Archives for June 2016

Although most banks and building societies do not have to deduct Income Tax from interest payments they make to depositors from April 2016, the same does not apply to others that pay interest.

Consider an owner managed company whose directors had deposited a considerable sum with the company that was credited to a loan account in the company books. Periodically, the company made an interest payment to the directors involved.

When the interest payment was made the company would have to pay 80% to the director and 20% basic rate tax to HMRC. The company would then be required to notify HMRC that the payment had been made and pay over the tax deducted.

The CT61 is the form that would need to be completed. Regular payments would have to be reported and paid quarterly. To ease the red-tape, payments of interest could be made at the end of the tax year in which case only one return would be necessary.

 

In the context of this article tax credit does not refer to the child or working tax credits – these are part of the benefits system. Tax credits in this article refer to a deduction made from your overall tax liabilities, usually at a fixed percentage rate of the relevant income.

For example, up to 5 April 2016, dividend payments were made net of a deemed tax credit of 10%. If you received a dividend of £100 this would actually be a gross dividend of £111.11, less a 10% tax credit of £11.11. As far as HMRC was concerned, if your dividend income formed part of your basic rate band no additional tax would be payable. In this case your basic rate Income Tax liabilities on your dividend income could be said to be covered by the tax credit.

After 5 April 2016, the 10% tax credit was abolished and replaced by the so-called dividend tax allowance. Dividends received of up to £5,000 are taxed at 0%, and any dividends received in excess of this amount are taxed at 7.5%, 32.5% or 38.1% depending on whether the dividends fall into your basic, higher or additional rate bands.

However, the £5,000 allowance does not reduce your income for tax purposes. If your income from dividends is £5,000 or less this amount will still be added to your taxable income. The relief is actually applied further down your tax computation for the year. The first £5,000 of your dividend income is effectively taxed at 0%.

Why does this matter? After all, the effect would appear to be the same…

Unfortunately, it does matter. If the allowance is no longer a valid deduction from your income, but instead, is a reduction in the tax payable, the extra income may push you into the higher rate or additional rate bands, or if your income is in excess of £100,000 you may lose part of your personal allowance.

The Treasury seems to be viewing this reclassification of tax allowances as tax credits as an uncontroversial way to increase their Income Tax take simply by turning reductions in taxable income into a tax credit, even when, as with the title “dividend allowance” the £5,000 is not an allowance/deduction but a 0% tax band.

For the tax year 2016-17, most taxpayers are entitled to claim a tax-free personal allowance of £11,000 from their taxable income. The maximum income that can be taxed at the basic rate of 20%, after the personal allowance has been deducted, is £32,000.

Accordingly, if your total income is £43,000 or below you will only pay Income Tax at the basic rate. Any income earned in excess of £43,000 will therefore be taxed at higher rates: 40% or 45%, unless the £43,000 has been increased.

For 2016-17, the higher rate (40%) Income Tax band is £118,000. Income taxable in excess of £150,000 (£43,000 plus £118,000 less the £11,000 personal allowance) will be taxed at the additional (45%) Income Tax rate.

How can you increase your Income Tax bands?

The most common way is to make personal pension contributions or charitable donations under the gift aid regulations. You will get no basic rate Income Tax relief for charitable donations as the payment you have made to the charity is deemed to be the amount of the gift after basic rate tax has been deducted. However, your higher rate (40% and 45%) Income Tax liabilities will be reduced as the basic rate and higher rate Income Tax bands will be increased by the gross gift aid payments you have made: “gross” means the amount before the basic rate tax is deducted. If you make a gift aid contribution of £100, the gross payment is £125 (100/80 x100).

Pension contributions – paid net of basic rate tax relief – have a similar effect, but there are limits on the amount of contributions that can be paid. Advice should be sought before considering this option.

These options for tax planning are especially beneficial for tax payers with annual income between £100,000 and £122,000; as the Income Tax personal allowance is gradually reduced for taxpayers in this income band the effective rate of tax chargeable is 60% on the gross income equivalent.