Taxation of Individuals Flashcards
What is the distinction between capital and income?
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.
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).
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.
What is the difference between direct and indirect taxes?
Of these, 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. 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.
What are 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.
What is expenditure?
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.
What are trading profits?
INCOME RECEIPTS – LESS – INCOME EXPENDITURE = TRADING PROFITS
In general, relief for CAPITAL expenditure can only be deducted for tax purposes from the proceeds realised when a CAPITAL asset is disposed of.
What are 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 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.
How is tax assessed?
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.
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.
What is the 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).
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).
What is the difference between gross 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.
How does HMRC collect and assess income tax?
- 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.
What are the three kinds of income calculations needed to calculate individual income tax?
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
Summary of Income Tax Calculation
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 any personal savings allowance that is available (ie 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
Anti-avoidance legislation
A certain amount of tax legislation has been developed by successive governments in order to put a stop to loopholes which have been exploited by taxpayers seeking to reduce or eliminate their tax liabilities. HMRC and the courts are increasingly hostile towards tax avoidance schemes.
In relation to income tax ,you should be aware that a taxpayer cannot reduce their income tax liability by making gifts of certain income-producing items eg shares (which give rise to dividends) or a lump sum (which gives rise to interest) to their children. Instead, under special legislation often referred to as the ‘settlements’ legislation the income is treated as remaining with the taxpayer who made the gift.
Step 1: Calculating 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 grossamount 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 £2,000 of dividend income they receive. 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.
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).
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.
