INCOME TAX

Question 1

What Is Income?

Answer 1

1. There is no statutory or comprehensive
   judicial defnition. Generally, income is money received on a
   recurring basis
2. A distinction must be made between income and
   capital profts. Capital profts are not recurring; they come
   from the sale of an asset (such as land, shares of a company, or an antique) and are subject to capital gains tax rather than income tax.

Question 2

Who Pays Income Tax?

Answer 2

*Individuals(employees, sole traders, partners, shareholders, lenders, and debenture holders);
*Personal representatives on behalf of deceased per-
sons (for the deceased’s outstanding income tax and for
income earned by the estate during administration of the
estate); and
*Trustees on behalf of the trusts, for income made by the
trust.

Question 3

The Tax Year

Answer 3

Taxes are assessed based on a tax year. The tax year (or
‘year of assessment’) for income tax runs from 6 April to 5
April. So, the tax year 2025/26 runs from 6 April 2025 to 5 April 2026.

Question 4

COLLECTION OF TAX

Answer 4

His Majesty’s Revenue and Customs (‘HMRC’) is responsible for the collection of tax. It does this through two primary sys-tems: Pay As You Earn (‘PAYE’) and Self-Assessment.

Question 5

PAYE System

Answer 5

1. The vast majority of income tax is collected by employers
   from the PAYE system and sent to HMRC.
2. Employers must
   request a tax code from HMRC for each employee.
3. The code indicates the amount of tax-free allowance and the tax rate applicable to the employee’s income.
4. Each payroll period, the employer must deduct the appro-
   priate tax from each employee’s salary along with National
   Insurance contributions for employees earning more than
   £242 per week.
5. *On or before each payday, employers must send to
   HMRC a report (a ‘Full Payment Submission’ or ‘FPS’) of
   the money deducted.
6. *Payments may be submitted to HMRC monthly (or quar-
   terly if paying less than £1,500 per month).
7. If reporting and paying electronically, the report and pay-
   ments must be received by the 22nd.
8. HMRC may assess interest and a penalty for late reports
   and payments. The penalty is a percentage of the pay-
   ments made, and the percentage increases depending
   on the number of defaults

Question 6

Self-Assessment

Answer 6

Taxpayers who have signifcant income from trading or rental profts, or who receive dividends on shares they own, must
report all their income through self-assessment and pay tax-
es on the taxable income from these sources (any taxes al-
ready collected through the PAYE system will be ofset at the end of the computation). In context of the SQE, such persons will usually be sole traders or partners of a partnership.

Question 7

Tax Returns

Answer 7

Taxpayers submit annual tax returns, normally online. Tax
returns must be fled by 31 January after the tax year. For
example, for the tax year 2025/26, a return would have to
be fled by 31 January 2027. A paper return must be fled
three months earlier (for example, by 31 October 2026 for the 2025/26 tax year).

Question 8

Payment Dates
Taxpayers who self-assess typically are required to make two payments on account towards the income tax due for any
year.

Answer 8

1. The frst payment on account is due on 31 January in
   the tax year in question.
2. The second payment is due on 31 July after the end of the tax year.
3. Any balancing payment re-
   quired is due by 31 January after the end of the tax year—the same deadline as for fling an electronic return and paying
   the frst installment for the current tax year.
4. Each payment on account is 50% of the previous tax year’s
   liability (after giving credit for tax already paid/collected, for
   example, through PAYE).

Question 9

CATEGORIES OF INCOME

Answer 9

*Non-savings income;
*Savings income; and
*Dividend income

Question 10

Non-Savings Income

Answer 10

a.Earnings and Pensions
b.Trading Income
c.Property Income

Question 11

Earnings and Pensions

Answer 11

For many people, their main source of income is income de-
rived from earnings and pensions. The term ‘earnings’ covers salaries, bonuses, and non-cash benefts (such as a car or
private medical insurance).

Question 12

Trading Income

Answer 12

1. This covers profts from a trade. For example, a self-employed person in business as a taxi driver, market trader, builder, or plumber would be taxed on their trading income.
2. Trading income also covers profts from a profession or vocation, **including the income of a self-employed professional, such
   as a solicitor or barrister.

Question 13

Property Income

Answer 13

Some people also derive income from property. Property
income is income from land and buildings, such as rental in-
come. Property income from UK land and buildings is treated diferently to property income from non-UK land and build-
ings. Therefore, each must be recorded separately.

Question 14

Savings Income

Answer 14

There are various types of savings income, including interest arising from UK banks and building society accounts, credit
union accounts, government or company bonds, and the like
(interest income). Interest (savings) income needs to be kept separate from non-savings income because there is a small
diference in how it is taxed.

Question 15

Dividend Income

Answer 15

Another type of investment income is dividends received
from companies.

Question 16

Foreign Income

Answer 16

All income arising outside the UK is called foreign income.
Foreign income can still be taxable in the UK. As a general
principle, a UK resident will generally pay UK income tax on
both their UK and foreign income. A person will be consid-
ered to be a UK resident if they spent 183 days or more in the UK during the tax year.

Question 17

Exempt Income
There are a few sources of income which are specifcally exempt from income tax, including:

Answer 17

*Interest from National Savings Certifcates;
*Interest or dividends received from an Individual Savings
Account;
*Winnings on Premium Bonds and any income from bet-
ting, gaming, or lotteries;
*Many social security benefts, including the universal
credit, housing benefts, and winter fuel allowances for
pensioners (however, state pension and job-seekers
allowances are taxable income);
*Child Beneft is not taxable, although a high-income Child
Beneft charge applies where a recipient or their partner
has income greater than £50,000; and
*Child Tax Credit and the Working Tax Credit are exempt
from income tax.

Question 18

Individual Savings Account Income

Answer 18

Legislation allows taxpayers to invest up to £20,000 per
year in an Individual Savings Account (more commonly
known as an ‘ISA’). There are four types of ISA accounts:
cash, stocks and shares, innovative fnance, and Lifetime ISAs. The income from these accounts is tax free.

Question 19

CALCULATING TRADING PROFIT

Answer 19

1. If a taxpayer is a sole trader or is a partner in a partnership,
   the taxpayer will need to calculate their trading income to
   include it in their tax return as non-savings taxable income.
   They also must register with HMRC within three months of
   becoming self-employed/starting their business.
2. To calculate trading income, we start with gross income
   for the business’s accounting period (that is, the 12-month
   period the taxpayer has chosen for keeping fnancial records of the business, which may be diferent to the tax year). We
   then subtract expenses of the business which are revenue
   related (such as employee salaries, electricity bills, and the
   cost of the goods sold). The cost of one-of items (that is,
   capital assets, such as the cost of a new machine or motor
   vehicle to be used in the business) is a capital expense,
   which is treated diferently

Question 20

Wholly and ExclusivelyTest
Trading Profit

Answer 20

Expenses are deductible only to the extent they were in-
curred wholly and exclusively for business purposes. Howev-er, if an expense was incurred for both personal and business purposes, HMRC will allow a tax deduction for the business
proportion of the expense.

Question 21

Capital Assets/Allowances
Trading profit

Answer 21

The taxpayer is given an annual
investment allowance (‘AIA’) which allows them to deduct all
of the costs of plant and machinery (such as tools, machines, and computers – but not cars, land, or buildings) in the ac-counting period in which they were incurred, up to the avail-
able AIA amount for the period. (Since 1 January 2019, the
annual investment allowance has remained at £1,000,000 for a 12-month accounting period.) For most small businesses,
this means all their qualifying capital expenditures in the year will be 100% tax deductible.
Note: A separate Structures and Buildings Allowance is
also available for buildings (and other structures) used by a
business if construction began on or after 29 October 2018.
Though you certainly do not need to memorise this for SQE
purposes, this allowance is 3% of the cost per year (excluding the cost of the land itself).

Question 22

Writing Down Allowance

Answer 22

If the cost of the capital assets purchased in a year exceeds
the AIA (or is for a car or buildings), a Writing Down Allow-
ance is available. This enables the taxpayer to deduct a fxed percentage of the cost of the asset (18% for most assets; 6%
for long-life assets). The value of the asset is reduced by the amount of the allowance taken.In essence, this allows the
taxpayer to claim a tax deduction for the cost of an asset
over time.

EXAMPLE
Chloe is a self-employed courier. She started trading two
years ago when she bought a new car for £18,750. This is
the only plant and machinery used in her trade. Remem-
ber, no AIA can be claimed on a car. Chloe would be able
to write down 18% of the car’s value (£3,375) in her frst tax
year. After claiming the allowance, the car would now have a tax value of £15,375 (£18,750 cost - £3,375 allowance). In
her second tax year, she could take a writing down allow-
ance of 18% of the car’s then-current cost basis (that is, 18% of £15,375 = £2,768). In her third tax year, she would be able
to write down 18% of the car’s then-current basis (18% of
£12,607) and take that as an allowance, and so on.

Question 23

Pools

Answer 23

Assets can be aggregated into pools (the main pool for
18% assets and the special rate pool for 6% assets). If
items are pooled, the deduction is based on the current
tax value of all assets in the pool.
Exam Tip
It seems unlikely that an SQE question could require
you to build an asset pool and calculate the deduction
available for the pool in (for example) its second year. It
should be sufcient for you to merely understand what
we mean by standard pool (an aggregation of assets
written down at 18% per year) and the special rate pool
(an aggregation of assets written down at 6% per year),
and that the values of these pools is decreased by the
writing down allowances claimed each year.

Question 24

Partners

Answer 24

1. If an individual is a partner in a partnership, they will need to
   include in their non-savings income their share of the part-
   nership’s proft. Their share is the share set out in the part-
   nership agreement. If the agreement is silent as to each part-ner’s share (or there is no agreement), each partner has an
   equal share. The partners must include their whole share of
   the partnership’s annual profts, even if the partners decide
   to retain part (or all) of the year’s proft in the business
2. The partnership itself does not
   pay any taxes, but it must fle a partnership tax return, declar-
   ing the partnership’s income, deductions, and expenses.

Question 25

Salaries and Interest Deducted First
Partners

Answer 25

If the partnership agreement provides that one or more
partners are to receive a salary or if the partnership is paying one or more partners interest on their capital account(s) (that
is, the money the partner contributed to the partnership),
these sums are allocated to the particular partner frst, and
the amount remaining after allocating these sums will then
be divided among the partners as the partnership agreement provides.

EXAMPLE
Same facts as in the previous example, except the part-
nership agreement provides that Leo is also entitled to a
salary of £20,000 whilst Martha has £10,000 as interest
on her capital account. After we allocate these sums to
Leo and Martha, £120,000 remains to be distributed to the
partners on their agreed 3:2:5 basis (Katie: £36,000, Leo
£24,000, and Martha £60,000). Thus, Katie will be liable to
tax on £36,000 (her proft share), Leo will be liable to tax
on £44,000 (£20,000 salary + £24,000 proft share), and
Martha will be liable to tax on £70,000 (£10,000 interest plus £60,000 proft share).

Question 26

Partnership Tax Return

Answer 26

Whilst the partnership does not pay income tax, a partner
must be nominated to fle a Partnership Tax Return with
HMRC, which declares the partnership’s income, expenses, and deductions and clearly shows the net income of the part-nership and each partner’s share of that income under the
partnership agreement.

Question 27

The Overlap Proft Problem

Answer 27

1. As noted above, business owners may use a 12-month ac-
   counting period that does not coincide with the tax year. If so, the business is taxed on the profts made during the account-
   ing period that ends in the tax year to 5 April. This is known
   as** the basis period**.
2. Unless a trader makes up their accounts to 5 April, some profts made in the business’s frst account-ing period will be taxed twice. Such profts are called overlap profts.

Question 28

Net Income

Answer 28

To determine net income, a taxpayer subtracts from gross income payments of interest on certain qualifying loans, including loans used to fund:
*Capital contributions to (or loans to) a partnership;
*Investments in a close trading company; and
*Payments of inheritance tax for personal representa-
tives.

Question 29

Taxable Income

Answer 29

net income-allowance

Question 30

allowances

Answer 30

1.persaonal allowance
2.marriage allowance
3.additional allowances

Question 31

persaonal allowance

Answer 31

1. Individual taxpayers (including sole traders and partners) are entitled to a Personal Allowance.
2. The amount is changed
   annually For example, for the 2023/24
   tax year, the personal allowance was set at £12,570. The per-
   sonal allowance is tapered (that is, reduced) by £1 for every
   £2 of income above £100,000. For example, if a person’s
   taxable income is £120,000, their personal allowance would
   be reduced by £10,000 (half the amount over £100,000). And (at least for tax year 2023/24), if a taxpayer has net income in excess of £125,140 (that is, in excess of £100,000 plus twice
   the Personal Allowance), they will not be entitled to any Per-
   sonal Allowance.

Question 32

Marriage Allowance

Answer 32

1. Efectively, the Marriage Allowance enables a person to
   transfer part of their Personal Allowance to their spouse. (The amount is often adjusted from year-to-year; for the 2023/24
   tax year, it is set at £1,260.
2. Three conditions must be met:
   *The couple must actually be married or in a civil partner-
   ship;
   *The transferring spouse’s income must be less than the
   Personal Allowance; and
   *The recipient spouse must be a basic rate taxpayer (as
   will be discussed below, that is, a taxpayer who is in the
   20% income tax income band).
3. The transferring spouse reduces their allowance by the
   amount transferred. (So, using 2023/24 fgures, the trans-
   ferring spouse would have an allowance of £11,310 (£12,570
   - £1,260) and the recipient spouse would be entitled to an in-come tax liability reduction of 20% of the amount transferred (for tax year 2023/24 that’s 20% x £1,260 = £252).

Question 33

Additional Allowances

Answer 33

1. There are also allowances for income derived from personal savings and from the receipt of dividends.
2. Allowances are not exemptions,they are amounts that are taxed at 0%

Question 34

RATES OF TAX
Non-savings Income

Answer 34

*Basic Rate Band (20%): taxable income from £1 to £37,700
*Basic Rate Band (20%): taxable income from £1 to £37,700
*Additional Rate Band (45%): taxable income over
£125,140
A taxpayer whose taxable income does not exceed the basic rate band is known as a basic rate taxpayer; a taxpayer
whose income is within but does not exceed the higher rate band is known as a higher rate taxpayer; and, of course, a
taxpayer with income in the additional rate band is an addi-
tional rate taxpayer.

Question 35

Rates of Tax
Savings Income

Answer 35

1. Savings income is taxed based on the tax band in which it
   falls (20%, 40%, and 45%). However, before calculating tax
   on savings income, we must frst apply the Personal Savings Allowance (‘PSA’) if available. A PSA is available to basic rate and higher rate taxpayers.
   2, *Basic Rate Taxpayer – PSA of £1,000
   *Higher Rate Taxpayer – PSA of £500
   *Additional Rate Taxpayer – No PSA

It is important to remember that this allowance applies only
to savings income, such as interest earned at a bank. Addi-
tionally, from a technical standpoint, the Personal Savings
Allowance amount is taxable income and, therefore, still uses the basic rate band or higher rate band at that point in the tax calculation, but it is taxed at 0% (a ‘nil rate band’).

Question 36

Rates of Tax
Dividend Income

Answer 36

1. a £1,000 Div-
   idend Allowance is available to all taxpayers regardless of
   whether they are a basic rate, higher rate, or additional rate
   taxpayer. Under the allowance, the frst £1,000 of dividends
   are taxed at 0%
2. In any case, if a taxpay-
   er’s dividends exceed the Dividend Allowance, the tax is as
   follows:
   *Dividends within the taxpayer’s basic rate band: 8.75%
   *Dividends within the taxpayer’s higher rate band: 33.75%
   *Dividends within the taxpayer’s additional rate band:
   39.35%

Question 37

TRADING LOSSES

Answer 37

A sole trader or partnership does not always make a trading proft each year—sometimes a loss is incurred. Sole traders and partners can make a claim for relief from their losses.
Claiming loss relief results in a sole trader or partners pay-
ing less tax by ofsetting the loss against income that would otherwise be taxed.

Question 38

OnlyTrader/Partner Entitled to Claim Loss

Answer 38

Only the sole trader or partner is entitled to claim the loss;
the loss cannot be transferred to a spouse. In the case of
a partnership, generally each partner’s share of a loss is
proportionate to the partner’s share of the partnership’s proft (unless they agree otherwise). Thus, a partner entitled to 20% of the partnership’s proft may claim 20% of the partnership’s
loss.

Question 39

Four Alternatives
Trading Loss

Answer 39

a.Current Year/Prior YearLoss Relief
b.Carry Forward of Loss Relief
c.Carry Forward Relief on Incorporation of a Business

d.Terminal Loss Relief

Question 40

Current Year/Prior YearLoss Relief

Answer 40

Trade losses may be set of against the taxpayer’s total
income (total income before personal allowances) from the
current year or from the prior year. A taxpayer must either uti-lise all the loss available for relief or relieve all their available income. No partial claims are permitted. However, if a person claiming relief for a trade loss against total income is unable to make full use of that loss, they may use the balance as an
allowable loss to reduce their capital gains and save capital
gains tax.
EXAMPLE
Aseeba makes a trading loss of £30,000 in 2023/24. In that
tax year, Aseeba’s only other income is rental income from
property of £18,000 and a £20,000 gain from the sale of
commercial property. Aseeba may elect to ofset her trading
loss against property income, which would leave her with
£12,000 of loss (since she must use the loss to ofset total
income before applying her personal exemption). She could
then choose to ofset the £12,000 against her total income
from the prior 2022/23 tax year (in which case she would
apply for a refund due to the retroactive application of the
loss) or use the loss to ofset £12,000 of her capital gain.
Note that Asseba may not deduct her personal allowance
frst to increase the amount she could carry back. Neither
could she choose to ofset only £15,000 of her 2023/24
income, as she must utilise all the loss available for relief or
relieve all her available income.

Question 41

Carry Forward of Loss Relief

Answer 41

Losses may be carried forward and set of against future prof-its of the same trade. This is often a ‘last resort’ as it delays
relief for losses. Once a claim has been made, the carried
forward loss must be set of against the next available trading income—not against other forms of income.

Question 42

Carry Forward Relief on Incorporation of a
Business

Answer 42

When a sole trader or partner transfers the business to a
company and receives shares in return, they can set of any
unused trading losses that remain against salary or dividend payments received from the company for any year in which
they own those shares.
EXAMPLE
Sarah incorporates her sole trade business and receives
shares in return for the trade and assets. At the date
of cessation of her trade, Sarah has unrelieved trading
losses of £40,000. They are her losses—they cannot be
transferred to the company. However, if each tax year she receives £15,000 from the company in the form of salary
and/or dividends, this income can be reduced by the car-
ried forward losses, at least until the loss is fully utilised.

Question 43

Terminal Loss Relief

Answer 43

When a trader ceases trading, terminal loss relief is available. This allows a loss to be deducted from trading profts in the
tax year of cessation (if there are any) and then to be carried back to the three preceding tax years, taking later years frst
(Last in, First Out—‘LIFO’). The losses may be set of only
against profts of the trade; they cannot be used to ofset
other income.