gross
The following savings income is received gross.
- National Savings & Investments interest including interest from Direct Saver Accounts, Investment Accounts, and Income Bonds
- Interest from company loan stock which is listed on a recognised stock exchange
- Interest on Government securities (these are also called ‘gilts’)
2.2.3 Savings income received net of 20% tax
The following savings income is received net of 20% tax. This is called income taxed at source.
- Bank and building society interest paid to individuals
- Interest paid to individuals by companies on company loan stock which is not listed on a recognised stock exchange and other loans made by individuals to companies
- Savings income from non discretionary trusts (dealt with later in this Text)
The amount received is grossed up by multiplying by 100/80 and is included gross in the income tax computation. The tax deducted at source is deducted in computing tax payable and may be repaid.
| In examinations you may be given either the net or the gross amount of such income: read the question carefully. If you are given the net amount (the amount received or credited), you should gross up the figure at the rate of 20%. For example, net building society interest of £160 is equivalent to gross income of £160 100/80 = £200 on which tax of £40 (20% of £200) has been suffered. |
Exam focus point
Although bank and building society interest paid to individuals is generally paid net of 20% tax, if a recipient is not liable to tax, they can recover the tax suffered, or they can certify in advance that they are a non-taxpayer and receive the interest gross.
2.3 Dividends on UK shares
Dividends on UK shares are received net of a 10% tax credit. This means a dividend of £90 has a £10 tax credit, giving gross income of £100 to include in the income tax computation. The tax credit can be deducted in computing tax payable but it cannot be repaid.
2.4 Exempt income
|
Some income is exempt from income tax. Several of these exemptions are mentioned at places in this
Text where the types of income are described in detail, but you should note the following types of exempt income now.
- Scholarships (exempt as income of the scholar. If paid by a parent’s employer, a scholarship may be taxable income of the parent)
- Betting and gaming winnings, including premium bond prizes
- Interest or terminal bonus on National Savings & Investments Certificates
- Certain social security benefits, including child benefit (but this may be recovered through the child benefit income tax charge discussed later in this chapter)
- Income on investments made through Individual Savings Accounts (ISAs).
| 3 Deductible interest | 6/15 |
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Deductible interest is deducted from total income to compute net income.
3.1 Interest payments
An individual who pays interest on a loan in a tax year is entitled to relief in that tax year if the loan is for one of the following purposes:
- Loan to buy plant or machinery for partnership use. Interest is allowed for three years from the end of the tax year in which the loan was taken out. If the plant is used partly for private use, the allowable interest is apportioned.
- Loan to buy plant or machinery for employment use. Interest is allowed for three years from the end of the tax year in which the loan was taken out. If the plant is used partly for private use, the allowable interest is apportioned.
- Loan to acquire any part of the ordinary share capital of a close company (other than a close investment-holding company) or to lend money to such a company which is used wholly and exclusively for the purpose of its business or that of an associated close company. A close company is a company controlled by its shareholder-directors or by five or fewer shareholders (see later in this Text). For a company to be a close company, it must be resident in the UK. However, for the purposes of relief for interest payments, this definition is extended to include companies which are resident in an European Economic Area (EEA) state other than the UK which would be a close company if it was UK resident.
When the interest is paid, the borrower must either hold some shares in the close company and work the greater part of their time in the actual management or conduct of the company (or of an associated company) or have a material interest in the close company (ie hold more than 5% of the shares). Also, the individual usually must not have recovered any capital from the company.
Relief is not available if Enterprise Investment Scheme (EIS) relief (see later in this Text) is claimed on the shares.
- Loan to buy interest in employee-controlled company. The company must be an unquoted trading company resident in the UK or another EEA state and not resident outside the EEA, with at least 50% of the voting shares held by employees.
- Loan to invest in partnership. The investment may be a share in the partnership or a contribution to the partnership of capital or a loan to the partnership. The individual must be a partner (other than a limited partner) and relief ceases when they cease to be a partner.
- Loan to invest in a co-operative. The investment may be shares or a loan. The individual must spend the greater part of their time working for the co-operative.
Tax relief is given by deducting the interest from total income to calculate net income for the tax year in which the interest is paid. It is deducted from non-savings income first, then from savings income and lastly from dividend income.
There is a limit on the amount of deductions from total income, including deductible interest, which an individual taxpayer can make in a tax year. This limit is discussed in the chapter on trading losses later in this Text.
3.2 Example
Frederick has taxable trading income for 2015/16 of £43,000, savings income of £1,320 (gross) and dividend income of £1,000 (gross).
Frederick pays interest of £1,370 in 2015/16 on a loan to invest in a partnership.
| Frederick’s net income is: | ||
| Non-savings Savings | Dividend | |
| income income | income | Total |
| £ £ | £ | £ |
| Total income 43,000 1,320 | 1,000 | |
| Less interest paid (1,370) | ||
| Net income 41,630 1,320 | 1,000 | 43,950 |
| 4 Allowances deductible from net income 4.1 Personal allowance |
6/14 |
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All persons are entitled to a personal allowance. It is deducted from net income, first against non savings income, then against savings income and lastly against dividend income. The personal allowance is reduced by £1 for every £2 that adjusted net income exceeds £100,000 and can be reduced to nil.
Once income from all sources has been aggregated and any deductible interest deducted, the remainder is the taxpayer’s net income. An allowance, the personal allowance, is deducted from net income. Like deductible interest, it reduces non savings income first, then savings income and lastly dividend income.
All individuals born after 5 April 1938 (including children) are entitled to the personal allowance of £10,600.
Exam focus There is a higher personal allowance for individuals born before 6 April 1938 but this is not examinable in point P6(UK). You should therefore assume in questions that all individuals are born after 5 April 1938.
However, if the individual’s adjusted net income exceeds £100,000, the personal allowance is reduced by £1 for each £2 by which adjusted net income exceeds £100,000 until the personal allowance is nil (which is when adjusted net income is £121,200 or more).
Key term Adjusted net income is net income less the gross amounts of personal pension contributions (and gift aid donations – not in your syllabus).
We will look at personal pension contributions later in this Text and revisit this topic again then. At the moment, we will look at the situation where net income and adjusted net income are the same amounts.
In 2015/16, Clare receives employment income of £97,000, bank interest of £6,400 and dividends of £6,750.
Calculate Clare’s taxable income for 2015/16.
| Non-savings | Savings | Dividend | ||
| income | income | income | Total | |
| £ | £ | £ | £ | |
| Employment income | 97,000 | |||
| Bank interest £6,400 100/80 | 8,000 | |||
| Dividends £6,750 100/90 | 7,500 | |||
| Net income | 97,000 | 8,000 | 7,500 | 112,500 |
| Less: personal allowance (W) | (4,350) | |||
| Taxable income | 92,650 | 8,000 | 7,500 | 108,150 |
| Working | |
| Net income | 112,500 |
| Less income limit | (100,000) |
| Excess | 12,500 |
| Personal allowance | 10,600 |
Less half excess £12,500 ½ (6,250)
4,350
Where an individual has an adjusted net income between £100,000 and £121,200, the effective rate of tax on the income between these two amounts will usually be 60%. This is calculated as 40% (the higher rate on income) plus 40% of half (ie 20%) of the excess adjusted net income over £100,000 used to restrict the personal allowance. The individual should consider making personal pension contributions to reduce adjusted net income to below £100,000.
5 Computing tax liability 12/12, 6/13, 12/13, 6/14, 9/15
| Income tax is worked out on taxable income. First tax non-savings income, then savings income and then dividend income. |
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|
5.1 Tax rates
Income tax payable is computed on an individual’s taxable income, which comprises net income less the personal allowance. The tax rates are applied to taxable income on non-savings income first, then to savings income and finally to dividend income.
5.1.1 Savings income starting rate
There is a tax rate of 0% for savings income up to £5,000 (the savings income starting rate limit). This rate is called the savings income starting rate.
The savings income starting rate only applies where the savings income falls wholly or partly below the starting rate limit. Remember that income tax is charged first on non-savings income. So, in most cases, an individual’s non-savings income will exceed the starting rate limit and the savings income starting rate will not be available on savings income.
In 2015/16, Joe earns a salary of £11,750 from a part-time job and receives bank interest of £4,800.
Calculate Joe’s tax liability for 2015/16.
| Non-savings income | Savings income | Total | |
| £ | £ | £ | |
| Employment income | 11,750 | ||
| Bank interest £4,800 100/80 | 6,000 | ||
| Net income | 11,750 | 6,000 | 17,750 |
| Less personal allowance | (10,600) | ||
| Taxable income | 1,150 | 6,000 | 7,150 |
| Income tax | |||
| Non-savings income | |||
| £ | |||
| £1,150 20% | 230 | ||
| Savings income | |||
| £(5,000 – 1,150) = 3,850 0% | 0 | ||
| £(6,000 – 3,850) = 2,150 20% | 430 | ||
| Tax liability | 660 |
5.1.2 Basic rate
The basic rate of tax is 20% for 2015/16 for both non-savings income and savings income.
The basic rate of tax is 10% for 2015/16 for dividend income.
The basic rate limit for 2015/16 is £31,785.
5.1.3 Higher rate
The higher rate of tax is 40% for 2015/16 for non-savings and saving income.
The higher rate of tax is 32.5% for 2015/16 for dividend income.
The higher rate limit for 2015/16 is £150,000.
In 2015/16, Margery has employment income of £37,835, receives building society interest of £1,200 and dividends of £9,000.
Calculate Margery’s tax liability for 2015/16.
| Non-savings income | Savings income | Dividend income | Total | |
| £ | £ | £ | £ | |
| Employment income | 37,835 | |||
| BSI £1,200 100/80 | 1,500 |
Dividends £9,000 100/90
| Less personal allowance | (10,600) | |||
| Taxable income | 27,235 | 1,500 | 10,000 | 38,735 |
Net income 37,835 1,500 49,335
Income tax
£
Non-savings income
£27,235 20% 5,447 Savings income £1,500 20% 300
Dividend income
£(31,785 – 27,235 – 1,500) = 3,050 10% 305 £(10,000 – 3,050) = 6,950 32.5% 2,259
Tax liability 8,311
5.1.4 Additional rate
The additional rate of tax is 45% for 2015/16 for non-savings and saving income.
The additional rate of tax is 37.5% for 2015/16 for dividend income.
The additional rate of tax applies to taxable income in excess of £150,000.
|
|||||||||
Non-savings Savings Dividend
income income income Total
£ £ £ £
Employment income 148,000
Bank interest £5,000 100/80 6,250
Dividends £18,000 100/90 20,000 Taxable income (no personal allowance 148,000 6,250 20,000 174,250 available)
Income tax
£
Non-savings income
£31,785 20% 6,357
£(148,000 – 31,785) = 116,215 40% 46,486
Savings income
£(150,000 – 148,000) = 2,000 40% 800
£(6,250 – 2,000) = 4,250 45% 1,912
Dividend income
£20,000 37.5% 7,500
Tax liability 63,055
5.2 Child benefit income tax charge
FAST FORWARD
There is an income tax charge to recover child benefit if the recipient or their partner has adjusted net income over £50,000 in a tax year.
An income tax charge applies if a taxpayer receives child benefit (or their partner receives child benefit) and the taxpayer has adjusted net income over £50,000 in a tax year. Adjusted net income is defined in the same way as for the restriction of the personal allowance described earlier in this chapter.
A ‘partner’ is a spouse, a civil partner, or an unmarried partner where the couple are living together as though they were married or were civil partners. Civil partners are members of a same sex couple which has registered as a civil partnership under the Civil Partnerships Act 2004. Since 2014, in England, Wales and Scotland (but not Northern Ireland) a same sex couple may also marry.
If the taxpayer has adjusted net income over £60,000, the charge is equal to the full amount of child benefit received.
If the taxpayer has adjusted net income between £50,000 and £60,000, the charge is 1% of the child benefit amount for each £100 of adjusted net income in excess of £50,000. The calculation, at all stages, is rounded down to the nearest whole number.
If both partners have adjusted net income in excess of £50,000, the partner with the higher adjusted net income is liable for the charge.
The child benefit income tax charge is collected through the self-assessment system (dealt with later in this Text). This includes the need for taxpayers to submit tax returns, which can be time consuming and costly. To avoid this, taxpayers can opt not to receive child benefit at all so that the child benefit income tax charge does not apply.
Robert and Roslyn are not married but live together as though they were married. They have a five year old son.
Robert has net income of £52,000 (all non-savings income) in 2015/16. His adjusted net income is also £52,000 since he made no personal pension contributions in 2015/16. Roslyn has no income. She receives child benefit of £1,076 in 2015/16.
Calculate Robert’s tax liability for 2015/16.
| £ | |
| Net income | 52,000 |
| Less personal allowance | (10,600) |
| Taxable income | 41,400 |
| Income tax | |
| £31,785 @ 20% | 6,357 |
| £9,615 @ 40% | 3,846 |
| 10,203 | |
| Add child benefit income tax charge (W) | 215 |
| Tax liability Working |
10,418 |
| £ | |
| Adjusted net income | 52,000 |
| Less threshold | (50,000) |
| Excess | 2,000 |
| ÷ £100 | 20 |
| Child benefit income tax charge: 1% × £1,076 × 20 | 215 |
Robert will be liable to the child benefit income tax charge in 2015/16 since his partner receives child benefit during that year and he has adjusted net income over £50,000.
Samantha is divorced and has two children aged ten and six. She has net income of £56,000 (all nonsavings income) in 2015/16. Samantha made personal pension contributions of £4,500 (gross) during 2015/16. She receives child benefit of £1,788 in 2015/16.
Calculate Samantha’s income tax liability for 2015/16.
Answer
Samantha
£
Net income 56,000
Less personal allowance (10,600)
Taxable income 45,400 £
Income tax:
£36,285 @ 20% (W1) 7,257
£9,115 @ 40% 3,646
10,903
Add child benefit income tax charge (W2) 268
Tax liability 11,171
Workings
- Basic rate limit
£31,785 + £4,500 = £36,285
- Child benefit income tax charge
£
Net income 56,000
Less personal pension contributions (gross) (4,500)
Adjusted net income 51,500
Less threshold (50,000)
Excess 1,500
÷ £100 15
Child benefit income tax charge: 1% × £1,788 × 15 268 At all stages of the calculation, round down to the nearest whole number.
Tutorial note
If Samantha had made an extra gross personal pension contribution of £1,500 during 2015/16, her adjusted net income would not have exceeded £50,000 and she would not have been subject to the child benefit income tax charge.
5.3 Tax reducers
FAST FORWARD
Tax reducers reduce tax on income at a set rate of relief.
5.3.1 Introduction
Tax reducers do not affect income; they reduce tax on income. The tax reducers are:
- Investments in venture capital trusts (VCTs)
- Investments under the enterprise investment scheme (EIS)
- Investments under the seed enterprise investment scheme (SEIS)
- Transferable personal allowance (marriage allowance)
Tax reducers are deducted in computing an individual’s income tax liability. The tax liability can only be reduced to zero: a tax reducer cannot create a repayment.
5.3.2 Tax reducers on investments
Investments in VCTs and under the EIS and SEIS qualify for tax reducers of a percentage of the amount subscribed for qualifying investments.
For investments in VCTs and under the EIS, the percentage is 30%. For investments under the SEIS, the percentage is 50%. Further details are given later in this Text.
If the individual is entitled to more than one tax reducer in relation to such investments, the VCT reducer is deducted first, then the EIS reducer and finally the SEIS reducer.
During 2015/16 Peter makes qualifying investments of £5,000 in a venture capital trust and of £2,000 under the seed enterprise investment scheme. Show his tax position for 2015/16 if his income consists of:
- trading profits of £46,910
- trading profits of £17,145.
(a): High income (b): Low income Non-savings Non-savings
| £ | £ | ||
| Trading profits | 46,910 | 17,145 | |
| Less personal allowance | (10,600) | (10,600) | |
| Taxable income | 36,310 | 6,545 | |
| Income tax | |||
| £ | £ | ||
| Non-savings income | |||
| £31,785/£6,545 20% | 6,357 | 1,309 | |
| £4,525/nil 40% | 1,810 | ||
| 8,167 | 1,309 | ||
| Tax reducers | |||
| VCT £5,000 30% | (1,500) | (1,309) | |
| 6,667 | 0 | ||
| SEIS £2,000 50% | (1,000) | – | |
| Tax liability | 5,667 | 0 |
The tax reducers cannot lead to repayments of tax, so in (b) the SEIS relief and some of the VCT relief is wasted.
5.3.3 Transferable personal allowance NEW
A spouse/civil partner can elect to transfer £1,060 of their personal allowance to the other spouse/civil partner if certain conditions are met. This is sometimes known as the marriage allowance.
| The transferrable amount of the personal allowance will be given to you in the tax rates and allowances in the examination paper. |
Exam focus point
Neither the spouse/civil partner making the transfer nor the spouse/civil partner receiving the transfer can be a higher rate or additional rate taxpayer.
The spouse/civil partner receiving the transfer does not have an increased personal allowance. Instead, they are entitled to a tax reducer of £1,060 × 20% = £212.
Alec and Bertha are a married couple. In the tax year 2015/16, Alec has net income of £7,000 and Bertha has net income of £25,000. All their income is non-savings income. Alec has made an election to transfer part of his personal allowance to Bertha. Show Alec and Bertha’s taxable income for 2015/16 and compute Bertha’s income tax liability.
| Alec | |
| Non-savings | |
| Income | |
| £ | |
| Net income | 7,000 |
| Less personal allowance £(10,600 – 1,060) | (9,540) |
| Taxable income
Bertha |
0 |
| Non-savings | |
| Income | |
| £ | |
| Net income | 25,000 |
| Less personal allowance | (10,600) |
| Taxable income | 14,400 |
| £ | |
| Income tax | |
| £14,400 × 20% | 2,880 |
| Less marriage allowance tax reducer £1,060 × 20% | (212) |
| Income tax liability | 2,668 |
The election for the transferable personal allowance is made to HMRC online by the spouse/civil partner making the transfer. For the tax year 2015/16, if the election is made before 6 April 2016, it will have effect for 2015/16 and subsequent tax years unless it is cancelled by the transferor spouse/civil partner or circumstances change (eg divorce or a tax reduction is not actually obtained). If the election for the tax year 2015/16 is made on or after 6 April 2016 it must be made within four years of the end of the tax year (ie by 5 April 2020) and will only apply for the tax year 2015/16. The couple, as a whole, will save tax through the election if the net income of the transferor is below £10,600.
6 Computing tax payable
| From tax liability, first deduct the tax credit on dividend income and then any income tax suffered at source to arrive at tax payable. The tax credit on dividend income cannot be repaid if it exceeds the tax liability calculated so far. Other tax suffered at source can be repaid. |
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|
6.1 Steps in the personal tax computation
Step 1 The first step in preparing a personal tax computation is to set up three columns
One column for non-savings income, one for savings income and one for dividend income. Add up income from different sources. The sum of these is known as ‘total income’. Deduct deductible interest and trade losses to compute ‘net income’. Deduct the personal allowance to compute ‘taxable income’.
Step 2 Deal with non-savings income first
Any non-savings income up to the basic rate limit of £31,785 is taxed at 20%. Non-savings income between the basic rate limit and the higher rate limit of £150,000 is taxed at 40%.
Any further non-savings income is taxed at 45%.
Step 3 Now deal with savings income
If non-savings income is below the savings income starting rate limit of £5,000, then savings income taking the total up to that limit is taxed at the savings income starting rate of 0%. Savings income between the starting rate limit and the basic rate limit of £31,785 is taxed at 20%. Savings income between the basic rate limit and the higher rate limit of £150,000 is taxed at 40%. Any further savings income is taxed at 45%. In most cases, nonsavings income and savings income can be added together and tax calculated on the total, provided that the savings income starting rate does not apply.
Step 4 Lastly, tax dividend income
If dividend income is below the basic rate limit of £31,785, it is taxed at 10%. Dividend income between the basic rate limit and the higher rate limit of £150,000 is taxed at 32.5%.
Any further dividend income is taxed at 37.5%.
Step 5 Add the amounts of tax together.
Step 6 Once tax has been computed, deduct any available tax reducers (eg EIS, marriage allowance).
Step 7 Calculate the amount of any child benefit income tax charge and pension annual allowance charge (see later in this Text) add to the tax remaining after step 6. The resulting figure is the income tax liability.
Step 8 Next, deduct the tax credit on dividends. Although deductible this tax credit cannot be repaid if it exceeds the tax liability calculated so far.
Step 9 Finally deduct the tax deducted at source from savings income and any PAYE. These amounts can be repaid to the extent that they exceed the income tax liability.
In 2015/16, Jules has a business profit of £55,685, net dividends of £6,750 and building society interest of £3,000 net. He pays deductible interest of £3,000. Jules makes an investment of £5,000 under the Enterprise Investment Scheme. How much income tax is payable?
| Non-savings | Savings | Dividend | |||
| income | income | income | Total | ||
| £ | £ | £ | £ | ||
| Business profits | 55,685 | ||||
| Dividends £6,750 100/90 | 7,500 | ||||
| Building society interest £3,000 100/80 | 3,750 | ||||
| Total income | 55,685 | 3,750 | 7,500 | ||
| Less interest paid | (3,000) | ||||
| Net income | 52,685 | 3,750 | 7,500 | 63,935 | |
| Less personal allowance | (10,600) | ||||
| Taxable income | 42,085 | 3,750 | 7,500 | 53,335 |
| £ | |
| Non-savings income | |
| £31,785 20% | 6,357 |
| £10,300 40% | 4,120 |
| 10,477 | |
| Savings income | |
| £3,750 40% | 1,500 |
| Dividend income | |
| £7,500 32.5% | 2,437 |
| Tax reducer | 14,414 |
| EIS £5,000 30% | (1,500) |
| Tax liability | 12,914 |
| Less tax credit on dividend income | (750) |
| Less tax suffered on building society interest | (750) |
| Tax payable | 11,414 |
Savings income and dividend income fall above the basic rate limit but below the higher rate limit so they are taxed at 40% and 32.5% respectively.
6.2 Calculating additional tax due
FAST FORWARD
Higher rate taxpayers pay an effective rate of 25% on their dividend income. Additional rate taxpayer pay an effective rate of 30.555% on their dividend income.
The above question showed a full income tax computation. Often a taxpayer is more interested in looking at the after tax return from a particular investment or transaction. In each of the following examples we will calculate the additional tax due as a result of acquiring a new investment. Note how it is not necessary here to use the full income tax proforma.
6.3 Examples: additional tax due
(a) Kate receives an annual salary of £70,000. Her grandfather dies leaving her shares in Axle plc. She receives dividends of £22,500 during 2015/16. The additional tax due as a result of receiving the dividend income can be calculated as follows:
Income tax on dividends of (£22,500 100/90) = £25,000 is all at the higher rate as Kate’s taxable income is above the basic rate limit but below the higher rate limit:
£
£25,000 @ 32.5% 8,125
Less tax credit @ 10% (2,500)
Additional tax due 5,625
This is the same as taking 25% of the net dividend taxable at the higher rate ie £22,500 (25,000 90%) @ 25% = £5,625.
You should always check the effect of additional income on the personal allowance. Here, Kate’s net income would be £70,000 + £25,000 = £95,000 which is less than the limit of £100,000 and so she is still entitled to the full personal allowance.
(b) Kate receives an annual salary of £41,410. Her grandfather dies leaving her shares in Axle plc. She receives dividends of £22,500 during 2015/16. The additional tax due as a result of receiving the dividend income can be calculated as follows:
Income tax on dividends of (£22,500 100/90) = £25,000
Amount remaining below basic rate limit:
£31,785 – (£41,410 – £10,600) = £975
£
£975 @ 10% 97
£24,025 @ 32.5% 7,808
7,905
Less tax credit @ 10% (2,500) Additional tax due 5,405
Dividend income below the basic rate limit is taxed at 10% (not 20%).
This is the same as taking 25% of the net dividend taxable at the higher rate ie (£24,025 90%) @ 25% = £5,405 (subject to rounding).
- Kate receives an annual salary of £99,000. Her grandfather dies leaving her shares in Axle plc. She receives dividends of £22,500 during 2015/16. The additional tax due as a result of receiving the dividend income can be calculated as follows:
Income tax on dividends of (£22,500 100/90) = £25,000 is all at the higher rate as Kate’s taxable income is above the higher rate limit. In addition, Kate will no longer be entitled to the personal allowance since her net income is £(99,000 + 25,000) = £124,000.
The additional tax due is therefore calculated as follows:
£
£25,000 @ 32.5% 8,125
Less tax credit @ 10% (2,500)
Additional tax on dividend income 5,625
Tax on income previously covered by personal allowance £10,600 @ 40% 4,240 Additional tax due 9,865
- Kate receives an annual salary of £175,000. Her grandfather dies leaving her shares in Axle plc. She receives dividends of £22,500 during 2015/16. The additional tax due as a result of receiving the dividend income can be calculated as follows:
Income tax on dividends of (£22,500 100/90) = £25,000 is all at the additional rate as Kate’s taxable income is above the higher rate limit:
£
£25,000 @ 37.5% 9,375
Less tax credit @ 10% (2,500) Additional tax due 6,875
This is the same as taking 30.555% of the net dividend taxable at the higher rate ie £22,500 (25,000 90%) @ 30.555% = £6,875.
Kate’s existing net income (salary) is of such a level that she is not entitled to the personal allowance, even before the dividends are received and so there is no further impact on additional tax due.
6.4 Income taxed as top slice of income
One type of income (covered later in this Text) is taxed after dividend income, so that dividend income is not always the top slice of income. This is the taxable portions of partly exempt payments on the termination of employment.
So someone with wages of £22,385 (using the personal allowance of £10,600 and £11,785 of basic rate band), gross dividend income of £20,000 and a £50,000 termination payment will have the dividend income taxed at 10%, instead of 32.5% as the dividend income will be within the basic rate band. The termination payment will be wholly taxed at 40% since it is above the basic rate limit of £31,785.
6.5 The complete proforma
| Here is a complete proforma computation. You can refer back to it as you work through this Text. You will | ||||
| also see how losses fit into the proforma later in this Text. | ||||
| Non- | ||||
| savings | Savings | Dividend | ||
| income | income | income | Total | |
| £ | £ | £ | £ | |
| Trading income | X | |||
| Employment income | X | |||
| Property business income | X | |||
| Bank/building society interest (gross) | X | |||
| Other interest (gross) | X | |||
| (as many lines as necessary) | ||||
| Dividends (gross) | X | |||
| Total income | X | X | X | |
| Less interest paid | (X) | (X) | (X) | |
| Net income | X | X | X | X |
| Less personal allowance | (X) | (X) | (X) | |
| Taxable income 7 Families |
X | X | X | X |
FAST FORWARD
Spouses, civil partners and children are all separate taxpayers. There are special rules to prevent parents from exploiting a child’s personal allowance.
One of the competencies you require to fulfil Performance Objective 17 Tax planning and advice of the PER is to review the situation of an individual or entity advising on any potential tax risks and/or additional tax minimisation measures. You can apply the knowledge you obtain from this section of the text to help to demonstrate this competence.
7.1 Spouses and civil partners
Spouses and civil partners are taxed as two separate people. Each spouse/civil partner is entitled to a personal allowance depending on his or her income.
7.2 Joint property
When spouses/civil partners jointly own income-generating property, it is assumed that they are entitled to equal shares of the income. This does not apply to income from shares held in close companies (see later in this Text for an explanation of close companies).
If the spouses/civil partners are not entitled to equal shares in the income-generating property (other than shares in close companies), they may make a joint declaration to HMRC, specifying the proportion to which each is entitled. These proportions are used to tax each of them separately, in respect of income arising on or after the date of the declaration. For capital gains tax purposes it is always this underlying beneficial ownership that is taken into account.
7.3 Example: income tax planning for spouses/civil partners
Mr Buckle is a higher rate taxpayer who owns a rental property producing £26,000 of property income on which he pays tax at 40%, giving him a tax liability of £10,400. His spouse has no income.
| His wife’s liability is then calculated as follows: | |
| £ | |
| Net income | 13,000 |
| Less personal allowance | (10,600) |
| Taxable income | 2,400 |
If he transfers only 5% of the asset to his wife, they will be treated as jointly owning the property and will each be taxed on 50% of the income. Mr Buckle’s tax liability will be reduced to £5,200.
| Tax on £2,400 @ 20% | 480 |
This gives an overall tax saving of £(5,200 – 480) = £4,720. This could alternatively be calculated as £10,600 @ 40% = £4,240 plus £2,400 @ 20% = £480 giving the total saving of £4,720.
7.4 Minor children
Income which is directly transferred by a parent to their minor child, or is derived from capital so transferred, remains income of the parent for tax purposes. This applies only to parents, however, and not to any other relatives. Even where a parent is involved, the child’s income is not treated as the parent’s if it does not exceed £100 (gross) a year.
Chapter roundup
| | In a personal income tax computation, bring together income from all sources, splitting the sources into non-savings, savings and dividend income. |
| | Don’t forget to gross up dividends by 100/90 and taxed interest by 100/80. |
| | Deductible interest is deducted from total income to compute net income. |
| | All persons are entitled to a personal allowance. It is deducted from net income, first against non savings income, then against savings income and lastly against dividend income. The personal allowance is reduced by £1 for every £2 that adjusted net income exceeds £100,000 and can be reduced to nil. |
| | Income tax is worked out on taxable income. First tax non-savings income, then savings income and then dividend income. |
| | There is an income tax charge to recover child benefit if the recipient or their partner has adjusted net income over £50,000 in a tax year. |
| | Tax reducers reduce tax on income at a set rate of relief. |
| | From tax liability, first deduct the tax credit on dividend income and then any income tax suffered at source to arrive at tax payable. The tax credit on dividend income cannot be repaid if it exceeds the tax liability calculated so far. Other tax suffered at source can be repaid. |
| | Higher rate taxpayers pay an effective rate of 25% on their dividend income. Additional rate taxpayer pay an effective rate of 30.555% on their dividend income. |
| | Spouses, civil partners and children are all separate taxpayers. There are special rules to prevent parents from exploiting a child’s personal allowance. |
Quick quiz
- At what rates is income tax charged on non-savings income?
- Is UK rental income savings income?
- List three types of savings income that are received by individuals net of 20% tax.
- How is tax relief given on interest payable on a loan to invest in a partnership?
- How is dividend income taxed?
- What is the amount below which a child’s income deriving from a parental disposition (ie gift) is not taxed as the parents’ income?
Answers to quick quiz
- Income tax on non-savings income is charged at 20% below the basic rate limit, at 40% between the basic rate limit and the higher rate limit and at 45% above the higher rate limit.
- It is non-savings income.
- Bank and building society interest, interest paid on loan stock which is not listed on a recognised stock exchange, savings income from non discretionary trusts.
- Interest payable on a loan to invest in a partnership is deductible from total income to compute net income.
- Dividend income below the basic rate limit is taxed at 10%. Dividend income between the basic rate limit and the higher rate limit is taxed at 32.5% and at 37.5% above the higher rate limit. A tax credit of 10% is available.
- £100
| Number | Level | Marks | Time |
| Q1 | Introductory | 20 | 39 mins |
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