INCOME TAX Flashcards
1
Q
What Is Income?
A
- There is no statutory or comprehensive judicial defnition. Generally, income is money received on a recurring basis
- A distinction must be made between income and capital profits. Capital profits 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.
2
Q
3
Who Pays Income Tax?
A
- Individuals(employees, sole traders, partners, shareholders, lenders, and debenture holders);
- Personal representatives on behalf of deceased persons (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.
3
Q
The Tax Year
A
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.
4
Q
COLLECTION OF TAX
A
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.
5
Q
PAYE System
A
- The vast majority of income tax is collected by employers
from the PAYE system and sent to HMRC. - Employers must request a tax code from HMRC for each employee.
- The code indicates the amount of tax-free allowance and the tax rate applicable to the employee’s income.
- Each payroll period, the employer must deduct the appropriate tax from each employee’s salary along with National Insurance contributions for employees earning more than
£242 per week. - On or before each payday, employers must send to HMRC a report (a ‘Full Payment Submission’ or ‘FPS’) of the money deducted.
- Payments may be submitted to HMRC monthly (or quarterly if paying less than £1,500 per month).
- If reporting and paying electronically, the report and payments must be received by the 22nd.
- 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
6
Q
Self-Assessment
A
- Taxpayers who have signifcant income from** trading or rental** profits, or who receive dividends on shares they own, must report all their income through self-assessment and pay taxes on the taxable income from these sources (any taxes already collected through the PAYE system will be offset at the end of the computation).
- In context of the SQE, such persons will usually be sole traders or partners of a partnership.
7
Q
Tax Returns
A
- Taxpayers submit annual tax returns, normally online.
- Tax returns must be filed** by 31 January** after the tax year. For
example, for the tax year 2025/26, a return would have to be filed by 31 January 2027. A paper return must be filed three months earlier (for example, by 31 October 2026 for the 2025/26 tax year).
8
Q
3
Payment Dates
Taxpayers who self-assess typically are required to make two payments on account towards the income tax due for any year.
A
- The first payment on account is due on 31 January in the tax year in question.
- The second payment is due on 31 July after the end of the tax year.
- Any balancing payment required is due by 31 January after the end of the tax year—the same deadline as for fling an electronic return and paying
the first installment for the current tax year. - 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).
9
Q
3
CATEGORIES OF INCOME
A
*Non-savings income;
*Savings income; and
*Dividend income
10
Q
Non-Savings Income
A
a.Earnings and Pensions
b.Trading Income
c.Property Income
11
Q
Earnings and Pensions
A
For many people, their main source of income is income derived from earnings and pensions. The term ‘earnings’ covers salaries, bonuses, and non-cash benefits (such as a car or private medical insurance).
12
Q
Trading Income
A
- 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.
- Trading income also covers profts from a profession or vocation, **including the income of a self-employed professional, such
as a solicitor or barrister.
13
Q
Property Income
A
Some people also derive income from property. Property income is income from land and buildings, such as rental income. Property income from UK land and buildings is treated differently to property income from non-UK land and buildings. Therefore, each must be recorded separately.
14
Q
Savings Income
A
- 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 difference in how it is taxed.
15
Q
Dividend Income
A
Another type of investment income is dividends received
from companies.
16
Q
3
Foreign Income
A
- 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 considered to be a UK resident if they spent** 183 days** or more in the UK during the tax year.
17
Q
6
Exempt Income
There are a few sources of income which are specifcally exempt from income tax, including:
A
- Interest from National Savings Certificates;
- Interest or dividends received from an Individual Savings Account;
- Winnings on Premium Bonds and any income from betting, 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.
18
Q
Individual Savings Account Income
A
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 finance, and Lifetime ISAs. The income from these accounts is tax free.
19
Q
5
CALCULATING TRADING PROFIT
A
- 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.
- 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 financial records of the business, which may be different 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
20
Q
Wholly and ExclusivelyTest
Trading Profit
A
Expenses are deductible only to the extent they were incurred** wholly and exclusively** for business purposes. However, if an expense was incurred for both personal and business purposes, HMRC will allow a tax deduction for the business proportion of the expense.
21
Q
3
Capital Assets/Allowances
Trading profit
A
- 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 accounting period in which they were incurred, up to the available 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).
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Q
3
Writing Down Allowance
A
- If the cost of the capital assets purchased in a year exceeds the AIA (or is for a car or buildings), a Writing Down Allowance is available.
- This enables the taxpayer to deduct a fixed 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. Remember, 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.
23
Q
Pools
A
- 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 suffcient 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.
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Q
4
Partners
A
- If an individual is a partner in a partnership, they will need to include in their non-savings income their share of the partnership’s profiit.
- 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 profits, even if the partners decide to retain part (or all) of the year’s proft in the business
- The partnership itself does not
pay any taxes, but it must file a partnership tax return, declaring the partnership’s income, deductions, and expenses.
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Salaries and Interest Deducted First
Partners
1. 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 first, 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).
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Partnership Tax Return
Whilst the partnership does not pay income tax, a partner must be nominated to file 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.
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The Overlap Profit Problem
1. As noted above, business owners may use a 12-month accounting period that does not coincide with the tax year. If so, the business is taxed on the profts made during the accounting 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**.
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Net Income
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.
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Taxable Income
net income-allowance
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# 3
allowances
1.persaonal allowance
2.marriage allowance
3.additional allowances
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persaonal allowance
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**.
3. The personal 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).
4. 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 Personal Allowance.
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# 3
Marriage Allowance
1. Effectively, 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 partnership;
*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 figures, 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).
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Additional Allowances
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%
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# 3
RATES OF TAX
Non-savings Income
*Basic Rate Band (20%): taxable income from £1 to £37,700
*Higher Rate Band (40%): taxable income from £377001 to £125,140
*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.
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35
Rates of Tax
Savings Income
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. Additionally, 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’).
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Rates of Tax
Dividend Income
1. a £1,000 Dividend Allowance is available to all taxpayers regardless of whether they are a basic rate, higher rate, or additional rate
taxpayer. Under the allowance, the first £1,000 of dividends are taxed at 0%
2. In any case, if a taxpayer’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%
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TRADING LOSSES
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.
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OnlyTrader/Partner Entitled to Claim Loss
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.
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Four Alternatives
Trading Loss
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
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# 4
Current Year/Prior YearLoss Relief
1. Trade losses may be set off against the taxpayer’s total income (total income before personal allowances) from the current year or from the prior year.
2. A taxpayer must either utilise all the loss available for relief or relieve all their available income.
3. No partial claims are permitted.
4. 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 offset her trading loss against property income, which would leave her with £12,000 of loss (since she must use the loss to offset total
income before applying her personal exemption). She could then choose to offset 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 offset £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 offset only £15,000 of her 2023/24 income, as she must utilise all the loss available for relief or relieve all her available income.
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Carry Forward of Loss Relief
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.
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Carry Forward Relief on Incorporation of a
Business
When a sole trader or partner transfers the business to a company and receives shares in return, they can set off 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 carried forward losses, at least until the loss is fully utilised.
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Terminal Loss Relief
1. 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 **3 **preceding tax years, taking later years first (Last in, First Out—‘LIFO’).
2. The losses may be set off only
against **profts of the trade**; they cannot be used to offset other income.
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