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Introduction to Income Tax

1 The structure of a basic income tax computation


The basic charge
Income tax is levied on individuals by reference to the taxable income of a tax year, or fiscal
year. A tax year runs from 6 April to the following 5 April.

For 2004/05 the starting rate of tax of 10% is charged on the first £2,020 of taxable income,
the basic rate of 22% is charged on the next £29,380 (£31,400 - £2,020) and the higher rate
of 40% is charged on all taxable income above £31,400. A proforma is given later in this notes,
when the rules for different types of income have been covered.

2 Types of income
Earned income
There are two main types of earned income.
a. Income from employment Schedule E
b. Income from self–employment Schedule D Case I and II

The sources of income assessed and the basis of assessment for each of the above are as
follows.
Schedule E Schedule D Case I

Income assessed Income from employment (salary, Profits of the business


bonus, pension, benefits in kind etc)

Basis of assessment Emoluments received in the fiscal Profits, adjusted for tax purposes, of
year the accounting period ended in the
fiscal year
Savings income
Some savings income is received gross, and some is received net of tax but it is all-taxable
under Schedule D Case III (Interest Income). You will need to learn which sources are
received gross and which net, because net income must be grossed up before inclusion in the
income tax computation.

Savings income received GROSS


♦ Interest on a National Savings Bank (NSB) account. There are two types of NSB
accounts: investment accounts and ordinary accounts. The distinction between the two
is important because interest on an investment account is ALL TAXABLE, whereas
the first £70 of interest on an ordinary account is EXEMPT (the balance being taxable).
♦ Interest on UK government stocks is received GROSS (sometimes called ‘gilt-edged’
stocks).

All of the above are received gross, so the amount received in the fiscal year can be slotted
directly into the income tax computation.
Savings income received NET
The following are received net of tax at the special lower rate of 20%.
♦ Building society interest
♦ Bank interest
♦ Interest on debentures
♦ Life annuity income (only the income element is taxable).

All of the above are received net of a 20% tax credit, but must be included gross in the
income tax computation. This means that if you are given the amount received, this is the net
amount, and must therefore be grossed up by 100/80.

All savings income is taxed in the fiscal year in which it arises. This is the date on which it is
paid or credited to the taxpayer from the payer’s viewpoint (person or company paying)

Dividend income
Dividends are treated as though they are also received net of tax. However, the rate of tax is
the ‘ordinary Schedule F’ rate of 10%. If you are given the amount received, this is the net
amount, and must therefore be grossed up by 100/90. Dividends are taxable under Sch. F.

Strictly there has not been a deduction of 10% tax by the company paying the dividend. The
company merely declares and pays a dividend out of its taxed reserves. A 10% credit is
imputed so if a dividend of £900 is declared and paid, the shareholder receives £900 with a
notional £100 tax credit resulting in a gross Schedule F receipt of £1,000.

The tax credit cannot be repaid to the shareholder – it was never paid in the first place. It is
a means of passing on a useable credit on account of the corporation tax that was (probably)
paid on the profits out of which the dividend is declared.

Non–savings investment income


This covers such items as rental income (Schedule A) and income assessable under
Schedule D Cases IV, V and VI. Computing the taxable amount of investment income other
than interest and UK dividends is excluded from the syllabus. You may, however, be given a
figure for, say, Schedule A income to slot into the income tax computation.

Exempt income
A few types of income are completely exempt from income tax, and should not be included in
the computation. These include the following.
♦ Interest on an ordinary account with the National Savings Bank to the extent of the first
£70 of interest in each fiscal year (husband and wife may each claim £70 on a joint
account).
♦ Interest on National Savings Certificates
♦ Interest on Save As You Earn (PAYE) share save accounts.
Exempt income … contd.

♦ Interest on delayed tax repayments (called repayment supplements)


♦ Income from ISAs (individual savings accounts)
♦ Damages for personal injury or death
♦ Scholarships and educational grants
♦ Prizes, lottery winnings and gambling winnings
♦ Statutory redundancy pay
♦ Some social security benefits, including housing benefit and child benefit, working
families tax credit and disability allowances.

Full income tax computation proforma


Income tax computation – A Person 2003/04
£ £
Earned income
Schedule D Case I X
Schedule E X
___
X
Schedule D Case III (Savings income)
Building society interest (amount received × 100/80) X
Bank interest (amount received x100/80) X
Corporate bond interest (amount received x100/80) X
Gilt–edged security interest (received gross) X
National Savings Bank interest (received gross) X
___ X
Schedule F (amount received × 100/90) X
Schedule A (normally given in exam) X
Less Charges on income
Eg patent royalties (X)
___
Statutory total income (STI) X
Less Personal allowance (PA) (X)
___
Taxable income X
___
Income tax liability and income tax payable
On non–savings income (at starting, basic and higher rates) X
On savings income X
On dividend income X
Add Basic rate tax retained on charges X
___
Income tax liability X
Less Tax suffered by deduction at source and notional tax credits on
dividend income (X)
___
Income tax payable X
___
3 Personal allowance (PA)
All individuals are entitled to a personal allowance of £4,745 for 2004/05.
The personal allowance is deducted from total income (called statutory total income (STI) for
tax purposes) in arriving at taxable income (TI). The personal allowance is not transferable,
and cannot be carried back or forward if not used.

4 Calculation of an income tax liability


The effect of savings income and dividend income
The simple calculation of tax uses the three different income tax rates and the corresponding
bands.
£ Rate
Band
Starting rate First 2,020 10% (£0 to £2,020 above £4,745 p.a.)
Basic rate Next 29,380 22% (£31,400 – £2,020)
Higher rate Above 31,400 40% (£31,401 and above)

Where there is savings income and/or dividend income included within STI, the situation is
slightly more complicated. The tax must be calculated in three stages.

Step 1
Calculate the tax on income which is neither savings income or dividends, using the above
bands and rates (Non-savings Income first – Schedule E or Sch. D case I/II income)

Step 2
Calculate the tax on savings income (this term excludes dividend income). Any savings income
that falls within the starting rate band is taxed at 10% and any income falling in the basic rate
band is taxed at 20% (NOT 22%). Any savings income exceeding the basic rate threshold of
£31,400 is taxed at 40%. Savings income - Schedule D case III) is never taxed at 22%.

Step 3
Calculate the tax on dividend income. Any dividend income that falls within the starting or basic
rate bands is taxed at 10%. Any dividend income exceeding the basic rate threshold of £31,400
is taxed at 32.5%. Dividend income (Schedule F income) is never taxed at either 22% or 40%.

The tax credits on savings income and dividends are deducted from the individual’s tax
liability. This means that a higher rate taxpayer will have to pay an additional 20% on savings
income and 22.5% (32.5% - 10%) on dividend income.

Repayment of tax credit


Sometimes the tax credit on savings income is greater than an individual’s tax liability. If so,
the excess may sometimes be repaid. Note, however, that non-taxpayers cannot claim a
repayment of the tax credit attaching to dividends.
Terminology – tax liability and tax payable
If you are asked to calculate income tax liability this is done as follows.
£
Calculation of tax X
Add Basic rate tax retained on charges paid net X
___
Income tax liability X
Less tax suffered by deduction at source (X)
___
Income tax payable X
___
The terminologies are NOT the same, do not let these terms confuse you!

You arrive at Tax Liability first before Tax payable (after deducting Tax suffered at SOURCE –
e.g. Savings - 20%, Diviends - 10% and PAYE deducted by employer/advance payment for
self-employed persons etc..

5 Business charges on income


Charges paid gross and charges paid net
Certain payments made by a taxpayer during the fiscal year can be deducted gross from the
taxpayer’s income in arriving at STI. These are called charges on income.

Some charges on income are paid gross, whereas others are paid net of basic rate income tax
(22%). Where charges are paid gross, the amount paid will simply be deducted in the income
tax computation without adjustment.

Where charges are paid net, they must be grossed up before inclusion in the computation, and
the tax added to the taxpayer’s liability. The most common charges on income you will
encounter in examination questions are paid net. You must learn which are paid gross, and
which net.

Charges paid gross


The following are the most common types of charges paid gross.
♦ Copyright royalties
♦ Interest on a qualifying loan. There are several types of loans that are qualifying, but the
ones most often encountered in exams are a loan to buy into a partnership, a loan to buy
into a company and a loan to acquire plant used in the borrower’s employment.

Charges paid net


Income tax at the basic rate of 22% is deducted by the payer from patent royalties. This is one
of a very few situations where an individual has to collect basic rate tax for the Inland Revenue.
The recipient (i.e. the patent holder) has a 22% tax credit to use in his personal tax
computation.
Method of obtaining tax relief for patent royalties
If an individual trader pays an amount of patent royalties of £1,000 (gross), the cash paid to the
holder of the patent is £780. The individual retains £220. The full £1,000 (gross) is then
deducted as a charge on income so that higher rate relief may be given where necessary, but
in doing so the taxpayer also gets basic rate relief of £220.

This means that the taxpayer has had tax relief twice: once through retention of £220 and
secondly through saving 22% tax. The £220 is therefore added back to the tax liability.