Personal taxation

Income tax is a tax on an individual’s income. The rates and bands are changed each year by Parliament in the annual Budget. Income tax is not paid by companies, who are liable for Corporation Tax on their profits and capital gains instead. The laws relating to taxing income from employment, pensions and State benefits are contained in the Income Tax (Earnings and Pensions) Act 2003 (ITEPA 2003).  Incom...

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...t helpful to refer to the Tax Tables as we work through it.

NOTE: We will refer you to the Tax Tables througout this course, click here to open. Also see the IMPORTANT READ FIRST section at the start of chapter 1 and return to that section to open the document in future if you have not already saved it.

We will start by identifying in the next sections the different types of income an individual could have.

The type of income an individual has wi...

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...ow look at each of these in turn.

 

Income tax is charged on trades, professions and vocations carried out by UK residents in any location worldwide and on trades, professions and vocations carried on by non-UK residents in the UK.

Self-employed individuals and those in partnerships are assessed for income tax on the taxable profits from their trading activ...

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...000. Trading income is exempt from tax and does not have to be declared if it is less than this amount (before deducting expenses). If trading income is more than £1,000, the allowance can be claimed against income instead of deducting expenses and is therefore only of benefit to the very smallest businesses.

 

Individuals who are employed are liable for Income Tax on the income from their employment. This includes salaries, fees, bonuses and the taxable value of any benefits they receive. These are all liable for income tax in the tax year in which they are received or the benefits are enjoyed. 

The extent to which earnings are taxed is dependent on an individual’s residence and domicile status. These aspects are examined fully in the chapter on residence and domicile.

The income tax due on these types of income is normally deducted by the employer from the gross amounts before the individual receives the payments, under the PAYE system.

TAXATION OF EMPLOYEE BENEFITS

Benefits that an employee may receive as a part of their remuneration package may be taxed in different ways, but the overall regime is largely the same for most employees

Cash equivalent

For most employees, any benefits provided to them directly or to their immediate family members are treated as earnings and are therefore taxable.

The tax is calculated on the cash equivalent, which is broadly the cost to the employer of providing the benefit to the employee, referred to as the ‘marginal cost’. This was clarified in the case of Pepper v Hart (1992). Any contribution made by the employee is deducted from the cash equivalent. For many of the benefits that may be provided there are specific rules set in legislation that determine how the cash equivalent is calculated.

The benefits to be considered are:

Cash vouchers

These can be exchanged for cash and are treated as earnings for tax purposes.

Non-cash vouchers

These can be exchanged for goods or services. Employees are taxed on an amount equal to the cost of the voucher to the employer, less any amounts they individually make good. Where an employer provides a subsidised nursery that complies with local authority regulations, or other child-minding facilities that are not primarily for educational purposes (nursery schools), this is generally tax-free. 

Credit tokens

This includes credit cards provided to employees where the repayments are made by the employer. In using a credit token, the employee is treated as having received a benefit equal to the cost incurred by the employer. Where it is used for business purposes, the employee can claim an expense deduction for the business part.

Living accommodation

When an employee occupies rent-free or low rent accommodation, there is generally a taxable benefit. Depending on the type of accommodation, there are different rules.

The assessment of the benefit from provided accommodation is firstly based on the ‘annual value’ (the rent which might reasonably be expected if the property was let or the gross rateable value at the last valuation), or on the rent actually paid by the employer if that is greater. Where the accommodation is owned by the employer and cost more than &po...

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... are.

Long service awards

Where an employer rewards long service, considered to be 20 years or more, with tangible articles or shares in the company, there is no taxable benefit when the cost to the employer is not more than £50 for each year of service, and no similar award has been made to the individual within the previous 10 years.

Suggestion schemes

Awards can be made to individuals of up to £25 for suggestions that have merit, where a formal suggestion scheme exists and the suggestion made is outside the scope of the employee’s normal duties. Larger awards of up to £5,000 can be made if the suggestion is implemented and the amount awarded is not more than 50% of the net financial benefit of the suggestion to the employer in the first year or 10% of the net benefit over 5 years. Any amounts in excess of these limits are taxable.

Work training

An employee who is leaving service can be provided with paid for counselling or work-related training in relation to future employment with no tax charge. Employees receiving first aid and health and safety training are also not taxed on the benefit.

Relocation and removal expenses

Where an employee is required to relocate to continue in their duties or take up another position, there is no tax charge where the costs met by the employer do not exceed £8,000.

Homeworking

Employers can make tax-free contributions of up to £6 per week towards the additional household costs incurred by employees who work from home. If amounts are to be made in excess of £6 per week, they have to be supported with evidence that they are wholly in respect of the additional household costs.

Liability insurance

If employees or directors are provided with liability (indemnity) insurance, the benefit is not taxable. The same treatment applies also to work-related liabilities such as legal costs. Where the individual employees or directors pay, they can claim tax-relief on their payments.

The payments can be made up to 6 years after the year in which the employment ended.

Workplace nurseries

Employer subsidised nurseries or child-minding facilities is tax free if certain conditions are met; they must not be primarily for educational purposes, the employer must participate in the financing and arranging, they must not be provided in a private home and they must meet local authority regulations. Tax-free childcare in the form of vouchers can also be provided up to a maximum weekly amount.

We have now covered all the potential benefits an employee could receive as a part of their remuneration package from their employer.

In relation to how these are treated for Income Tax purposes, the taxable value of all the benefits received by each employee, is calculated and shown on their P11D form. This amount is then included in the income from employment figure at the start of the tax calculation process.

 

Individuals, who obtain an income from property, including rents and other receipts from letting activities, are liable for Income tax on all properties in the UK whether or not they are UK residents. Income from the letting of properties overseas is only liable for Income Tax if the individual receiv...

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...ucting actual expenses. This again only benefits those receiving small levels of property income.

Rent-a-room relief of £7,500 can be claimed for those letting part of their own home. Income in excess of this amount is taxed according to special rules. This is fully explained in Chapter 9.

Savings and investment income includes: dividends, interest payments from deposits and fixed interest securities, purchased life annuity payments and gains from certain life assurance contracts. Income received from these sources by a UK resident is liable for income tax whether or not it was generated inside or outside of the UK. Income received from these sources by a non-UK resident is only taxable if its source is in the UK.

T...

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...ces as intellectual property rights, trusts and estates in administration. These sources do not have any allowable deductions and are also liable for tax in the year in which the income has arisen.

 

Self-employed individuals and those in partnerships are able to deduct ‘allowable expenses’ from their trading profits. How are ‘allowable expenses’ defined?

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When considering the Income Tax liability on any income from employment, we identified that this generally has the tax deducted from the gross amount by the employer under the PAYE system before the individual receives it. Some other types of income received by an individual may also have tax deducted at source.

Interest from Banks and Building Societies

UK resident holders of UK Bank and Building Society deposit accounts receive interest payments gross with no tax deducted at source. For individual’s whose only income is from savings, there is a starting rate of tax of 0% up to a stated annual amount. Basic and higher rate taxpayers have a personal savings allowance on which no liability for tax arises. Interest received in excess of the allowance is taxed at...

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...ectly or through collective investments are received as gross income. All individuals have a dividend allowance on which no liability for tax arises.  Dividends received in excess of the allowance are taxed at the appropriate rates for the individual.

You can see the rates in the tax tables.

Having identified all the sources and the taxable amounts to be taken into account, the figures from the different areas are added together to give the individual’s total income figure. Before calculating the actual amount of tax to be paid, there are possible deductions that may be applicable, and we will move on now to examine these.

Under what circumstances would the payer of an annuity have to deduct tax from the payment?

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Certain payments can give an individual tax relief by allowing a deduction to be made from the amount of total income before any Income Tax liability is calculated. Total income is the sum of the amounts of income on which the taxpayer is charged income tax for the tax year. The payments which can be deducted are:

Qualifying interest payments

Allowable business losses

Contributions to certain registered occupational pension schemes and retirement annuity plans

Gifts to charities of shares and securities

We will now look at each of the payments that can be deducted from income in turn.

Qualifying interest payments

Interest payments on loans are allowable deductions from income if they meet the stated qualifying purposes. The qualifying purposes are:

The purchase of shares in the borrower’s company or to finance loans to the company

Investment in a partnership

Buying of plant and machinery for use in a partnership

Payment of an inheritance tax liability

If the purpose of the loan falls into one of the above categories, the gross figure of interest paid can be deducted from total income. However, the gross amount of interest plus allowable businesses losses that can be deducted is capped at the higher of £50,000 or 25% of a person’s adjusted total income (i.e. total income, with any charitable donations made through payroll giving being added back and all types of pension payment being deducted).

Share purchase and loans to companies

For the interest payments on loans to fund the purchase of shares in the borrower’s company or to make a loan to the company to qualify for tax relief, the company itself must be a close trading company. This means that the company is controlled by 5 or fewer shareholders or the directors only. In addition, the borrower must own more than 5% of the shares at the time of paying the interest on the loan, or work for the greater part of their time in the management or business of the company.If these conditions are met, the relief is given at the borrower’s highest tax rate but is subject to a cap of £50,000 or 25% of adjusted total income. No relief is available if the loan is used to purchase shares on which Enterprise Investment Scheme (EIS) relief is claimed.

Example

Janice, a higher rate taxpayer, is a 40% shareholder in the family bakery. She borrows &pou...

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... given in the previous year and is given as a repayment for the tax assessment for the year in which the claim arises. Payments carried back do not amend the previous year’s assessment and therefore don’t reduce the payments on account for the current year.

Payroll giving scheme

The payroll giving scheme enables employees to make regular gifts to charity tax-efficiently through their employer’s payroll system.

The employee nominates a charity they wish to make donations to, which can be for any chosen amount, and instructs the employer to make the payments. The employer deducts the payment from the employee’s salary before the calculation of the tax liability under the PAYE system. The employee therefore benefits from tax relief at their highest rate.

If the amount of contribution is more than the amount of pay on which tax is deducted, the relief will be restricted. Therefore, it is important to realise that this scheme has no benefits for non-taxpayers.

Donations made in this way do not have to be shown on a tax return.

Gifts of assets

Gifts of certain assets to charities receive tax relief on the full market value of the gifts. These include:

Listed shares and securities

Unlisted shares and securities dealt in on a registered exchange

Units in Unit Trusts

Shares in OEICs

Holdings in foreign collective investment schemes

Any freehold or leasehold property provided the whole interest is given

Individuals who donate pre-eminent objects to the nation can also benefit from a tax reduction of 30% of its value. This can be used against the individual’s income tax or capital gains tax liabilities, and can be spread over 5 years if desired.

This relief against Income tax is in addition to the Capital Gains tax exemption available on gifts to charities. This enables the individual to benefit from tax savings against two taxes. This will be covered fully in the later chapter on Capital Gains tax.

Having now covered the amounts that can be deducted to reduce the amount of total income we will move on to cover the available annual personal allowances, which further reduce the amount of income that will become liable for Income tax.

Where basic rate tax relief on a pension contribution is given at source, how does a higher rate taxpayer receive additional tax relief?

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The available personal allowances are:

Personal allowance

Married couple’s allowance

Blind person’s allowance

You can see the current rates in the Tax Tables.

Personal Allowance

All UK residents, including children, are entitled to the annual personal allowance. This is an amount of income that can be received without having to pay any Income Tax on it.  Certain categories of non-UK residents can also claim the allowances against income that is taxable in the UK. These include: UK citizens, nationals of countries in the EEA (which continues despite the UK leaving), employees of the Crown, residents of the Channel Isles and Isle of Man, previous residents now living abroad for health reasons and persons whose late spouse/civil partner were in the service of the Crown. Certain other individuals are also able to claim the allowances under the ‘double taxation’ agreements that may exist between different countries.

Anyone paying tax on the ‘remittance basis’ is not entitled to the personal allowance unless their remitted income to the UK is less than £2,000.

Where an individual’s ‘adjusted net income’ (i.e. total income less deducti...

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...tax year.

Similar to the personal allowance, the married couple’s allowance is also reduced by £1 for every £2 down to a minimum of £4,280 (2024/25), where an individual’s income exceeds the stated annual amount, which is £37,000 (2024/25).

This relief is given as a tax reducer i.e. deducted after the individual’s income tax liability has been calculated. Where the relief is available it is given at 10% on payments up to £4,280 a year (2024/25). The recipient is not taxed on the payments.

Blind person’s allowance

The blind person’s allowance (available to registered blind people) is given as a deduction when calculating total income, in the same way as the basic personal allowance.

Having now identified the sources and amounts of different types of income, deducted any allowable expenses, added the amounts together to identify total income, deducted any available tax reliefs and personal allowances, we have arrived at the amount of income liable for Income Tax.

We will now move on to examine how the actual liability is calculated.

Explain the difference between the Personal Allowances and tax reducers.

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You may find it useful to refer to the Tax Tables with this section.

Firstly, we will recap the steps in the process we have covered so far:

1. Identify the sources and amounts of income

Income is taxed in the following order:

Earnings, pensions, rental income and all sources not classed as savings or dividends

Deposit and other savings income – this is important if non-savings income is within the starting rate

Dividend income

Chargeable gains from life assurance policies

2. Deduct any allowable expenses

3. Add together amounts from each source to identify total income

4. Deduct available reliefs from total income. Note that the deductions will be made from income in the same order as shown in the order of how income is taxed

5. Deduct available personal allowances

Having completed these steps, we arrive at an amount of income liable for Income Tax, the taxable income.

Before applying the appropriate rates of tax to the taxable income, it is at this stage in the process that any payments made which enable the basic rate tax band to be extended, would be taken into the account (for example, pension contributions and gift aid donations to charity). Where relevant, the basic rate or higher rate tax thresholds will be extended by the ‘grossed up’ amount of the payments.

So, the final 3 steps in the process are:

6. Extend basic rate or higher rate thresholds where applicable

7. Apply the appropriate rates of tax

8. Deduct any tax reducers, for example, married couple's allowance.

The resulting figure is the individual’s Income Tax liability.

We have already identified that the Married C...

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...cted is more than the calculated liability, the excess will be repaid.

Scottish Taxpayers

Although the amount of personal allowance is the same for those living in Scotland as the rest of the UK, the rates of income tax have been set by the Scottish Government since April 2017.

In the 2024/25 year the rates are:

Taxable income

Band

Rate

£0 to £2,306

Starter

19%

£2,307 to £13,991

Basic

20%

£13,992 to £31,092

Intermediate

21%

£31,093 to £62,430

Higher

42%

£62,431 to £125,140

Advanced

45%

Over £125,140

Top

48%

The Government has legislated to ensure that Scottish taxpayers are still able to transfer the permitted amount of the personal allowance as long as they are  not higher, advanced or top rate taxpayers, but they will still not be in the same position as the rest of the UK as they start paying higher rate tax at a lower amount.

Additionally, in the current year, where an individual makes a payment into a personal pension, they will still receive basic rate tax relief at 20% even if they are only paying tax at the 19% rate. Those paying tax at the 21% rate will be able to claim an additional 1% relief, 22% relief will be available to 42% taxpayers, 25% relief is available to 45% taxpayers, and 28% relief to those paying income tax at 48%.

Having now covered all the steps in the process we will look at some examples of calculating the Income Tax liability for a number of individuals with different circumstances.

List the order in which income is taxed.

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Although children under working age are likely to have little income (if any), they are still liable for Income Tax in the same way as adults and have the same Personal Allowance which they can use against any tax liability. Any income they do receive from Bank or Building Society accounts in the form of interest or from employment, for example, paper rounds, is likely to be below the personal allowance and therefore not taxable.

Care needs to be ...

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...0 have a tax charge equivalent to the amount of child benefit received. If both partners have income in excess of £60,000 the charge is applied to the one with the higher income. The tax charge is collected through the self-assessment system.

 

Doreen invested £5,500 for the benefit of her daughter in a bank account, which is earning interest of 2% per year. Who will be taxed on the interest?

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Although the repayment of student loans is not a tax, it is linked to income and is collected in a similar way.

Tuition fee, maintenance and postgraduate loans have to be repaid, even when a course of study is not completed.  For employees the repayments are deducted from sa...

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...ffer for courses started prior to 1 August 2023, for Scottish and Welsh students and for the repayment of postgraduate loans.

Loans for courses in England starting after 1 August 2023 will start to be repaid when income reaches what amount?

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Trusts are subject to income tax in a number of different ways and are subject to a range of special rules.

Tax liability of trustees

Where a trust has at least one trustee who is resident in the UK there is a general potential liability for income tax on all of the trust’s income. The trustees are jointly and severally liable for all tax due under self-assessment and they have to complete tax returns and assess income and capital gains in the same way as individuals. They must also make payments on account based on the previous year’s income tax and balancing payments at the same dates as individuals. Although in practice one trustee may be nominated to deal with the completion of documentation and deal with HMRC, they are all responsible for the nominated trustee's acts and omissions and can all be individually subject to penalties imposed by HMRC.

Bare trusts

With a bare trust, the asset is in the name of a nominee but the asset itself and any income produced belongs to the beneficiary. This means that any income is taxable as the beneficiary’s income and will be taxed at the appropriate rates depending on their other income. Any income received from the trust must be included on the beneficiary’s tax return.

Where a bare trust is set up for a minor with funds from a parent, the income is normally taxed as the parent’s income, but if the capital comes from a grandparent or other individual it is not. Therefore, grandparents could use trusts to provide income to grandchildren to pay school fees, for example.

A bare trust and a ‘designated account’ to provide funds for minors has capital gains tax advantages even when set up by parents, as any gains are taxed as the child’s, who can use their annual exempt amount which is double the amount available to the trust itself.

Trusts for vulnerable beneficiaries

The Finance Act 2005 created a new tax regime for trusts that were established for  vulnerable beneficiaries. The main theme of the provisions was to tax the income and gains of these trusts according to the tax position of the beneficiary rather than under normal trust rules.

Not every trust that is created for a disabled person or a relevant minor qualifies for special tax treatment. Th...

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...all the net income that has arisen in the trust, the tax they have paid on that income is carried forward in a ‘tax pool’. If the income is then distributed in a later year, the tax brought forward is available to ‘frank’ the 45% tax credit. It therefore reduces any additional liability the trustees may have on distributions of dividend income where the 45% tax credit exceeds the tax the trustees have paid on that income. If the income is accumulated in such a way that it becomes part of the trust capital, if and when it is then distributed to beneficiaries it becomes a capital payment and not income.

Income tax on the settlor of a trust

A ‘settlor-interested’ trust is one where the law treats trust income as if it were the settlor’s and the settlor is therefore taxed on the income even though they have not received it.

There are two situations where trust income as treated as the settlor’s income:

Where the settlor or their spouse or civil partner has retained any interest in the trust (this includes being a beneficiary)

Where the trust is for the benefit of the settlor’s minor unmarried child – does not apply if the income is less than £100 gross/year

If the trust is a discretionary trust, the trustees still have to account for tax at the trust rates, effectively paying tax on behalf of the settlor who will receive a tax credit. In this case, the settlor will be able to use their personal savings and/or dividend allowance.

A settlor who receives capital sums from a trust is liable for income tax on the payment received up to the amount of any undistributed trust income. If the amount received exceeds this the balance is carried forward to match against future undistributed income for a maximum period of ten years following the year in which the capital was paid. Loans and loan repayments are considered to be capital sums.

If a beneficiary receives regular capital amounts HMRC may try to tax them, but it will depend on the terms of the trust and the tax tatus of the beneficiary.

Lydia is a higher rate taxpayer and beneficiary of an interest in possession trust. Why is it better for her to receive the income via the trust rather than paid direct to her?

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Chapter revision test. Your results and 3.5 hours of estimated study time will be added to your CPD certificate on completion. If you retake the test then additional CPD time for the test will be added.

Multiple response question – select your answers from the list