7 - Individual Taxation Flashcards
Key terminology relating to taxation in BLP.
Annual exemption: For CGT: A tax allowance for individuals only.
Annual investment allowance: A special type of capital allowance.
Available tax reliefs: Certain payments which reduce an individual taxpayer’s Total Income eg interest on certain loans and pension contributions (relevant for income tax only).
Business Asset Disposal Relief: A tax relief available to individuals in certain circumstances to reduce their chargeable gains. It was formally known as “Entrepreneurs’ Relief” or “ER”.
Capital allowances: Tax allowances (ie deductions) for capital expenditure available to businesses (whether run by individuals or companies).
Capital gains tax (CGT): A tax paid by individuals on their taxable chargeable gains.
Corporation tax: A tax paid by companies on their taxable total profit (TTP).
Current year basis: Income tax is charged on the current year basis. This means that income earned in this current year (from 6 April 2024 to 5 April 2025) will be taxed in, and according to, the rates applicable to the tax year 2024/25. (See definition of ‘Tax year’ below.)
Deduction of tax at source: In some circumstances the payer of certain sums is obliged to deduct tax when making a payment eg deductions of income tax by employers (the PAYE system).
Dividend allowance: A band of tax free dividend income available to individuals for income tax purposes.
Financial year: Companies are assessed to corporation tax by reference to financial years (rather than calendar years). The financial year begins on 1 April in one calendar year and ends on 31 March in the next calendar year. A company’s accounting period can differ from the financial year.
Gross sums and net sums: A gross sum is the total sum before tax is levied. A net sum is the amount left after tax has been paid/deducted.
HMRC: HM Revenue & Customs, the body responsible for collection of all UK taxes covered in this Topic.
Income tax: A tax paid by individuals on their Taxable Income.
Indexation allowance: A tax allowance (ie deduction) for indexation available to companies in calculating their chargeable (ie capital) gains. This allowance takes into account inflation based on the Retail Price Index (“RPI”), so that a company is not taxed on chargeable gains arising solely because of inflation. Indexation allowance was frozen on 31 December 2017 and cannot be claimed for any period commencing on or after 1 January 2018.
Investors’ Relief (IR): A tax relief available to individuals in certain circumstances to reduce their chargeable gains.
Net Income: Total Income less available tax relief.
Non-savings income: Income which is not savings or dividend income such as salary (relevant for income tax only).
Pay As You Earn (PAYE): The system under which income tax and employees’ national insurance contributions are deducted at source (ie by the employer) from payments of salary and other employment income to employees.
Personal allowance: A band of tax-free income for individuals (relevant for income tax only).Personal savings allowance: A band of savings income available for basic and higher rate taxpayers which is taxed at the savings nil rate (relevant for income tax only).
Savings income: Income from savings, such as interest (relevant for income tax only).
Taxable income: Net Income less the personal allowance (relevant for income tax only).
Tax year: Individuals are assessed to tax by reference to tax years rather than calendar years. The tax year begins on 6 April in one year and ends on 5 April in the next year.
Total Income: A taxpayer’s gross income from all sources before any deductions (relevant for income tax only).
TTP: Taxable total profits, chargeable to corporation tax. The total of a company’s taxable income profits and chargeable gains.
Value Added Tax (VAT): A tax collected by registered businesses chargeable on supplies of goods and services.
What is the difference between direct and indirect taxes?
Income tax, CGT, and corporation tax are examples of direct taxes whilst VAT is an example of an indirect tax.
Direct taxes are imposed by reference to a taxpayer’s circumstances. For example, CGT is assessed by reference to an individual’s chargeable gains calculated on the basis of that individual’s circumstances.
Indirect taxes are imposed by reference to transactions eg VAT is chargeable by reference to the value of supplies of goods or services provided.
What is the difference between a receipt and an expense?
- A receipt is money (of whatever nature) that is paid to the business and is often referred to as income.
- An expense is money the business pays out.
It is necessary to distinguish income receipts from capital receipts and income expenditure from capital expenditure, as income expenditure can only be deducted from income receipts, and capital expenditure can only be deducted from capital receipts to reduce the overall tax bill (with exceptions regarding capital allowances).
What are income receipts and capital receipts?
Income receipts are regular payments received by the business, such as:
- Trading profits
- Interest paid by a bank on savings
- Rent received by a landlord
Capital receipts are from transactions that are not part of regular activity, such as:
- Gains from selling premises owned by a business, like a newsagent selling the property it operates from.
What are income expenditure and capital expenditure?
Income expenditure is money spent as part of day-to-day trading, including:
- Bills for heating, lighting, rent, marketing, stationery, staff wages
- General repairs
- Interest payable on loans
Capital expenditure is money expended to purchase a capital asset for the business or for enduring benefit, such as:
- Buying equipment, machinery, or property
- Enhancing a capital asset beyond routine maintenance
Why is it necessary to make the distinction between income and capital expenditure?
The distinction is necessary because income expenditure can be set off against income receipts in a business context to reduce the overall tax bill.
Formula: Income receipts – Income expenditure = Trading profits
Capital expenditure, on the other hand, can only be deducted from capital receipts in most cases.
When can relief for capital expenditure be deducted?
Relief for capital expenditure can generally only be deducted for tax purposes when a capital asset is disposed of (e.g., sold or gifted).
A proportion of the cost of some capital assets can be set off against trading profits during the asset’s life via capital allowances.
What are capital allowances?
Capital allowances spread the cost of capital expenditure on certain capital items over a period of time.
A proportion of the capital expenditure is deducted from income receipts over time, allowing some capital expenditure to be deducted from income receipts.
How is tax assessed?
Individuals are assessed to income tax and capital gains tax on the basis of a tax year, which runs from 6 April to 5 April.
Companies pay corporation tax on all income profits and chargeable gains arising in each accounting period, and they are assessed on the basis of a financial year, which runs from 1 April to 31 March.
What is the PAYE system?
Under PAYE (Pay As You Earn), the payer of a taxable sum deducts the tax due and accounts for it to HMRC on the recipient’s behalf.
The recipient receives the sum net of tax.
An example is income tax deducted from an employee’s wage or salary by an employer, who accounts for this tax to HMRC. The employee receives the wage or salary net of income tax.
Provide a summary of the general taxation principles.
- Income vs capital: it is important to distinguish between income receipts and expenses and capital receipts and expenses so that the correct tax treatment can be applied and the correct amount of tax paid.
- Capital allowances: a regime that allows certain types of capital expenditure to be deducted when calculating income receipts, thereby reducing the taxpayer’s tax bill.
Assessment of tax:
* Individuals are assessed to tax by reference to the tax year; and
* Companies are assessed to tax by reference to the financial year (companies can choose an accounting period that does not match the financial year but will still have to calculate tax due for each financial year).
* Deduction of tax at source: certain payments require the payer to deduct the tax (which would ordinarily be payable by the recipient) from the payment and account for the tax to HMRC on behalf of the recipient.
What are the two methods by which HMRC assesses and collects income tax?
- Self-Assessment
It is up to the individual to calculate the tax bill, not HMRC. Not all individuals are required to complete a self-assessment tax return.
E.g., employed individuals with uncomplicated tax affairs are not required to complete a self-assessment tax return because their tax is calculated via the PAYE system.
Directors, high, and additional rate tax payeres and self-employed people are individuals who are always required to complete a self-assessment tax return.
- Deduction at source.
Used where the payer of a taxable sum is obliged to deduct tax and account for it to HMRC. The recipient of the taxable sum receives it ‘net of tax’. One example is the PAYE system.
Which three key terms are essential for calculating a simple personal tax computation for an individual taxpayer in a non-business context?
Total Income: A taxpayer’s gross income from all sources.
Net Income: Total Income less available tax reliefs.
Taxable Income: Net Income less the personal allowance
What is the summary of the income tax calculation process?
Step 1 - Calculate Total Income
Step 2 - Deduct available tax reliefs (interest on qualifying loans and pension contributions) = Net Income
Step 3 - Deduct Personal Allowance (reduced by £1 for every £2 of net income above £100,000) = Taxable Income
Step 4 - Split the Taxable Income into Non-Savings, Savings and Dividend Income
NB. Taxable Income less (Savings Income and Dividend Income) = Non-Savings Income
Step 5 - Calculate whether the Personal Savings Allowance (PSA) is available (i.e. looking at the Taxable Income figure to see which income tax band it ends in)
Step 6 - Apply relevant tax rates
Step 7 - Add together the amounts of tax calculated at Step 6 = Total tax liability
Step 1 - How do you calculate a taxpayers total income?
This is a taxpayer’s total gross income from all sources. To calculate this, we need to add together all the receipts from all the sources of income of that particular individual. This does not include one off transactions.
Income received after tax deductions (net of tax) must include the gross amount in the Total Income calculation, known as “grossing up”.
Savings:
Interest on savings is subject to income tax; however, some taxpayers benefit from a personal savings allowance:
- Basic rate taxpayers: first £1,000 of interest taxed at 0%.
- Higher rate taxpayers: first £500 of interest taxed at 0%.
- Additional rate taxpayers do not receive a personal savings allowance.
Dividends:
Companies pay dividends from profits already taxed at corporation tax. A dividend allowance means no tax is paid on the first £500 of dividend income (previously £1,000 before 6 April 2024), applicable to all taxpayers regardless of non-dividend income.
Benefits in kind:
Employees may receive benefits in kind (e.g., health insurance, company cars) in addition to salary.
Cash payments are subject to PAYE deductions; benefits in kind are taxed as income but not deducted under PAYE. Instead, employers must report these to HMRC, and employees include them on tax returns if they complete one.
Benefits in kind must be included in the individual’s Total Income.
Step 2 - How is a taxpayer’s net income determined?
Once Total Income has been calculated, the next stage is to deduct available tax reliefs to establish the taxpayer’s Net Income.
- Interest paid on qualifying loans.
Not to be confused with interest received by the individual from a bank on savings held at the bank. This interest is the interest an individual must pay TO the bank as the cost of receiving certain qualifying loans from the bank.
Interest on qualifying loans is a form of tax relief because it can be deducted from Total Income to reduce the amount of income subject to tax, thereby reducing the tax bill.
The amount of the interest paid on these loans must be deducted from the taxpayer’s Total Income in order to determine the taxpayer’s Net Income.
Qualifying loans include:
- loans to buy an interest in a partnership;
- loans to contribute capital or make a loan to a partnership;
- loans to buy shares in (or make a loan to) a ‘close’ company
- loans to buy shares in an employee-controlled company or invest in a co-operative.
- Pension Scheme Contributions:
Many individuals pay contributions into a pension scheme, either a scheme set up by their employer (an occupational pension scheme) or a personal pension scheme. Such contributions have the benefit of relief from income tax, subject to certain limits.
Relief on pension contributions is given as follows: An amount equivalent to the pension scheme contributions made by a taxpayer during the tax year is deducted from their Total Income for that year (ie at the same time as interest on qualifying loans).
Note: There are limits to the amount an individual can pay into their pension scheme each year. Most contributions made by an employer to an employee’s pension scheme will be exempt from income tax. Certain charitable donations are also eligible for tax relief.
Example: A woman bought an interest in a catering business which is run as a partnership with two others. In order to do so, she took out a bank loan on which the annual interest payments are £3,000. The woman also paid £2,500 into her personal pension scheme. The woman’s annual income from the partnership for the 2024/25 tax year is £56,000.
The woman’s Net Income would be calculated as follows:
- Total income: £56,000 (annual income)
- Less Tax reliefs:
- £3,000 (interest paid on bank loan – this is a “qualifying loan”)
- £2,500 (pension contributions)
- Net Income: £50,500
Step 3 - How do you calculate a taxpayers taxable income (- personal allowance)?
Once net income has been calculated, the next stage is to deduct the taxpayers Personal Allowance to ascertain the taxpayers Taxable Income.
The personal allowance for the tax year 2024/25 is £12,570. The amount of this allowance is reduced by £1 for every £2 of Net Income above £100,000.
Example: If a woman had a net income of £50,000, her taxable income would be £37,930 less after taking away the personal allowance of £12,750.
The personal allowance of £12,570 is reduced by £1 for every £2 of Net Income above £100,000. This means that individuals with Net Income of £125,140 and above will lose the benefit of the personal allowance completely. To work out the reduced allowance for individuals with Net Income between £100,001 and £125,000, follow this formula:
£12,570 – [(Net Income - £100,000) / 2] = reduced allowance
Example: Net Income: £110,000
Less Personal Allowance Calculated by:
£12,570 – [(£110,000 - £100,000) / 2]
i.e. £12,570 – 5,000
= £7,570 (amount of reduced allowance)
Taxable Income = £110,000 - £7,570 = £102,430
What is the significance of step 4 in the income tax calculation, particularly regarding spltting the taxable income for non-savings income?
It is CRITICAL that the different types of income (non-savings, savings, and dividend income) are separated at this point as they MUST be taxed in the order of non-savings, then savings, and then dividend income, as different tax rates apply to each type of income.
In order to calculate non-savings income:
- Deduct the savings and dividend income figures from the Taxable Income.
- Formula: Taxable Income LESS Savings Income LESS Dividend Income = Non-Savings Income.
The tax rates for the different income types in 2024/25 are as follows:
Basic rate (Taxable income: £0 - £37,700):
- Non-savings: 20%
- Savings: 20%
- Dividends: 8.75%
Higher rate (Taxable income: £37,701 - £125,140):
- Non-savings: 40%
- Savings: 40%
- Dividends: 33.75%
Additional rate (Taxable income: £125,140+):
- Non-savings: 45%
- Savings: 45%
- Dividends: 39.35%
The savings rates are applied AFTER the personal savings allowance has been applied.
Dividend rates are applied AFTER the nil rate has been applied to the first £500 of dividend income. The nil rate applies to ALL individuals irrespective of the level of their taxable income. For the year 2023/24, the nil rate for dividend income applied to the first £1,000 of dividend income.
What are the tax rates for different income types in the year 2024 to 2025?
The tax rates for the different income types in 2024/25 are as follows:
Basic rate (Taxable income: £0 - £37,700):
- Non-savings: 20%
- Savings: 20%
- Dividends: 8.75%
Higher rate (Taxable income: £37,701 - £125,140):
- Non-savings: 40%
- Savings: 40%
- Dividends: 33.75%
Additional rate (Taxable income: £125,140+):
- Non-savings: 45%
- Savings: 45%
- Dividends: 39.35%
How does step 5, following the Personal Savings Allowance affect the calculation of a taxpayer’s income tax?
Savings income is taxed at 0% (the savings nil rate) for the first £1,000 (if the taxpayer’s entire Taxable Income is within the basic rate band) or the first £500 (if the taxpayer’s entire Taxable Income exceeds the basic rate band but does not exceed the higher rate band, ie is not over £125,140).
There is no savings nil rate for taxpayers whose Taxable Income exceeds the higher rate band (over £125,140).
Following step 6 and 7, how are tax rates applied and added together when calculating a taxpayer’s total tax liability in the context of income tax?
Tax rates are applied in the following order for different types of income (non-savings, savings, and dividend) and then summed to determine the total tax liability.
Example 1:
A woman has Taxable Income of £37,930, which is entirely non-savings income. Her income is taxed as follows:
- 20% on the first £37,700 = £7,540
- 40% on the remaining £230 = £92
- Total tax payable = £7,632
Note: The woman’s non-savings income crossed over the basic and higher rate bands, so the income is apportioned accordingly. Always use up the lower bands first.
Example 2:
A man receives a salary of £75,000, benefits in kind of £450, pays pension contributions of £3,000, earns £2,000 in interest on savings, and £2,500 in dividends.
Step 1: Calculate Total Income
- Salary: £75,000
- Benefits: £450
- Interest: £2,000
- Dividends: £2,500
- Total Income = £79,950
Step 2: Calculate Net Income
- £79,950 (Total Income) LESS £3,000 (pension contributions) = Net Income = £76,950
Step 3: Calculate Taxable Income
£76,950 (Net Income) LESS £12,570 (personal allowance) = Taxable Income = £64,380
Step 4: Split the Taxable Income
£64,380 (Taxable Income) LESS £2,500 (dividends) LESS £2,000 (savings) = Non-savings Income = £59,880
Step 5: Apply the personal savings allowance (PSA)
As a higher rate taxpayer, he is entitled to the first £500 of savings income at 0%.
Step 6: Apply the relevant tax rates
Non-savings Income (£59,880)
£0 to £37,700 @ 20% = £7,540
The balance of £22,180 @ 40% = £8,872
Total tax on non-savings income = £16,412 (i.e. £7,540 + £8,872)
Savings Income (£2,000)
£500 @ 0% (PSA applied)
Balance of £1,500 @ 40% = £600
Total tax on savings income = £600
Dividend Income (£2,500)
£500 @ 0% (nil rate band applied)
Balance of £2,000 @ 33.75% = £675
Total tax on dividend income = £675
Step 7: Add the tax amounts together
£16,412 (non-savings) + £600 (savings) + £675 (dividend) = Total tax payable = £17,687
How does the ‘cake’ method help in understanding the income tax calculation process?
The ‘cake’ method provides another way to look at applying the different tax rates to the different bands of income in calculating income tax.
1. Non-savings income is the base layer.
2. Savings income is the cream filling.
3. Dividend income is the top layer.
How is the income tax due for the year calculated?
At the end of the personal tax computation, the total amount of tax the individual taxpayer should pay for the year is established. This calculation considers:
- Income tax already paid through the PAYE system for employed individuals with little other income.
- Any remaining income tax to be paid must be settled by a final payment to HMRC.
- If the amount due is small, it may be recovered by HMRC through an adjustment to the taxpayer’s PAYE tax code for the following tax year.
- If the taxpayer has overpaid tax during the year, they will receive a tax refund from HMRC.
National Insurance Contributions (NICs) are also deducted through PAYE but do not affect the personal income tax computation.
How is income tax liability calculated for a higher rate taxpayer at the end of the year?
In the case of a higher rate taxpayer with income made up of non-savings, savings, and dividends, the tax is calculated in the following steps:
Non-savings income:
Tax 20% on the first £37,700 = £7,540
Tax 40% on the balance (£39,600 - £37,700) = £760
Savings income:
Tax 0% on the first £500 (personal savings allowance) = £0
Tax 40% on the balance (£5,000 - £500) = £1,800
Dividend income:
Tax 0% on £100 (dividend allowance) = £0
Total tax liability: £7,540 + £760 + £1,800 = £10,100
If £9,000 has already been deducted from the taxpayer’s salary through PAYE, the remaining tax due is £1,100 (£10,100 - £9,000).
