Chapter 6: Taxation of Individuals Flashcards
Introduction
The taxes covered on the BLP module are:
- Income Tax;
- Capital Gains Tax (‘CGT’);
- Value Added Tax (‘VAT’); and
- Corporation Tax.
Of these, income tax, CGT, and corporation tax are examples of direct taxes whilst VAT is an example of an indirect tax.
Direct Taxes
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. By contrast, indirect taxes are imposed by reference to transactions eg VAT is chargeable by reference to the value of supplies of goods or services provided. Inheritance Tax is only covered to a limited amount and Stamp Duty Land Tax is not covered in this module as you will learn more about these taxes in other modules.
The distinction between income and capital
Whilst the difference between a receipt and an expense appears obvious, the distinction can be confusing in practice especially when dealing with the various types of each. A receipt is money (of whatever nature) that is paid TO the business and is often referred to as income. Contrast that to an expense which is money the business pays OUT.
The distinction between income and capital
It is necessary to distinguish income receipts from capital receipts and income expenditure from capital expenditure. The reason for this is that, in general, 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 (but see the corporation tax element regarding capital allowances for relief available in some circumstances).
No statutory definition
There is no statutory definition of income or capital, but a series of general guidelines have been established by case law, which are summarised in this element. In practice, it can sometimes be difficult to distinguish between income and capital and you may come across scenarios where it is not clear into which category a particular receipt or expense falls.
It is important to be able to distinguish between income and capital to ensure that the correct tax treatment is applied. This will be explained in more detail later in the element.
Income Receipts
Income receipts
Money received on a regular basis will be classified as an income receipt. For example:
- the trading profits of any business/profession will be income (this is synonymous to the salary received by an individual employee);
- interest the bank pays in relation to savings held in an account is an income receipt for the individual/business, and
- rent received by a landlord is an income receipt of the landlord.
Capital Receipts
If a receipt is from a transaction that is not a part of such regular activity this is likely to be classified as a capital receipt. Think of capital transactions as ‘one-off’ transactions.
Therefore, if a newsagent’s business owned the premises from which the business operates then any gain on the sale of those premises would be a capital receipt.
Expenditure
Having determined whether receipts are of an income or capital nature, it is also necessary to decide whether expenditure is of an income or capital nature.
Income Expenditure
Money spent as part of day-to-day trading, is ‘income’ expenditure.
Bills for heating and lighting, rent, marketing and stationery expenses, staff wages and other fees in the general running of a business will be income expenses. General repairs will also amount to income expenses. Interest payable on loans is also expenditure of an income nature as it will be paid to the lender on a regular basis (whether that is monthly or quarterly) over a period of time.
Capital Expenditure
If money is expended to purchase a capital asset as part of the infrastructure of the business or as an enduring benefit for the business, it is ‘capital’ expenditure.
As with capital receipts, capital expenditure can be seen as a ‘one-off’ transaction. Expenditure on large items of equipment and machinery or property will be capital expenditure.
Equally expenditure on enhancing a capital asset (other than routine maintenance) will be capital expenditure. Even though these assets are used by a business to trade, they are one-off purchases.
It is necessary to make the distinction between income and capital expenditure because certain INCOME expenditure can be set off against INCOME receipts in a business context to reduce the overall tax bill.
INCOME RECEIPTS – LESS – INCOME EXPENDITURE = TRADING PROFITS
Example: deduction of INCOME expenditure from income receipts
A man runs an antique shop. He calculates all his income receipts from his trading activities so that he can then set off against (ie deduct from) these income receipts the income expenses he has incurred in the course of trading. Examples of such deductible income expenses are the cost of buying his stock and the lighting, heating and insurance for his shop. Accordingly, his tax bill is reduced because his income receipts (ie the amount in respect of which he is taxed) are reduced by his income expenditure.
In general, relief for CAPITAL expenditure can only be deducted for tax purposes from the proceeds realised when a CAPITAL asset is disposed of.
Example: deduction of CAPITAL expenditure from CAPITAL receipts
The initial cost of an individual’s capital assets, for instance the cost of buying a shop and the van used to collect and deliver stock, cannot be set off against income receipts in order to reduce the individual’s tax bill. If, however, the shop or van was subsequently sold at a gain/profit (a capital receipt), for tax purposes it would be possible to reduce the gain/profit made on the sale of the asset by deducting the original cost of the asset (capital expenditure).
NB. a proportion of the cost of some capital assets (capital expenditure) can be set off against the trading profits (income receipts) of the business each year during the life of the asset concerned
Capital Allowances
Tax relief (deductions from the tax bill) for capital expenditure is usually only given at the time when the capital asset is sold or otherwise disposed of (eg by way of gift).
Most of us are familiar with the concept of depreciation. We know the new car we buy (a capital asset) will depreciate in value over time. Depreciation is an accounting concept, whereby the cost of an asset is deducted in the accounts over a period of time. Depreciation is used here simply to illustrate the concept of capital allowances used in tax calculations as the tax equivalent of depreciation is capital allowances.
Capital allowances spread the cost of capital expenditure
Capital allowances spread the cost of capital expenditure on certain capital items over a period of time. This is achieved by a proportion of the capital expenditure being deducted from income receipts over a period of time. Note that as an exception to the general rule you read about above (capital receipts less capital expenditure), capital allowances enable certain types of capital expenditure to be deducted from income receipts.
You will learn more about these in the Corporation Tax element. The relevant allowances are deducted when calculating trading profits (ie income) for tax purposes.
Assessment of Tax
In general, there is a separate system for the administration of each particular tax which will be addressed in the relevant section of this topic.
It is important to note that the tax year (for individuals) and the financial year (for companies) are different to the calendar year.
HMRC collects tax from individuals and businesses (including sole traders, partnerships and companies) via the self-assessment system.
Corporation Tax
Companies pay corporation tax on all income profits and chargeable gains that arise in each accounting period (this will be explained further in the corporation tax element).
Individuals are assessed to income tax and capital gains tax on the basis of a tax year which runs from 6 April in one calendar year to 5 April in the next.
Companies are assessed to corporation tax on the basis of a financial year which runs from 1 April in one calendar year to 31 March in the next.
PAYE System
It is also important for you to be aware that in some cases income tax is deducted at source. This is the system whereby the payer of a sum that is taxable in the hands of the recipient deducts the tax due in respect of the sum and accounts for it to HMRC on the recipient’s behalf.
The recipient of the taxable sum therefore receives the sum net of tax (ie after tax has been deducted).
PAYE System
One example of a sum where tax is deducted at source by the payer is the Pay As You Earn (PAYE) system. The employer deducts the income tax payable by the employee from the employee’s wage or salary, and accounts for this tax to HMRC. The employee receives the wage or salary net of income tax.
In calculating tax liabilities, it is important to note where tax has been deducted at source because it is the the gross amount of the receipt that must be included in the calculation (rather than the net amount).
Glossary
You will come across the following terminology in this topic:
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).
Glossary
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.
Glossary
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.
Glossary
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).
Glossary
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.
Summary
- 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.
Self-Assessment
This means it is up to the individual to calculate the tax bill and not HMRC. Not all individuals are required to complete a self-assessment tax return. For example, employed individuals with uncomplicated tax affairs are not required to complete a self-assessment tax return because their tax is collected via the PAYE (Pay As You Earn) system. Directors, high and additional rate tax payers and self-employed people are examples of individuals who are always required to complete a self-assessment tax return.
Deduction at source
This system is 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.
Summary of Income Tax Calculations
In order to calculate an individual’s income tax liability correctly, the following formula should be followed:
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
Summary of Income Tax calculation
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
The personal tax computation You will now work through a simple personal tax computation for an individual taxpayer in a non-business context. In order to do this, there are three terms that you will need to become familiar with. These are:
Total Income:
A taxpayer’s gross income from all sources
Net Income:
Total Income less available tax reliefs
Taxable Income
Taxable Income: Net Income less the personal allowance It is important when calculating income tax that the steps are undertaken in order so that the correct amount of tax is applied to the correct elements of a person’s income.
Calculating the total income
Total Income is a taxpayer’s total gross income from all sources. This means that we need to add together all the receipts from all the sources of income of that particular individual.
Where income has been received by a taxpayer after deduction of tax at source (ie ‘net of tax’), you will need to include the gross amount in the calculation of Total Income. The calculation for this is known as “grossing up” (you are not expected to do this on this module).
You have already seen that tax is deducted at source from earnings through the PAYE system. Savings income and dividend income are received gross (ie with no deduction at source). There are some special rules and allowances which apply to these particular types of income, as follows.
Savings
Interest received by the individual on savings is subject to income tax but some taxpayers will have the benefit of a personal savings allowance. Basic rate taxpayers are entitled to their first £1,000, and higher rate taxpayers are entitled to their first £500 of interest received on savings at the savings nil rate. This means that the first £1,000, or £500 respectively of interest received on savings is taxed at 0%. Additional rate taxpayers do not get the benefit of a personal savings allowance. Examples of how savings income is taxed are set out later in this element.
Dividends
Companies pay dividends to shareholders out of profits that have already been charged to corporation tax. To take account of this (in part at least), a dividend allowance was introduced. The effect of this allowance is that no individual pays any tax on the first £500 of dividend income they receive (prior to 6 April 2024 the allowance was £1,000). The allowance is the same for all taxpayers, no matter how much non-dividend income they receive. As we will see when we apply the rates of tax, the tax rates for dividends are different to those applicable to other forms of income. There is a useful summary table of the tax rates in Step 4 below. Examples of how dividends are taxed are set out below in this topic.
Benefits in kind
Many employees receive benefits in kind in addition to the salary they are paid in respect of their employment. Benefits in kind include health insurance, company cars and gym membership.
Cash payments of salary (including bonuses) are subject to deduction of tax under PAYE. Benefits in kind are subject to income tax but are NOT subject to deduction of tax under PAYE. Instead, the employer must report the amount of the benefit to HMRC as well as to the employee. The employee then includes the benefit sums on their tax return if they complete one. Such benefits must be included in the individual’s Total Income.
Note: There are some minor exemptions to the rules on benefits in kind and there are also specific types of income which are exempt, but the detail of this is beyond the scope of this topic.
Step 2: Calculating Net Income
Once Total Income has been calculated the next stage of the income tax computation is to deduct available tax reliefs in order to establish the taxpayer’s Net Income. The only tax reliefs we look at in this topic are interest PAID on qualifying loans and pension scheme contributions.
- Interest paid on qualifying loans
This type of interest is not to be confused with interest received by the individual from a bank on savings held at the bank (considered previously under total income). 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.
- Interest paid on qualifying loans
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 (you will learn about these in more detail later); and - 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 are deducted from their Total Income for that year (ie at the same time as interest on qualifying loans).
Pension Scheme Contributions
Note: There are limits to the amount an individual can pay into their pension scheme each year but this is beyond the scope of this topic. 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
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: Calculating Taxable Income
Personal allowance taxed at 0%
Once Net Income has been calculated, the next stage of the income tax computation is to deduct the taxpayer’s Personal Allowance in order to ascertain the taxpayer’s 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.
Going back to the woman in the example above, the next stage in her income tax computation would be:
Net Income £50,500
Less Personal Allowance (£12,570)
Taxable Income £37,930
Reduced Personal Allowance
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: application of personal allowance on earnings up to £100,000 but below £125,140:
Amount of reduced allowance
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
Example: application of personal allowance on earnings above £125,140
Net Income £130,000
Less Personal Allowance (0)*
Taxable Income £130,000
*£12,570 – [(£130,000 - £100,000) / 2] = a negative figure.
In this scenario none of the personal allowance would be left so there is no deduction from Net Income.
Step 4: Split the Taxable 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. It may be useful to remember a mnemonic in order to recall which order the incomes are taxed (examples include: “never squash donuts” or “never say die”).
Step 4: Split the Taxable Income
In order to calculate non-savings income, simply deduct the savings and dividend income figures from the Taxable Income.
Taxable Income LESS Savings Income LESS Dividend Income = Non-Savings Income
Worked examples appear under the tax rate summary table.Step 4: Split the Taxable Income
Tax Rate Summary Table 2024/25 (post 6 April 2024)Tax band > taxable income > Non-savings > Savings* > Dividends**
Basic > 0 – 37,700 > 20% > 20% > 8.75%
Higher > 37,701- 125,140 > 40% > 40% > 33.75%
Additional > +125.140 > 45% > 45% > 39.35%
Tax Rate Summary Table 2024/25 (post 6 April 2024)Tax band > taxable income > Non-savings > Savings* > Dividends**
*NB these savings rates are applied AFTER the personal savings allowance has been applied (see below).
** NB these 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. NB for the year 2023/24 the nil rate for dividend income applied to the first £1,000 of dividend income.
STEP 5: The Personal Savings Allowance
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).
STEPS 6 and 7: Apply tax rates and add together tax - Worked Example
Example 1
If we continue with the example of the woman above, since all of her £37,930 Taxable Income is non-savings income, the next stage of her income tax computation would be as follows: Taxable Income £37,930
Charge tax as follows:
20% on first £37,700 = £7,540
40% on balance of £230 =£92
Total tax payable = £7,632
Example 1
You will see from the above example that the woman’s non-savings income crossed over / straddled the basic and higher rate bands. The non-savings income therefore had to be apportioned to the correct band. You ALWAYS use up the lower bands first, just as we did in the above example.
