Income Tax application to different types of income and benefits

Self Employment

Tax under Schedule D Cases I and II is normally charged on the profits earned in an accounting period. Deductions can be made against gross income for expenses that are wholly and exclusively incurred for business purposes.

• Tax is normally charged on the profits of the 12-month accounting period ending in the tax year.
• In the tax year in which the business is started, tax is charged on the profits of that tax year, calculated by apportioning accounting periods if necessary. Any profits taxed twice are treated as overlap profits.
• Businesses that started before 6 April 1994 may have transitional overlap profits. These are profits assessed in 1997/98, but actually earned before 6 April 1997
• In the tax year in which the business ends, tax is charged on the profits of the final period plus the profits of any previous accounting period ending in that tax year. Overlap profits can be deducted.

Losses can be carried forward against future profits of the business. Losses can be relieved against other income and capital gains of the same or the previous tax year. Losses in the first four tax years of a new business can be carried back and set against income of the previous three tax years.

Partnership profits are divided between the partners, who are taxed personally on their profit share on the same basis as self-employed individuals. Partners must include their profit share on their tax returns, and the partnership must also complete a return.

Employment

Employees and directors are taxed under schedule E on all their remuneration and benefits from their employment or directorship.

• Income is taxed in the tax year in which it is received.
• Employers normally deduct tax from pay under PAYE. Most pensions are also taxed in this way.

Many benefits in kind are taxed under schedule E. Directors and employees earning at least £8,500 a year (including benefits) are taxed according to the ’cash equivalent’, which is normally the cost of providing the benefit. Certain benefits are not taxable, eg contributions to approved pension schemes and mobile phones.

• The taxable benefit of beneficial loans is the interest saved compared with the Inland Revenue official rate. Loans up to £5,000 are exempt.
• Use of assets gives rise to a taxable benefit of 20% a year of the market value when the asset was first made available to the employee. There is a limited exemption for computer equipment.
• Living accommodation is taxed on gross rateable value (estimated for new properties) or rent paid by the employer if greater. If the property cost more than £75,000, there is an additional benefit based on the interest rate applied to cheap loans.
• A company car has a cash equivalent based on its list price when new (up to £80,000) and the level of business mileage.

Rates are reduced by 1/4 for cars at least four years old on 5 April in the tax year. Cars at least 15 years old and valued at over ?15,000 are taxed on the appropriate percentage of market value. Fuel for private use is taxable according to a fixed scale based on engine size (eg ?3,620 for a car over 2,000cc). From 2002/03 the taxable percentage of the list price will be graduated according to the car’s CO2 emission instead of age and mileage.

Approved profit sharing schemes and share option schemes can give tax benefits. The all-employee share scheme allows employers to give up to ?3,000 of shares to employees tax-free. In addition, employees may buy up to ?1,500 of shares out of pre-tax salary. To the extent that an employee invests, the employer may make a further tax-free gift of shares worth up to double the employee’s investment, ie up to a further ?3,000. The enterprise management incentives scheme allows certain smaller trading companies to grant tax-advantaged share options of up to ?100,000 per employee.

Investment Income

Dividends from UK companies and savings income are taxed according to special rules. These types of investment income are treated as the top slice of income, with dividends above other savings income.

• Most investment income other than dividends and rents is taxed at 20% where the taxpayer’s total income less allowances and reliefs is not more than the basic rate limit (?29,400).
• Taxpayers whose total income is more than ?29,400 (higher-rate taxpayers) have to pay 40% tax (32.5% for dividends) on that part of their gross investment income that falls above the basic rate limit.
• The 10% starting rate applies to investment income that falls within the starting rate band.

Taxed savings income is received after 20% tax has been deducted at source. Basic rate taxpayers therefore have no more tax to pay and higher-rate taxpayers are liable for a further 20% of gross income above the basic rate limit. Where taxed savings income falls into the 10% rate band or is covered by allowances, then the taxpayer can reclaim the tax deducted to the extent that it exceeds the tax actually due.

Taxed savings income includes bank and building society interest, annuities, and interest on government stocks if the taxpayer chooses.

Untaxed savings income includes most National Savings Bank income, interest on government stocks and interest on certain bank deposits of at least ?50,000.

Dividends from UK companies carry a tax credit of one-ninth of the cash dividend, an effective tax deduction at source of 10% of the gross dividend. The tax credit covers the full tax liability of shareholders whose income less allowances and reliefs is not more than ?29,400, but it cannot be repaid. Higher-rate taxpayers are taxed a total of 32.5% (including the tax credit) on that part of their gross dividends that falls above the basic rate limit. They therefore pay an extra 22.5% on gross dividends, equivalent to 25% of net dividends, after deducting the tax credit.

Property Income

Income tax is charged on rental and other income from property, including income from furnished lettings. Expenditure incurred in generating that income, including interest on money borrowed to buy the let property, is allowed as a deduction. The rents and deductions from all properties are combined to arrive at the net profit or loss.

Capital allowances are allowed as an expense. Losses can be carried forward against future letting profits. Losses on some short-term lettings, eg holiday lettings, can be set against other income. If the gross income from letting part of one’s home is no more than ?4,250 a year (?2,125 for jointly owned homes), it is exempt from tax.

Relief for Interest

Interest paid may be deducted from business profits or the profits from property letting. The interest must be incurred wholly and exclusively for the purpose of the business or property letting.

Other interest paid by an individual may be deducted from income if the loan has been taken out for a qualifying purpose. Qualifying loans include loans:

• To acquire shares in, or lend money to, a close company or partnership; to buy plant and machinery for use by a partnership or in one’s employment (employees’ car purchase loans are excluded from 6 April 2002); to contribute capital to a co-operative; to invest in an employee-controlled company; or to lend money to personal representatives to provide funds to pay inheritance tax. These loans are generally subject to special rules.
• Up to £30,000 to a person of 65 or over to buy an annuity. The loan must have been made or agreed before 9 March 1999 and be secured on the main residence. Relief remains at 23% in 2001/02. Relief is not lost if the borrower remortgages or moves home.

Relief is not available for interest on loans to acquire enterprise investment scheme shares or for interest on a personal overdraft.