Learning Outcomes
After studying this article, you will be able to identify who is liable to pay income tax in the UK, distinguish the main types of taxable income, and apply the correct steps to calculate an individual's income tax liability. You will also understand the main methods of tax collection, the operation of anti-avoidance rules, and the basics of trust and inheritance tax as relevant for SQE1.
SQE1 Syllabus
For SQE1, you are required to understand the calculation and collection of income tax as it applies to individuals, partners, and trusts. In your revision, focus on:
- identifying who is liable to pay income tax and the relevant taxable entities
- distinguishing between non-savings, savings, and dividend income
- applying the correct steps to calculate income tax liability, including allowances and reliefs
- understanding the main methods of income tax collection (PAYE and self-assessment)
- recognising the operation of anti-avoidance rules (including GAAR)
- outlining the taxation of trusts and the interaction with inheritance tax
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- What are the three main categories of income for UK income tax purposes, and how are they taxed?
- How is the personal allowance applied when calculating an individual's income tax liability?
- What is the General Anti-Abuse Rule (GAAR) and when does it apply?
- Who is responsible for paying income tax on partnership profits?
- How does the UK tax system collect income tax from employees compared to self-employed individuals?
Introduction
Income tax is a central part of the UK tax system and a key topic for SQE1. It is charged on the income of individuals, partners, trustees, and certain other entities. Understanding how to identify taxable income, apply allowances and reliefs, and calculate the correct tax due is essential for advising clients and answering SQE1 questions.
Who Pays Income Tax?
Income tax is charged on the income of:
- individuals (including employees, sole traders, and partners)
- trustees (on trust income)
- personal representatives (on estate income during administration)
Key Term: income tax A tax charged on the income of individuals, partners, trustees, and certain other entities, according to UK law.
Companies do not pay income tax; instead, they pay corporation tax on their profits.
Types of Taxable Income
Income tax applies to several categories of income. For calculation purposes, these are separated into:
- Non-savings, non-dividend income (NSNDI): e.g. employment income, self-employment profits, rental income, most pensions.
- Savings income: e.g. bank interest, certain bonds.
- Dividend income: e.g. dividends from UK and overseas companies.
Key Term: non-savings, non-dividend income (NSNDI) Income from employment, self-employment, property, and most pensions, excluding savings and dividend income.
Key Term: savings income Income from interest on bank accounts, savings bonds, and similar sources.
Key Term: dividend income Income received as dividends from shares in companies.
Steps in Calculating Income Tax
Calculating income tax liability involves a series of steps. Each must be applied in the correct order.
Step 1: Identify Total Income
Add together all sources of income for the tax year (6 April to 5 April), including NSNDI, savings, and dividends.
Step 2: Deduct Allowable Reliefs
Certain reliefs may be deducted from total income, such as pension contributions, qualifying loan interest, and charitable donations.
Key Term: allowable relief A deduction permitted by law from total income before calculating taxable income.
Step 3: Deduct Personal Allowance
Every individual is entitled to a personal allowance (currently £12,570), reducing the amount of income subject to tax. The allowance is reduced by £1 for every £2 of income above £100,000.
Key Term: personal allowance The amount of income an individual can receive each tax year before paying income tax.
Step 4: Apply Tax Rates to Each Income Type
Taxable income is divided into NSNDI, savings, and dividend income. Each is taxed at different rates and in a specific order:
- NSNDI is taxed first.
- Savings income is taxed next, with possible application of the starting rate for savings and the personal savings allowance.
- Dividend income is taxed last, with a dividend allowance applied.
Key Term: personal savings allowance An amount of savings income taxed at 0% (£1,000 for basic rate, £500 for higher rate, none for additional rate taxpayers).
Key Term: dividend allowance An amount of dividend income taxed at 0% (£1,000 for 2023/24).
The main income tax rates for 2023/24 are:
- Basic rate (20%): up to £37,700 of taxable income
- Higher rate (40%): £37,701 to £125,140
- Additional rate (45%): over £125,140
Dividend income is taxed at 8.75% (basic), 33.75% (higher), and 39.35% (additional) after the dividend allowance.
Step 5: Calculate Total Tax Due
Add together the tax due on each slice of income to find the total income tax liability.
Worked Example 1.1
Question: Jamie has employment income of £35,000, bank interest of £1,200, and dividend income of £2,500. Jamie makes a pension contribution of £2,000. What is Jamie's income tax liability for 2023/24?
Answer:
- Total income: £35,000 + £1,200 + £2,500 = £38,700
- Deduct reliefs: £38,700 - £2,000 = £36,700
- Deduct personal allowance: £36,700 - £12,570 = £24,130
- Taxable NSNDI: £24,130 (all basic rate)
- Savings income: £1,200 (personal savings allowance covers first £1,000 at 0%, remaining £200 at 20% = £40)
- Dividend income: £2,500 (first £1,000 at 0%, remaining £1,500 at 8.75% = £131.25)
- Total tax: £24,130 × 20% = £4,826; £40 (savings); £131.25 (dividends)
Total income tax liability: £4,826 + £40 + £131.25 = £4,997.25
Methods of Tax Collection
Income tax is collected in different ways depending on the taxpayer's circumstances.
Pay-As-You-Earn (PAYE)
Employees have income tax deducted from their salary by their employer before payment.
Key Term: PAYE The system by which employers deduct income tax and National Insurance from employees' pay and send it directly to HMRC.
Self-Assessment
Self-employed individuals, partners, and others with untaxed income must complete a self-assessment tax return and pay tax directly to HMRC, usually in two payments on account and a balancing payment.
Key Term: self-assessment The process by which individuals report income and pay tax directly to HMRC, typically used by the self-employed and those with complex tax affairs.
Taxation of Partnerships
Partnerships are not separate taxable entities. Each partner is taxed individually on their share of the partnership profits.
Taxation of Trusts
Trusts are taxed as separate entities, often at higher rates. The type of trust determines the applicable rates and allowances.
Key Term: trust A legal arrangement where trustees hold assets for the benefit of beneficiaries, with specific tax rules applying to trust income.
Worked Example 1.2
Question: A partnership earns £60,000 profit. There are two equal partners. How is income tax paid?
Answer:
Each partner is taxed on £30,000 as part of their personal income. Each calculates their own tax liability, applying their personal allowance and tax rates.
Anti-Avoidance Rules
The UK tax system includes measures to prevent tax avoidance.
General Anti-Abuse Rule (GAAR)
The GAAR targets arrangements that are abusive and seek to exploit loopholes in tax law.
Key Term: General Anti-Abuse Rule (GAAR) A statutory rule allowing HMRC to counteract tax advantages from arrangements deemed abusive of tax legislation.
Specific Anti-Avoidance Provisions
There are also targeted rules to prevent known avoidance schemes, such as rules on disguised remuneration or artificial loss creation.
Exam Warning
For SQE1, be able to distinguish between legitimate tax planning and arrangements that may be challenged under GAAR or specific anti-avoidance rules.
Trusts and Inheritance Tax
Trusts are subject to special income tax rules and may also trigger inheritance tax (IHT) charges.
- Interest in possession trusts: Income is taxed on the beneficiary.
- Discretionary trusts: Trustees pay income tax at the trust rate (currently 45% on most income).
- IHT: Transfers into certain trusts may be immediately chargeable to IHT, and periodic and exit charges may apply.
Key Term: inheritance tax (IHT) A tax on the transfer of assets on death or certain transfers into trusts, subject to exemptions and thresholds.
Key Point Checklist
This article has covered the following key knowledge points:
- Income tax is charged on the income of individuals, partners, and trustees, but not companies.
- Taxable income is divided into non-savings, savings, and dividend income, each taxed at different rates.
- The calculation of income tax involves identifying total income, deducting reliefs and allowances, and applying the correct rates.
- The personal allowance reduces taxable income and is withdrawn for high earners.
- Income tax is collected via PAYE for employees and self-assessment for others.
- Partnerships are transparent for tax; each partner is taxed on their share.
- Trusts are taxed as separate entities, often at higher rates, and may also be subject to IHT.
- Anti-avoidance rules, including GAAR, counteract abusive tax arrangements.
Key Terms and Concepts
- income tax
- non-savings, non-dividend income (NSNDI)
- savings income
- dividend income
- allowable relief
- personal allowance
- personal savings allowance
- dividend allowance
- PAYE
- self-assessment
- trust
- General Anti-Abuse Rule (GAAR)
- inheritance tax (IHT)
