Types of income

Introduction

Income tax in the United Kingdom is a levy on the income of individuals, covering a diverse range of income sources. The tax system classifies income into distinct categories, each governed by specific rules and regulations under the Income Tax Acts and related legislation. Understanding the details of these income types is critical for the accurate application of tax laws and is essential knowledge for the SQE1 FLK1 examination. The primary categories include employment income, trading income, property income, savings and investment income, dividend income, and foreign income. Each category possesses unique characteristics and tax implications that interact within the broader UK tax framework.

Employment Income

Employment income refers to earnings received from employment under a contract of service, including wages, salaries, bonuses, and certain benefits provided by the employer. Under the Income Tax (Earnings and Pensions) Act 2003, these earnings are subjected to income tax through the Pay As You Earn (PAYE) system, where employers deduct tax and National Insurance contributions before payment reaches the employee.

Let's examine some key aspects of employment income.

Key Aspects

1. Earnings and Benefits: Earnings include all forms of compensation from employment, encompassing cash payments and non-cash benefits known as benefits in kind. Common benefits in kind might include a company car, private medical insurance, or subsidised travel passes, which are assessed and taxed based on their value.

2. Allowable Expenses: Employees may deduct certain expenses incurred wholly, exclusively, and necessarily in the performance of their duties. For instance, if an employee purchases tools required for their job or travels to a temporary workplace, these costs may qualify for tax relief.

3. Benefits in Kind Taxation: Non-cash benefits are generally taxable. The employer must calculate the cash equivalent of the benefit, which is then added to the employee's earnings for tax purposes. Specific rules apply depending on the type of benefit provided.

4. Tax Codes and Personal Allowance: Each employee has a tax code that reflects their personal allowance—the amount of income they can earn before paying tax. For the tax year 2023/24, the standard personal allowance is £12,570.

Example Scenario:

Consider Alex, a software developer earning a salary of £50,000 per year. His employer also provides him with a season ticket loan and health insurance. The cash equivalent of these benefits is £2,000. Therefore, Alex's total taxable employment income becomes £52,000.

Trading Income

Trading income is derived from carrying on a trade, profession, or vocation. Under the Income Tax (Trading and Other Income) Act 2005, profits from self-employment or business activities are subject to income tax after allowable expenses are deducted from revenue. But when does an activity amount to a trade? That's where the concept of the "Badges of Trade" comes into play.

Understanding the Badges of Trade

The "Badges of Trade" are criteria established by case law to determine whether an activity constitutes trading for tax purposes. These include factors such as the frequency of transactions, the intention behind acquiring an asset, and the nature of the asset itself.

Illustrative Example:

Consider Lisa, who occasionally sells handmade jewellery on Etsy. If she makes occasional sales without a profit motive, HMRC may not consider her as trading. However, if she starts producing jewellery regularly with an intention to profit, holds stock, and markets her products actively, she is likely engaging in a trade and must declare her earnings accordingly.

Key Points

1. Allowable Expenses: Expenses that are incurred wholly and exclusively for the purpose of the trade can be deducted. This includes costs like office supplies, travel expenses, and marketing costs.

2. Accounting Methods: Smaller businesses may opt for the cash basis, recognizing income and expenses when money changes hands. Larger businesses typically use the accruals basis, accounting for income and expenses when they are earned or incurred, regardless of cash flow.

3. Capital Allowances: Instead of deducting capital expenditures like equipment purchase directly, businesses can claim capital allowances, spreading the cost over several years for tax purposes.

4. National Insurance Contributions: Self-employed individuals pay Class 2 and Class 4 National Insurance contributions, which should be accounted for alongside income tax.

Scenario Illustration:

Consider Raj, who runs a small café in London. His total revenue for the year is £150,000, and his allowable business expenses (including rent, utilities, staff wages, and supplies) amount to £110,000. Therefore, his taxable trading income is £40,000.

Property Income

Property income arises from the letting of land or buildings, whether residential or commercial. Under the Income Tax (Trading and Other Income) Act 2005, rental income is taxable after allowable expenses have been deducted. The taxation of property income can be complex, with specific rules applying to different situations.

Key Considerations

1. Allowable Expenses: Landlords can deduct expenses such as repairs and maintenance (but not improvements), insurance, letting agent fees, and mortgage interest (subject to restrictions).

2. Mortgage Interest Relief: For residential properties, landlords receive a basic rate tax reduction (currently 20%) on finance costs, including mortgage interest, rather than a full deduction from rental income.

3. Rent-a-Room Scheme: Individuals renting a furnished room in their only or main home can earn up to £7,500 per year tax-free under the Rent-a-Room Scheme.

4. Property Allowance: A property allowance of £1,000 per year allows individuals with modest rental income to receive up to £1,000 tax-free, simplifying their tax affairs.

Real-Life Example:

Suppose Emily owns a flat in Manchester which she rents out for £12,000 per year. Her allowable expenses, including repairs, insurance, and agent fees, total £3,000. She also pays £4,000 in mortgage interest. Under the new rules, she can deduct the £3,000 expenses from her rental income, reducing it to £9,000. She cannot deduct the mortgage interest but can claim a 20% tax credit on the £4,000 interest, amounting to £800. Her taxable property income is £9,000, and the tax liability is calculated accordingly, with the £800 tax credit applied.

Savings and Investment Income

Savings and investment income includes interest from bank accounts, building societies, bonds, and other savings instruments. The tax treatment of such income is governed by the Income Tax Act 2007, with several allowances and reliefs available to taxpayers.

Important Aspects

1. Personal Savings Allowance (PSA): Basic rate taxpayers can earn up to £1,000 in interest tax-free, while higher rate taxpayers have an allowance of £500. Additional rate taxpayers do not receive a PSA.

2. Starting Rate for Savings: An additional £5,000 of interest may be tax-free for individuals with low non-savings income, though this is reduced by £1 for every £1 of non-savings income over the personal allowance.

3. Individual Savings Accounts (ISAs): Interest and investment returns within ISAs are tax-free, and individuals can save up to £20,000 per year into ISAs.

Example Scenario:

Consider James, a basic rate taxpayer who earns £800 in interest from his savings account. Since this amount is below his £1,000 Personal Savings Allowance, he does not pay any tax on his interest income.

Dividend Income

Dividend income is received by individuals who own shares in companies when those companies distribute profits to shareholders. Dividends have their own tax rates and allowances under the Income Tax Act 2007.

Key Points

1. Dividend Allowance: For the tax year 2023/24, individuals have a £1,000 dividend allowance, meaning the first £1,000 of dividend income is tax-free.

2. Dividend Tax Rates: Dividends above the allowance are taxed at different rates depending on the individual's marginal tax rate: 8.75% for basic rate, 33.75% for higher rate, and 39.35% for additional rate taxpayers.

3. Interaction with Other Income: Dividends are taxed after non-savings income and savings income, affecting the tax bands and potentially pushing taxable income into a higher tax rate band.

Illustrative Example:

Consider Olivia, who has a salary of £35,000 and receives £5,000 in dividends. After her personal allowance, her salary uses up part of the basic rate band. The first £1,000 of her dividends is covered by the dividend allowance. The remaining £4,000 is taxed at the dividend basic rate of 8.75%, resulting in a tax charge of £350.

Foreign Income

Foreign income includes earnings from overseas employment, dividends from foreign companies, interest on overseas accounts, and income from foreign property. How this income is taxed in the UK depends on the individual's residency and domicile status.

Key Considerations

1. Arising Basis vs. Remittance Basis: UK residents are generally taxed on the arising basis, meaning worldwide income is taxed in the UK when it arises. Non-domiciled residents can opt for the remittance basis, being taxed only on income remitted to the UK, although this may involve a remittance basis charge after seven years of UK residence.

2. Double Taxation Relief: If foreign income has been taxed abroad, individuals may claim relief in the UK to avoid being taxed twice on the same income, under double taxation agreements.

3. Foreign Tax Credit Relief: Where no double taxation agreement exists, relief may still be available through unilateral relief for taxes paid overseas.

Example Scenario:

Emma is a UK resident but non-domiciled. She earns £20,000 from a rental property abroad. If she chooses the arising basis, this income is taxable in the UK, and she may claim foreign tax credit relief for any tax paid in the other country. Alternatively, she could opt for the remittance basis, paying UK tax only if she brings the income into the UK.

Key Tax Reliefs and Allowances

Understanding various tax reliefs and allowances is essential for effective tax planning and compliance.

1. Personal Allowance: The standard personal allowance is £12,570 for the tax year 2023/24. This allowance reduces by £1 for every £2 of income over £100,000, effectively becoming zero when income exceeds £125,140.

2. Marriage Allowance: Allows one spouse or civil partner to transfer 10% of their unused personal allowance to the other, provided certain conditions are met.

3. Pension Contributions: Contributions to registered pension schemes are eligible for tax relief, providing significant incentives for retirement savings.

4. Gift Aid: Donations to qualifying charities can be made under Gift Aid, allowing the charity to reclaim basic rate tax and higher rate taxpayers to claim additional relief.

5. Trading and Property Allowances: Individuals with minor trading or property income below £1,000 can benefit from full relief, simplifying tax reporting.

Conclusion

The taxation of foreign income illustrates the complex interplay of UK tax principles. Understanding the distinction between the arising basis and the remittance basis is necessary for accurate tax compliance, particularly in scenarios involving residence and domicile status. This complexity is further compounded by the application of double taxation relief provisions, which mitigate the risk of income being taxed both in the UK and abroad, pursuant to the UK's network of double taxation agreements and the provisions of the Income Tax Act 2007.

The various categories of income—employment, trading, property, savings and investment, and dividends—each possess unique tax treatments governed by specific legislation such as the Income Tax (Earnings and Pensions) Act 2003 and the Income Tax (Trading and Other Income) Act 2005. The interaction between different income types can affect an individual's tax bands and allowances. For instance, dividend income is taxed after non-savings and savings income, which can influence the rate at which dividends are taxed.

Being proficient in allowable expenses, reliefs such as the Personal Savings Allowance and Dividend Allowance, and the treatment of benefits in kind is necessary for precise calculation of tax liabilities. The principles governing capital allowances and the badges of trade are important when assessing trading income, ensuring that only legitimate business expenses reduce taxable profits.

In practice, applying these concepts often requires careful analysis of an individual's entire financial circumstances. Accurate classification of income and diligent application of the relevant tax rules ensure compliance with HMRC requirements and the effective application of the Income Tax Acts and related legislation.