SQE 1 - Business Law and Practice (Income Tax)

What are steps for income tax?

1. Identify who are chargeable persons for income tax purposes

What is income tax (IT)?

A tax levied on a chargeable person's icnome.

Do incorporated busineses (Companies and corporate partners) pay income tax?

No, they pay corporation tax on their income and capital gains instead.

What is a chargeable person?

Who are they?

Chargeable persons are liable to pay income tax.

They are:

- individuals (including sole traders)

- individual partners

- trustees

- Personal representatives

Do charities pay income tax?

No, charities are generally exempt.

What is income?

Any money received on a regular basis from work or investments.

The hallmark is that it is usually recurring in nature, unlike a capital gain which accumulates over time, because of an increase in an asset's value.

What are examples of income?

- Salary

- Dividends (a shareholder's return on their investment)

- Interest received (e.g. on a saving's account - i.e savings income)

- trading profit (for sole traders and partners)

- the profit element of rent received (e.g. renting out a property).

What are the key charging statutes regarding income tax?

1. Income Tax Act 2007 (ITA)

2. Income Tac (Trading and Other Income) Act 2005 (ITTOIA)

3. Income Tax (Earnings and Pension) Act 2003 (ITEPA)

What do chargeable persons pay income tax on?

Chargeable persons pay income tax on income earned/profits made during the income tax year.

What is income tax year?

The income tax year runs from 6 April in one year to 5 April in the next year.

It will be named after the two years that it straddles e.g. in October 2021 the tax year was 2021/2022.

If a person earns a salary between 6th April 2023 and 5th April 2024, which year do they pay income tax on?

The person will be charged for tax year 2023/2024.

Verka started business on 1 August 2020 and Bonnie started business on 10 March 2021.

What will be their first tax years?

Both Verka and Bonnie's first tax year will be 2020/21.

The businesses started during the tax year that started 6 April 2020 and ended on 5 April 2021.

Exam Tip

Income tax is renewed annually

This means rates, thresholds, exemptions and releifs can change year to year.

Check if these rates have updated by the time of the exam.

Income tax is progressive, what does this mean?

This means that the rate increases as income increases.

Individuals may make use of the lower rate(s) first, but pay IT at higher rate(s) as their income increases.

What is taxable income?

Income after deduction of allowable reliefs and personal allowances. From this figure, we can automatically tell what rate taxpayer someone is?

What is the 5-step calculation for income tax for individuals?

1. Calculate total income

2. Deduct allowable reliefs (this results in the net income)

3. Deduct personal allowances (this equals taxable income)

4. Calculate the tax for each source of income

5. Add together the amounts of tax from step 4 to give the overall Income Tax Liability

What are the three different types of taxpayer rates?

1. Basic rate taxpayer (BRT)

2. Higher rate tax payer (HRT)

3. Additional rateterm-14 taxpayer (ART)

What is a basic rate taxpayer (BRT)?

A person whose taxable income does not exceed the basic rate threshold (£37.7k as of 2021/2022)

What is a higher rate taxpayer?

A person whose taxable income exceeds the basic rate threshold but does not exceed the additional rate threshold.

i.e. they earn more than £37.7k but less than £125.140

What is an additional rate taxpayer?

A person whose taxable income exceeds the additional rate threshold (<£125,140)

What is NSNDI?

Taxable income, after deductions of savings income and dividend income.

i.e.

Taxable income - saving income - dividend income = taxable NSNDI

An indivdual's taxable icnome is charged at the appropriate rate(s).

There are different rates for differen categories of income

What is total income?

Step 1

Total income is the aggregate gross income for each source (ie without any IT deducted).

When is income taxable?

Income is taxable if it comes from a source specified in the relevant legislation:

- Part 2 ITTOIA (profits from trade or professions)

- Part 3 ITTOIA (property income)

- Part 4 ITTOIA (savings and investment income)

ITEPA --(employment and pension income)

What income is exempt from income tax?

- Child benefit

- Interest paid on national savings certificates

- premium bond winnings

- Interest from individual savings accounts (ISA)

- Interest on damages for personal injuries or death

What are examples of income that are paid gross?

Most types of income are paid gross and include:

- interest paid by banks and building societies

- dividends paid to shareholders

- property (rental) income (profit from the rental income)

What is the main source of income that is received net by the taxpayer (ie IT will already be deducted from source)?

The main source of income would be employment income, where tax is deducted as part of PATE (Pay as you earn scheme).

The gross amount (ie the net amount received, plus IT already deducted at source) must, however be included in the full IT calculation.

What is the charge to inheritance tax on directors and employers?

SPLIT FLASHCARDS

Covered under ITEPA includes:

- a charge on all 'earnings' (ie all benefits for services provided, e.g. salary)

A distinction is made between the receipt of a cash and a non-cash benefit, generally, all benefits that derive from the office or employment are liable to tax.

Employees are usually taxed on the cost to the employer of providing the benefit, and directors are generally liable to tax to the benefits of rent-free and low-rent accommodation.

A lump sum payment that is made to compensate a director/employee for an early termination of their contract will be taxable if they are contractually entitled to it. Any payment on retirement/removal from office that is not otherwise chargeable to tax may be taxable, although the first £30k of any such sum is usually exempt)

What is deduct allowable reliefs?

- Step 2 of Income tax calculation

Step two is to deduct allowable reliefs.

The figure after allowable reliefs have been deducted from total income is known as net income.

ie.

Total income - allowable reliefs = net income

What are allowable reliefs (AR)?

The most important AR is interest payments on 'qualifying loans' - this includes paid on:

a. a loan to buy a share in a partnership or

b. a loan to invest in a close trading company.

c. a loan to personal representatives to pay inheritance tax

What is net income?

The income after deductions of ARs but before the deduction of personal allowance.

What is deduct personal allowance?

- Step 3 of Income tax calculation

Step three is to deduct personal allowances

What is personal allowance (PA)?

The amount an individual can earn each year before paying IT.

PA is currently £12,570 as of 2021/2022 (subject to an income limit of 100k).

It cannot be carried forward to the next tax year.

What happens to personal allowance once an individual earns £100k or more?

The personal allowance is reduced by 50% (ie by £1 for every £2) to the extent that income exceeds £100k.

To arrive at the revised PA for those over this income limit,

-take the net income figure, minus £100k and divide it by two. Then deduct the resulting figure from the current PA.

Rafal has a net income of £110k in 2021/22.

What will his PA be?

£110k - £100k = £10k.

10k / 2 = £5k

£12,570 - £5k = £7570

What is the order of priority personal allowance is set against?

1. firstly, against NSNDI

2. If there is a surplus, against savings income

2. Any remaining surplus is applied against dividend income

What are the three other types of personal allowance that may be applicable?

1. Marriage Allowance

2. Blind person's allowance

3. Property and trading allowance?

What is marriage allowance?

Up to £1260 of an individual's unused personal allowance can be transferred to a spouse or civil partner (the spouse/civil partner must be a basic rate taxpayer)

What is blind person's allowance?

Any taxpayer who is registered blind receives an additional £2870 PA.

This is subtracted from net income just like personal allowance.

What is property and trading allowance?

Up to £1k of gross property income or £1k gross trading income will not be subject to IT.

For amounts over the £1k, the allowance may be deducted from the gross figure as an alternative to deducting actual expenses to arrive at their taxable income figure.

What are the sub-steps for step 4: Calculate the tax for each source of income?

Separate the different types of income and calculate the tax for each in this order (slices of income tax):

(a) Calculate NSNDI tax

(b) Calculate Saving Income tax

(c) Calculate Dividend tax

What are the income tax rates for NSNDI?

Step 4: sub-step (a)

bottom slice

Basic Rate

Charge - 20%

Taxable Income - £1-37,700

Higher Rate

Charge - 40%

Taxable Income - £37,701 - £125,140

Additional Rate

Charge - 45%

Taxable Income - £125,140 & Above

What are the income tax rates for Savings Income?

Step 4: sub-step (b)

Middle slice

Starting Rate

Charge - 0%

Taxable Income -£5000

Basic Rate

Charge - 20%

Taxable Income - £5001-£37,700

Higher Rate

Charge - 40%

Taxable Income - £37,701-£125.140

Additional Rate

Charge - 45%

Taxable Income - £125,140 & Above

What are the income tax rates for Dividend Income?

Step 4: sub-step (c)

Top slice

MAKE SURE RATES ARE ACCURATE

Ordinary Rate

Charge - 8.75%

Taxable Income - £1-£37,700

Upper Rate

Charge - 33.75%

Taxable Income -£37,701-£125,140

Additional Rate

Charge - 39.351%

Taxable Income -£125,1400 & above

In 2021/22,

Celine has a taxable NSNDI of £20k,

Sandra has a taxable NSNDI of £52k,

Gali has a taxable NSNDI of £200k.

Remember taxable income means that allowable reliefs and personal allowances have already been deducted.

What rate(s) of IT will they each pay?

Celine is BRT - she will pay IT at 20%

Sandra is an HRT, she will pay IT at 20% on the first £37.7k and 40% of the remaining balance

Gali is an ART. She will pay IT at 20% on the first £37.7k, 40% on the balance up to £125k and 45% on the 'top slice' of £50k.

Annie has a taxable NSNDI of 30k in 2021/22. How far away is she from moving up to the higher rate?

Higher rate - £37,700

£37,700 - £30,000 = £7,700

What is personal savings allowance (PSA)?

Under the PSA, up to the first £1k of saving s income will be tax-free. The PSA varies according to the individual's taxable income.

Not related to personal allowance.

Who receives and doesn't receive personal savings allowance?

Receives PSA

- BRT

- HRT

Doesn't receive PSA

- ART

What are the personal savings allowance rates?

BRT

Taxable Income - £0-37,700

PSA - £1000 tax-free

HRT

Taxable Income -£37,701-125,140

PSA - £500 tax free

ART

Taxable Income -£125,140 & above

PSA - No allowance received

FIGURE OUT A QUESTION FOR THIS

The available PSA is added to the taxable NSNDI figure, and then taxed at 0%.

Are the tax-free savings included in the cumulative total in moving from one threshold to the next?

Yes, any tax-free amount still counts to the cumulative total in moving from one threshold to the next.

Any savings income over the PSA is taxed at the appropriate rate(s) for savings income based on the cumulative income taxed so far.

Jamala has a taxable NSNDI of £5k and receives gross savings interest of £2k. She has no other income in 2021/22.

What rate(s) of IT will she pay?

Jamala is a BRT.

She will pay 20% on her NSNDI.

The PSA will mean that no IT is payable on the first £1k of interest.

She will pay IT of 20% on the remaining £1k.

Mary has a NSNDI of £38k and receives gross interest of £1k. She has no other income in 2021/22.

What rate(s) of IT will she pay?

Mary is an HRT.

Her basic rate band has already been used up and exceeded with her NSNDI.

She will be entitled to a PSA of £500 and will pay IT at 40% on the balance.

Colin has a taxable NSNDI, PSA and remaining savings income of £34,700 in 2021/22.

How far away is he from moving up to the higher rate?

£37,700 - £34,700 = £3000.

What is dividend allowance (DA)?

When taxing dividends, the DA needs to be considered.

The DA provides that the first £1k of a taxpayer's dividend income will be free from tax (this applies to all taxpayers irrespective of their taxable income).

THINK OF QUESTION FOR THIS + SPLIT

The available dividend allowance is added to the taxable NSNDI, the available PSA, and the remaining interest income and then taxed at 0%.

The tax free amount still counts to the cumulative total in moving from one threshold to the next.

Any dividend income over the DA is taxed at the appropriate rate for dividend income, based on the cumulative income taxed so far.

Sergey has a taxable NSNDI of £5k and receives a gross dividend payment of £1k. He has no other income in 2021/22.

How much IT will he pay on the dividend.

Sergey is a BRT. The dividend falls within the ordinary rate band, but due to the dividend allowance, not IT is payable.

Emmile has a taxable NSNDI of £38k and receives a gross divided payment of £3k. She has no other income.

How much IT will she pay on the dividend?

Emmelie is a HRT. Her basic rate band has already been used up (and exceeded) with her NSNDI. She will be entitled to a DA of £1k but will pay 33.75% on the balance.

Lulu has a total income of £40l from her salary. She also receives gross interest of £2k and a gross dividend payment of £10k in the same tax year. She pays £500 interest on a loan to buy shares in a partnership.

What is her IT liability.

Step 1 - Lulu's total income is £52k

Step 2 - £500 can be deducted as an AR = £51.5k

Step 3 - PA of 12,570 can be deducted. Her taxable income is £38,930, so she is a HRT.

Step 4 -

(a) - Deduct savings and dividend income from her taxable income to give a NSNDI of £26,930.

This is taxed at 20% = £5386 (she has £10,770 of income left before she moves up to the higher rate)

(b) - As an HRT, Lulu is entitled to a PSA of £500. The remaning £1500 will be taxed at the ordinary rate of 20% = £300 (she has £8700 of income left before she moves up to the higher rate)

(c) Lulu is entitled to a DA of £1k. The remaining 9k faills into two tax rates. The first £6770 is taxed at the ordinary rate of 8.75% and the remaining £2230 is taxed at the upper rate of 33.75% = £586.25 + 752.625 = £1338.875

Step 5 - Lulu's IT liability is:

£5386 + £300 + £1338.89 = £7024.89

She can deduct any tax previously paid under PAYE to give her IT payable.

Step 5

Add all of the tax is step 4 together

What is income tax is Wales?

Individuals living in Wales pay Welsh income tax rates.

There is potential for NSNDI to vary - check rates.

Income tax and sole traders

A sole trader will prepare accounts for the business for an 'accounting period' (usually 12 months) to show how much profit/loss has been made.

The accounting period will not always match the IT, so it is necessary to know the rules for assessment of trading profits.

If the business has made a profit, IT is payable on those income profits. If the business has made a loss, relief is available.

What is the opening year rule? (OYR)

In the first tax year in which a business trades, IT will be assessed on the taxable profits made by the business from the date it starts trading, to the following 5 April.

What is the current year basis (CYB)?

In the second tax year in which a business trades, IT will usually be assed on the taxable profits of the 12-month accounting period that ends in the second tax year. The CYB also applies to the third and subsequent tax year, until the final year of business.

What is the closing year rule (CYR)?

In the final tax year in which the business trades, IT will be assessed on the taxable profits made from the end of the last accounting period to the date the business stops trading, minus a deduction of any overlap profit.

What is the overall profit?

Overlap profit means income profits of a business which are assessed for IT more than once in the opening years of the business' trade.

Overall profit is deducted from the income profits assessable to IT in the business' final year of trade.

Mahmood starts business on 1 January 2017 and prepares accounts on a calendar basis (ie each 12-month calendar year).

Mahmood subsequently ceases trading on 31 January 2013, with the final accounts showing the profits:

y/e 31.12.2017 - £150k

y/e 31.12.2018 - £160k

y/e 31.12.2016 - £170k

What profits of the business will be assessed for IT in each year?

The first tax year is 16/17 and the subsequent tax years are 17/18, 18/19, and 19/20.

First year - OYR

Taxed for three months rom 01/01/17-05/04/17 £37.5k (approximately a quarter of the year)

Second year - CYB

01/01/18 - 31/12/18 - £150k (note overlap profit of £37.5k)

Third year- CYB

01/01/18-31/12/18 - £160k

Third year - CYR

01/01/19-31/12/19 - £170k (minus the overlap profit of £37.5k) = £132.5k

What is the general rules regarding partnerships and income tax?

SPLIT THIS

A partnership will be charged IT on the income profits the business makes in the same way as sole traders.

OYR, CYB and CYR all apply.

The taxable profit is apportioned between the partners as agreed between them for the relevant accounting period

- e.g. under default provisions oft the PA, a formal partnership agreement or any express/implied agreement

Partners are separately taxed on their own share of the partnership's profits and each partner is liable to pay their own tax. (as this is a general partnership not LLP)

If the partnership has made a loss, each partner may choose what type of relief to claim in respect of their share of loss.

What happens when there is a change of partners regarding income tax?

Effectively, each partner is treated as if they were a sole trader. Therefore, for each partner, the business begins when they become a partner and ends when they cease to be a partner (retire) - therefore new partners and retiring partners will be assessed to income tax differently.

When a partner joins an existing firm will OYR or CYB apply?

- Consequences of a partner joining a firm (figure out best question to write this as)

Both, but dependent on the individual partner.

OYR apples to the partner joining only because as far as they are concerned they are starting a new business.

The existing partners will continue to be assessed on the CYB.

Leonora joins Tamta and Luca in partnership on 1 May 2018.

Tamta and Luca have been trading since 1 May 2016.

Accounts are made up to 20 April in each year and the profits are as follows:

y/e 30.04.2017 - £60k

y/e 30.04.2018 - £80k

y/e 30.04.2019 - £90k

y/e 30.04.2020 - £120k

On the basis that the partners share profit equally, what is Leonara's share of the partnership profits that will be assessed for IT for both her first and second year?

The relevant tax years are 18/19 and 19/20

Year one - OYR - 11 months = £82.5k (1/3 = £27.5k)

Year two - CYB - £90k (1/3 - £30k) (Note overlap profit of £27.5k)

Tamta and Luca continue on the CYB throughout these years.

Consequences of partner leaving a firm

When a partner leaves a continuing firm, the CYR will apply to that partner only, because as far as they are concerned, they are ceasing to trade. The remaining partners continue to be assessed on the CYB.

Carrie, Bobby and Helen start a partnership on 1 January 2019, sharing profit equally.

They prepare accounts on a calendar year basis, making the following profits:

y/e 31.12.2029 - £48k

y/e 31.12.2020 - £60k

y/e 31.12.2021 - £90k

Helen leaves the firm on 30 April 2021. What is Helen's share of the partnership's profits that will be assessed to IT in the final tax year?

Final tax year - 2021/2022

CYR - 01/01/21 - 30/04/21 = four months (£30k) Helen's share = £10k (minus any overlap profit from the first year)

Bobby and Carrie continue on the CYB.

Collection of income tax: self-assessment

Some IT is deducted at source (e.g. employment income). If a taxpayer receives other income which the tax has not been deducted at source (e.g. rental income), they must complete a tax return under the self-assessment scheme.

What is a tax return?

A form submitted to HMRC annually, in circumstances where not all of an individual's IT has been deducted at source. The form sets out the income the individual has received and a self-assessment of the amount of the tax payable.

When should an individual liable for self-assessment notify HMRC?

If an individual is liable for self-assessment, HMRC must be notified within six months of the relevant tax year, or they will be fined.

When is a tax return submitted?

Either:

- 31 January (if submitted online)

or

- 31 October (if submitted via paper)

following the end of the relevant tax year.

How is payment made with a tax return?

Payment is made by way of two payments on account.

What is payments of account?

Two payments, generally representing half of the individuals' tax bill from the previous tax year and made by 31 January in the tax year and 31 July after the tax year.

A final balancing payment (the amount of the remaining tax liability) must be made by the following 31 January.

Who doesn't need to make payments on account?

Either those who:

- already paid more than 80% of their tax bill through deduction at source or

- with a small self-assessment liability in the previous tax year (less than £1k)

What penalties for payments are not made or made late?

- Payments on account

- interest on late payments

- fixed penalties if tax is not paid or paid late

- penalties for not keeping accurate records

How can you appeal a penalty?

Appeals are made to the First-Tier Tribunal.

Albert had self-assessment tax liability of £20k in the tax year 2020/21. in the following tax year, 2021/22, he has self-assessment tax liability of £30k.

When will he pay his tax liability for 2021/22?

He must make two payments on account of £10k by 31 January 2011 and 31 July 2022

The balancing payment of £10k will be payable by 31 January 2023/

What is tax avoidance?

Working, usually within the law, to minimise tax liability.

What is tax evasion?

Deliberately misinterpreting or misapplying the law to minimise tax liability.

Tax evasion is illegal.

What is the general anti-avoidance rule (GAAR)?

A rule that applies to certain taxes (including IT) to combat abusive tax avoidance arrangements that go beyond lawful tax avoidance.

What is an abusive tax avoidance arrangement (ATAA) for the purposes of GAAR?

A tax arrangement is abusive if it 'cannot reasonably be regarded as a reasonable course of action ... having regard to all the circumstances' - s207 Finance Act

SPLIT AND THINK OF A QUESTION FOR THIS FLASHCARD

Under the GAAR procedure, the taxpayer will be notified if an ATTA is uncovered and a request for tax adjustments will be made.

The GAAR advisory panel deals with any representations made by the taxpayer.

Any person who enabled the scheme as part of their business may be fined. Taxpayers have the right to appeal to a tax tribual.