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) Emoluments received in the fiscal Profits, adjusted for tax purposes, of year the accounting period ended in the fiscal year

Basis of assessment

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.

however. be given a figure for. These include the following. and must therefore be grossed up by 100/80. Computing the taxable amount of investment income other than interest and UK dividends is excluded from the syllabus. Exempt income A few types of income are completely exempt from income tax. Non–savings investment income This covers such items as rental income (Schedule A) and income assessable under Schedule D Cases IV. All of the above are received net of a 20% tax credit. but must be included gross in the income tax computation. Strictly there has not been a deduction of 10% tax by the company paying the dividend. The tax credit cannot be repaid to the shareholder – it was never paid in the first place. If you are given the amount received. Schedule A income to slot into the income tax computation.Savings income received NET The following are received net of tax at the special lower rate of 20%. V and VI. ♦ Interest on National Savings Certificates ♦ Interest on Save As You Earn (PAYE) share save accounts. However. ♦ Building society interest ♦ Bank interest ♦ Interest on debentures ♦ Life annuity income (only the income element is taxable). say. ♦ 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). 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. . the shareholder receives £900 with a notional £100 tax credit resulting in a gross Schedule F receipt of £1. Dividends are taxable under Sch.000. and must therefore be grossed up by 100/90. The company merely declares and pays a dividend out of its taxed reserves. this is the net amount. A 10% credit is imputed so if a dividend of £900 is declared and paid. F. This means that if you are given the amount received. and should not be included in the computation. You may. 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. All savings income is taxed in the fiscal year in which it arises. the rate of tax is the ‘ordinary Schedule F’ rate of 10%. this is the net amount.

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 Schedule E Schedule D Case III (Savings income) Building society interest (amount received × 100/80) Bank interest (amount received x100/80) Corporate bond interest (amount received x100/80) Gilt–edged security interest (received gross) National Savings Bank interest (received gross) Schedule F (amount received × 100/90) Schedule A (normally given in exam) Less Charges on income Eg patent royalties Statutory total income (STI) Less Personal allowance (PA) Taxable income Income tax liability and income tax payable On non–savings income (at starting. lottery winnings and gambling winnings Statutory redundancy pay Some social security benefits. ♦ ♦ ♦ ♦ ♦ ♦ ♦ 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.Exempt income … contd. including housing benefit and child benefit. basic and higher rates) On savings income On dividend income Add Basic rate tax retained on charges Income tax liability Less Tax suffered by deduction at source and notional tax credits on dividend income Income tax payable £ X X ___ X X X X X X ___ X X X (X) ___ X (X) ___ X ___ X X X X ___ X (X) ___ X ___ .

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%).5% (32. Any savings income exceeding the basic rate threshold of £31. The personal allowance is not transferable. If so. The tax credits on savings income and dividends are deducted from the individual’s tax liability. D case I/II income) Step 2 Calculate the tax on savings income (this term excludes dividend income).020) Higher rate Above 31. This means that a higher rate taxpayer will have to pay an additional 20% on savings income and 22. Any dividend income exceeding the basic rate threshold of £31. Note.400 – £2. the excess may sometimes be repaid. . £ Rate Band Starting rate First 2.020 above £4.10%) on dividend income.400 is taxed at 40%. that non-taxpayers cannot claim a repayment of the tax credit attaching to dividends.) Basic rate Next 29. Any dividend income that falls within the starting or basic rate bands is taxed at 10%.401 and above) Where there is savings income and/or dividend income included within STI. using the above bands and rates (Non-savings Income first – Schedule E or Sch.380 22% (£31.5%.a.020 10% (£0 to £2.5% .400 is taxed at 32. Dividend income (Schedule F income) is never taxed at either 22% or 40%. Savings income . The tax must be calculated in three stages. Repayment of tax credit Sometimes the tax credit on savings income is greater than an individual’s tax liability. Step 3 Calculate the tax on dividend income. Step 1 Calculate the tax on income which is neither savings income or dividends.745 p.745 for 2004/05. however. the situation is slightly more complicated.3 Personal allowance (PA) All individuals are entitled to a personal allowance of £4. and cannot be carried back or forward if not used. The personal allowance is deducted from total income (called statutory total income (STI) for tax purposes) in arriving at taxable income (TI).400 40% (£31.Schedule D case III) is never taxed at 22%. 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.

Where charges are paid net. and which net. The most common charges on income you will encounter in examination questions are paid net.Terminology – tax liability and tax payable If you are asked to calculate income tax liability this is done as follows. There are several types of loans that are qualifying.e.10% and PAYE deducted by employer/advance payment for self-employed persons etc. These are called charges on income. do not let these terms confuse you! You arrive at Tax Liability first before Tax payable (after deducting Tax suffered at SOURCE – e. Charges paid gross The following are the most common types of charges paid gross. Calculation of tax Add Basic rate tax retained on charges paid net Income tax liability Less tax suffered by deduction at source Income tax payable The terminologies are NOT the same. £ X X ___ X (X) ___ X ___ . the patent holder) has a 22% tax credit to use in his personal tax computation. they must be grossed up before inclusion in the computation. Diviends . This is one of a very few situations where an individual has to collect basic rate tax for the Inland Revenue. whereas others are paid net of basic rate income tax (22%).g. the amount paid will simply be deducted in the income tax computation without adjustment. The recipient (i.20%. ♦ Copyright royalties ♦ Interest on a qualifying loan. 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.. but the ones most often encountered in exams are a loan to buy into a partnership. and the tax added to the taxpayer’s liability. Where charges are paid gross. You must learn which are paid gross. 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. Savings . Some charges on income are paid gross.

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. . 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. the cash paid to the holder of the patent is £780. but in doing so the taxpayer also gets basic rate relief of £220.000 (gross).Method of obtaining tax relief for patent royalties If an individual trader pays an amount of patent royalties of £1.

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