Business Taxation - Income Tax Calculation (5) Flashcards
How is income tax calculated?
Income Tax Calculation: Liable parties must calculate and pay their income tax for the tax year (see income tax). This may be done on their behalf if subject to PAYE.
(1) Tax Year: 6 April to 5 April.
(2) Charities: Charities are exempt from income tax.
(3) Income: Profits recurring in nature, i.e. salaries, dividends, interest.
(4) Calculation: There are 5 steps: 1) calculate gross taxable income; 2) calculate net taxable income; 3) deduct personal allowances; 4) separate income streams; 5) apply tax rates to each type.
What is step 1: calcaultion of gross taxable income?
Gross Taxable Income: This is the total of taxable forms of income earned in the year. This includes:
(1) Trade Profit: Profits of trade minus any reliefs exercised (see trading profit).
(2) Rent: Rent earned from the leasing of land.
(3) Savings: Interest, annuities and dividends earned (unless non-taxable).
(4) Salary: Employment salaries (minus expenditure wholly and necessary for work).
(5) Pension: Pension payments during retirement.
(6) Social Security: Social security payments such as sick and maternity pay (unless non-taxable).
Non-Taxable Incomes
Non-Taxable Income: Certain forms of income are non-taxable, so are not added to gross taxable income.
(1) Personal Injury Damages Interest: Interest earned on any personal injury or death award.
(2) Specified Savings: a) Savings Certificates; b) Premium Bond Winnings; c) Individual Savings Accounts earnings (ISAs).
(3) State Benefits: State benefits, such as welfare support and job-seekers allowance.
Deductions at Source
Deductions at Source: Certain income will already have been taxed at source, such as PAYE on employment salaries. These deductions must be ignored for the sake of calculating total income tax, so are added to the calculation as if untaxed.
What is Step 2: Calculate Net Taxable Income?
Net Taxable Income: Reliefs must be applied to determine net taxable income. Most reliefs are applied by way of trading profit reliefs, but some are income-tax specific. The main is ‘qualifying loan’ interest.
(1) Qualifying Loan Interest: Interest paid on a qualifying loan is deducted from gross taxable income.
(2) Qualifying Loan: A loan to: a) buy or invest in a partnership share; b) a close trading company; and c) PRs for the purpose of paying inheritance tax.
What is Step 3: Deduct Personal Allowances?
Personal Allowances: Individuals are typically provided a personal allowance each year. They cannot be carried forward.
(1) Standard Rate: £12,570 for individuals with net incomes up to £100,000.
(2) Higher Rate: £1 personal allowance is lost for every £2 earned over £100,000.
(3) Additional Rate: Personal allowance is entirely exhausted once net income hits £125,140.
Application
Application: Personal allowance must be set against the three types of income stream in order. It must reduce a stream to zero before applying to the next: a) Non-Savings Non-Dividend Income; b) Savings Income; c) Dividend Income.
Other Allowances
Other Allowances: Other allowances may apply on a case-by-case basis.
(1) Marriage: £1,260 can be transferred from one legal spouse out of their unexhausted allowance to the other, unless the other spouse is a higher or additional rate taxpayer.
(2) Blind: £2,870 is added to the allowance of legally blind taxpayers.
What is Step 4: Divide Income Streams?
Income Streams: Income must be divided into three income streams, as tax rates differ for each.
(1) Non-Savings Non-Dividend: ‘NSNDI’ includes wages, pensions, taxable benefits, salaries, trade profits.
(2) Savings: Savings income is income generated on savings.
(3) Dividends: Dividend income is income generated on dividends.
What is Step 5: Tax Income Streams?
Tax Income Streams: Each income stream must be taxed at the appropriate bands (after personal allowances). NSNDI is taxed first, then savings, then dividends. It is cumulative, meaning each form of income is added to the previous.
NSNDI
NSNDI: NSNDI is charged first.
(1) Basic Rate: £0-£37,700 (20%).
(2) Higher Rate: £37,701-£125,140 (40%).
(3) Additional Rate: £125,141 - (45%).
Savings
Savings: Savings is charged next (added on top of NSNDI). The starting rate applies before the allowance.
(1) Starting Rate: £0-£5,000 (0%).
(2) Savings Allowance: Taxpayers may be entitled to an allowance (applied after starting rate if applicable).
Basic Rate Taxpayers: £1,000 allowance.
Higher Rate Taxpayers: £500 allowance.
Additional Rate Taxpayers: No allowance.
(3) Basic Rate: £5,001-£37,700 (20%).
(4) Higher Rate: £37,701-£125,140 (40%).
(5) Additional Rate: £125,141 - (45%).
Dividends
Dividends: Dividends income is charged last (added on top of NSNDI, Savings, Savings Allowance, and Dividend Allowance).
(1) Dividend Allowance: All taxpayers entitled to £1,000 allowance.
(2) Ordinary Rate: £0-£37,700 (8.75%).
(3) Upper Rate: £37,701-£125,140 (33.75%).
(4) Additional Rate: £125,141 - (39.33%).
Example of income tax calculation
Example: Below shows a full tax calculation from start to finish.
Gross Taxable Income
Gross Taxable Income: Calculated at £101,000.
Net Taxable Income
Net Taxable Income: £1,000 paid on a qualifying loan, making net taxable income £100,000.
Personal Allowance
Personal Allowance: Full personal allowance of £12,570.
Income Streams
Income Streams: Income is £50,000 NSNDI, £25,000 savings, £25,000 dividends. Personal allowance applies to NSNDI first, reducing it to £37,430.
Tax
Tax: Income is taxed according to each band.
(1) NSNDI: NSNDI falls entirely within (0-37,700) standard rate. £37,430 taxed at 20% = £7486.
(2) Savings: Savings is added to NSNDI. This is (37,430 to 62,430). As a basic rate taxpayer, £1000 allowance is given. As such, (37,430 to 61,430). £270 falls within the basic rate (37,430 to 37,700). Remaining £23,730 at 40%. Tax = £9546.
(3) Dividends: Dividends are added to NSNDI, Savings, Savings Allowance and Dividend Allowance. This is 62,430, plus dividend allowance of 1000. Remaining dividends are £24,000, falling entirety in upper rate (63,430-87430). This is taxed at 33.75% = £8100.
(4) Total: Total income tax to pay is therefore £25,132.
