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The seven steps required to calculate an individual’s income tax liability

Author Image The Technical Team
13 minutes read
Last updated on 28th Oct 2019

What are the seven steps required to calculate an individual’s income tax liability. Find everything you need to know in our knowledge library.

Key Points

·       Tax law states that seven steps are required to calculate an income tax liability

·       There are fixed ‘order of income’ rules that need to be followed

·       Savings income includes onshore and offshore bond gains

·       Reliefs and allowances should be deducted  in the most favourable way for the individual

Tax law

Tax law instructs us how to calculate an income tax liability. In simple terms, you add up the different components of income, then deduct any reliefs and allowances. You then calculate the tax due on each component and total these up. In straightforward cases, that will be all that is required but in more complex cases you then need to deduct any tax reducers and add in any further amounts of tax due.

The full details are set out below.

The importance of Section 23 Income Tax Act (ITA) 2007

Section 23 is titled “The calculation of income tax liability”, and it states the following.

“To find the liability of a person (“the taxpayer”) to income tax for a tax year, take the following steps.”

Steps one to seven are then listed. 

Step one – identify the ‘components’ of income then add together to arrive at total income

“Identify the amounts of income on which the taxpayer is charged to income tax for the tax year. The sum of those amounts is “total income”. Each of those amounts is a “component” of total income”.    

What is meant by a “component”?  These are all possible components of a client’s total income.

·       Employment income

·       Pension income

·       Social security income

·       Trading income

·       Property income

·       Savings income 

·       Dividend income

·       Miscellaneous income

Section 16 ITA 2007 states that savings and dividend income are treated as the highest part of total income. S16 also confirms that if an individual has savings and dividend income then the dividend income is treated as the higher part. It’s more complicated however where there is a top slicing calculation being carried out for insurance bond gains. Also, onshore bond gains are taxed after dividend income.

Section 18 confirms that ‘savings  income’ includes onshore and offshore insurance policy gains. S465A ITTOIA 2005 states that onshore bond gains are treated as the highest part of an individual’s total income.

The order of income tax - 

First

Earnings, pensions, taxable social security payments, trading profits, income from property

Then

Savings income (includes offshore bond gains)

Then

Dividend income

Then

Onshore bond gains


With regard to insurance bond gains, how does top slicing relief fit into these rules?

When calculating the tax liability before top slicing relief then the above order of tax rules apply. Note how onshore and offshore bond gains are slotted in differently in the order of tax rules.

When you come to calculate top slicing relief itself, then bond gains and slices are treated as the ‘highest part’ and therefore both onshore and offshore gains and slices come after dividends in the top slicing relief calculation. In other words, the order in the top slicing calculation is as follows.

First

Earnings, pensions, taxable social security payments, trading profits, income from property

Then

Savings income (excludes offshore bond gains)

Then

Dividend income

Then

Onshore and offshore bond gains and slices

Top slicing information is available here

Step two – deduct from the components any reliefs due then add up the remaining balances to arrive at net income

“Deduct from the components the amount of any relief under a provision listed in relation to the taxpayer in section 24... See sections 24A and 25 for further provision about the deduction of those reliefs. The sum of the amounts of the components left after this step is “net income”.”

Certain reliefs can be deducted from any component but others are restricted to a particular component. For example, if the client is a trader and sustains a trading loss in the tax year then the loss can be deducted against general income of the same or preceding tax year with any unrelieved loss then carried forward and set off only against future income from that same trade.

Section 24 of ITA 2007 lists the various reliefs which are potentially deductible and Section 25 tells us that the reliefs can be deducted in the way which will result in the greatest reduction in the client’s income tax liability. That means deducting, as far as possible, from non-savings, non- dividend, income (earnings, pensions, taxable social security payments, trading profits and income from property). Any remaining relief is then deducted from savings income (being mindful not to waste 0% savings rates) and finally from dividend income. Clearly these reliefs need to be deducted from the individual components rather than from total income, to achieve this objective.

Note that there is a limit on the amount of income tax relief deductible at Step 2 for certain reliefs. The cap is the higher of £50,000 or 25% of the individual’s adjusted total income.

Example of the cap on income tax relief - 

In the current tax year, Roddy has total income of £170,000 and trading losses of £60,000. He makes a claim to set his trading losses off against his total income.  Roddy’s relief will be £50,000 as that is higher than £42,500 (25% of £170,000).    

Step three – deduct any allowances due to arrive at the amount on which income tax is charged

“Deduct from the amounts of the components left after Step two any allowances to which the taxpayer is entitled for the tax year... See section 25 for further provision about the deduction of those allowances.”    

Step three is where the personal allowance (and blind person’s allowance) is deducted.  Further information here.

Again Section 25 tells us that this should be done in the way which will result in the greatest reduction in the client’s income tax liability, and again the allowance(s) must be deducted from components rather than from the total net income figure to achieve this. See the worked example later in the article.

Step four - calculate the tax on the component amounts remaining after Step three

“Calculate tax at each applicable rate on the amounts of the components left after Step three. See Chapter 2 of this Part for the rates at which income tax is charged and the income charged at particular rates.” 

The above is self- explanatory. Don’t forget to extend the basic rate band and higher rate limit for gross gift aid payments  and gross relief at source pension contributions

The different rates of tax are covered  here.

The above link details the main rates, dividend rates and savings rates. If the individual has savings income comprising a UK bond gain and other gross interest, then the zero rate band is applied to interest in priority to the onshore bond gain.

Step five – add together the tax due on each component calculated at Step four

“Add together the amounts of tax calculated at Step four.”

Step six – deduct any tax ‘reducers’ due

“Deduct from the amount of tax calculated at Step five any tax reductions to which the taxpayer is entitled for the tax year… See sections 27 to 29 for further provision about the deduction of those tax reductions.”

Step six is therefore the step where any tax reducers are deducted. Essentially they reduce the tax liability calculated above.

These reducers are listed in Section 26 with the most common being EIS, VCT & SEIS tax reliefstop slicing relief,  deficiency relief and community investment tax relief.  Also, marriage 'allowance' is deducted here. This arises when married couples and civil partners apply to transfer 10% of the unused income tax personal allowance from one to the other. To qualify, neither of the partners can be a higher rate taxpayer and they must not be claiming the married couple’s allowance. The word “allowance” is misleading as it delivers a tax reduction for the recipient rather than an additional allowance .

It is also here that additional ‘relief at source’ relief is available for Scottish (& Welsh when appropriate) taxpayers.  Scottish taxpayers subject to 21% intermediate, 41% higher or 46% additional rate are entitled to claim additional relief by completing a tax return. There is an example here.

Section 27 tells us that the general rule is to deduct the reductions in the order which will result in the greatest income tax reduction. There is a proviso however that, if a client is entitled to certain multiple reductions then a specific order applies. For example if  VCT, EIS and marriage ‘allowance’ reductions are all due then they need to be deducted in that order.  Section 28 is not relevant to individuals. Section 29 instructs that a tax reduction applies only so far as there is sufficient tax calculated at Step five.

Example of restricted tax reducer - 

If Jonny subscribed £20,000 for VCT shares, his maximum income tax relief at 30% would be £6,000. If his actual liability in that year before any VCT tax relief was £5,000, then that is the relief he would receive. The difference of £1,000 can’t be set off against the income tax liability of any other year.    

Step seven – add on any further amounts of tax due

“Add to the amount of tax left after Step 6 any amounts of tax for which the taxpayer is liable for the tax year under any provision listed in relation to the taxpayer in section 30. The result is the taxpayer’s liability to income tax for the tax year.” 

This is the final step in the process of calculating a client’s income tax liability. It is necessary to add any further amounts of tax due. Common examples include

·       Gift aid donations where the donor has not paid sufficient tax to cover the income tax deducted from the donation meaning that the individual is liable to pay the difference.

·       High income child benefit charge. See here to understand how reducing adjusted net income can reduce the impact.

·       The lifetime allowance charge.

·       The annual allowance charge.

Remember that a client’s income tax liability is not necessarily the same as tax payable because there may be tax already paid (e.g. PAYE) or tax deducted at source.    

Dealing with an onshore bond ‘tax credit’

Tax law for taxing insurance bond gains is contained in Part 4, Chapter 9 of the Income Tax (Trading and Other Income) Act (ITTOIA) 2005. Although, where the policyholder is a company, then the loan relationship rules apply instead as discussed here.

Chapter 9 comprises Sections 461 to 546 and from outset, S461 (1) makes it clear that gains are charged to income tax. Only in certain specific circumstances will a charge to capital gains tax arise.

Chargeable event gains on UK bonds are not liable to basic rate tax. The individual (or trustee) who is liable for tax under the chargeable event regime is treated as having paid tax at the basic rate on the amount of the gain. This reflects the fact that the funds underlying a UK policy are subject to UK life fund taxation.

It is a longstanding principle that the notional tax is not repayable (S530 (2) ITTOIA 2005    

Insurance Policyholder Tax Manual 3810

“The general rule is that an individual or trustee who is liable for tax under the chargeable event regime is treated as having paid tax at the basic rate on the amount of the gain. Where this rule applies, the notional tax is not treated as repayable in any circumstances but basic rate tax is still treated as paid if some or all of the gain is liable to income tax at the starting rate for savings.

However, where the amount of gain on which an individual is charged is reduced by any reliefs or allowances, including personal allowances, then the amount of the gain on which the individual is treated as having paid tax is correspondingly reduced. The reliefs and allowances concerned are those included in steps 2 or 3 of the calculation in section 23 of Income Tax Act 2007.”

HMRC manuals therefore state that basic rate tax is still treated as paid even if some or all of the gain is subject to the 0% starting rate for savings.

As far as we are aware, it has not been definitively settled whether or not the notional tax credit is repayable. S530(2) states that the notional credit cannot be repaid. That suggests  it is not available to set against other income resulting in income tax to be repaid,  but instead it should be possible to reduce that tax down to zero.  Nevertheless, we are aware that HMRC have previously taken the view that the notional tax credit can be set against other income, creating a refund of other income tax if appropriate. This is valid but at odds with the intention of the legislation.

Finance Act 2008 created a new 10% starting rate for savings. A consequence of this was that S530(6) was repealed. That particular subsection had been in place to ensure that gains taxed under the previous 10% starting rate band would be taxed at 20% rather than 10%. With S530(6) being omitted, this consequence was that gains with a notional 20% credit became chargeable at 10% (now 0%) leaving a balance of tax credit.

Example of bond gain partially taxable at 0% savings rate -

In 2019/20, Alex, who lives in Leeds, has earned income of £16,500 and an onshore bond gain of £30,000 with a 20% notional tax credit of £6,000.

After setting off the Personal Allowance of £12,500, his taxable earned income is £4,000. He will pay 20% tax on that = £800.

His £5,000 0% Starting Rate for Savings is reduced to just £1,000.

·       His Personal Savings ‘Allowance’ will be £1,000.

·       Tax due on his bond gain will be 20% of £28,000 = £5,600.

His notional tax credit of £6,000 ensures there is no tax liability on his bond gain but what is the position with the £400 which has not been required?

That can be set against the £800 tax due on his earnings reducing his overall tax bill to £400.

Adjusted net income

The Seven Steps outlined above help form the calculation of an individual’s ‘adjusted net income’. S58 ITA 2007 sets out the calculation as follows.

1.    

Start with the individual’s ‘net income’ as calculated at Step 2.

2.    

Deduct gross gift aid payments

3.    

Deduct gross relief at source pension contributions

4.    

Add back payments to trade unions and police organisations which were deducted in arriving at net income above

The term ‘adjusted net income’ is important for several reasons

·       The basic personal allowance is restricted for those where adjusted net income exceeds £100,000

·       The high income child benefit tax charge impacts those with an adjusted net income over £50,000

·       The amount of Personal Savings ‘Allowance’ (PSA) depends on adjusted net income (up to £50,000, the PSA is £1,000 then £500 up to £150,000 then zero

·       The income limit for Married Couples ‘Allowance’ where either party born before 6 April 1935 is based on adjusted net income

Example – deducting Personal Allowance to deliver the greatest reduction in tax liability

In 2019/20, Sarah has pension income of £8,500, savings income of £7,000 and dividends of £9,000    

 

Pension £

Savings £

Dividends £

Total £

 

8,500

7,000

9,000

24,500

Personal Allowance

(8,500)

(1,000)

(3,000)

(12,500)

Taxable

0

6,000

6,000

12,000

£5,000 taxable at 0%

 

(5,000)

 

(5,000)

£1,000 taxable at 0%

 

(1,000)

 

(1,000)

£2,000 taxable at 0%

 

 

(2,000)

(2,000)

£4,000 taxable at 7.5% = £300

 

 

(4,000)

(4,000)

 

0

0

0

0

 

The Personal Allowance is firstly set against the pension income.  That means the taxable savings income and taxable dividend income is maximised which is sensible as those components enjoy an element of 0% tax which we do not want to waste.

Note that the general rule of thumb is to deduct the maximum personal allowance from non-savings, non-dividend income as this component suffers tax at the highest rates and enjoys no 0% bands which may apply to savings and dividend income; also remember that dividends are taxed at a maximum rate of just 38.1%.

Sarah’s non savings income is lower than the personal allowance meaning that she is entitled to a £5,000 0% band for her savings income.

Sarah’s adjusted net income is lower than £50,000 meaning that she is entitled to a Personal Savings ‘Allowance’ of £1,000.

To maximise use of the £5,000 0% rate and the £1,000 PSA, only £1,000 of personal allowance is set off against the savings income of £7,000. That leaves £3,000 of personal allowance to be deducted from dividends.

Regarding dividends, the £2,000 nil rate is available to anyone who has dividend income. Sarah is comfortably a basic rate taxpayer meaning that she will pay 7.5% on dividends in excess of £2,000.

 

© Prudential 2019