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One of the fundamental concepts of personal tax has been eroded by legislation in the Finance Act 2000 with some surprising results, says SONIA GABLE ATII.
One of the fundamental concepts of personal tax has been eroded by legislation in the Finance Act 2000 with some surprising results, says SONIA GABLE ATII.
TOTAL INCOME IS defined in section 835, Taxes Act 1988 as 'the total income of that person from all sources estimated in accordance with the provisions of the Income Tax Acts'. Until a few years ago tax reliefs generally took the form of a deduction from total income, or from a particular source of income. This is often still the case, for example interest on a qualifying loan to purchase shares in a close company is deducted from total income, and retirement annuity payments are deducted from net relevant earnings.
Most tax practitioners and the Inland Revenue generally use the term 'total income' to mean income before personal allowances. This is not strictly correct. Section 835(5) states: 'Deductions from total income under Chapter I of Part VII [personal allowances] shall be made after any other deductions and shall not affect the amount to be taken as a person's total income for the purposes of section 257(5) …'. The rule ensures that age allowances are restricted by reference to total income before deduction of personal allowances and the implication is that total income otherwise means income after deduction of all allowances including personal allowances. This article will use the term total income to mean income after all allowances, except in the context of age allowances.
Alternative method
The notion that there were other ways of giving tax relief arrived first with life insurance premium relief and later more significantly when relief for interest on a loan to purchase an only or main residence ceased to be a deduction from total income.
The Finance Act 2000 represented a new departure. Before then, where it was necessary to calculate higher rate tax relief in respect of a payment on which basic rate tax relief had been given by deduction at source, such as a covenanted donation to charity, accountants had often used the non-statutory short cut of extending the basic rate band. This method of giving relief became statutory in 2000-01 for charitable donations under gift aid and in 2001-02 for personal pension payments. By this means, personal pension payments and gift aid donations ceased to be deductions from total income.
However, certain other reliefs are still given by reference to total income and the interaction between those reliefs and those given by extension of the basic rate band is in some instances anomalous.
Age allowance
The age allowances are restricted where total income (before personal allowances) exceeds a threshold. As personal pension payments are no longer deductions from total income, individuals over 65 can no longer increase the available age allowance by making a personal pension payment. This is a change from the position in 2000-01 and earlier, when individuals entitled to age allowance could, by making personal pension payments, obtain effective tax relief at 33 per cent (in 2000-01) on pension and earned income within the age allowance withdrawal band. Although pensioners under 75 without net relevant earnings are eligible for the first time to make personal pension contributions, they cannot use such payments as a means of qualifying for or increasing age allowances.
A similar problem would have arisen with gift aid donations to charity, except that section 25(8), Finance Act 1990 (as amended by section 39, Finance Act 2000) provides that for the purposes of calculating age allowances the donor's total income is treated as reduced by the aggregate amount of gross gifts. Such a provision is absent from the personal pension legislation, which suggests that the effect on age allowance was an intentional by-product of the changes to the personal pension rules.
Tax credits
The interaction between personal pension payments and children's tax credit leaves an element of doubt and produces one strange result. Section 257AA(3), Taxes Act 1988 states: 'Where any part of the claimant's income for the year of assessment falls within section 1(2)(b), his children's tax credit for the year shall be calculated as if the amount specified in subsection (2) above were reduced by £2 for every £3 of that part of his income'. Section 1(2)(b) imposes higher rate tax on that part of an individual's total income that exceeds £29,400 (2001-02). Section 639(5A) gives higher rate relief for personal pension payments by increasing 'the basic rate limit for that year … by the addition of the amount of the contributions in respect of which he is entitled to relief under this section'. For the definition of the basic rate limit one has to return to section 1(3), which states: 'The amount up to which an individual's income is by virtue of subsection (2) above chargeable for any year at the starting rate or the basic rate shall be known as the basic rate limit'.
It is odd that the children's tax credit withdrawal provision refers to section 1(2)(b), which specifies a fixed amount of income, rather than to the basic rate limit. The reason might simply lie in the fact that the children's tax credit legislation predates the provisions extending the basic rate limit in the Finance Act 2000. However, although the argument is somewhat circular, it would seem that any provision that increases the basic rate limit must alter the amount on which higher rate tax is charged under section 1(2)(b). If this were not so, section 639(5A) would seem to be meaningless. In any case, the Revenue has confirmed to the writer that the increase in the basic rate limit as a result of personal pension payments is effective for the purpose of calculating withdrawal of children's tax credit. This results in tax relief at an effective rate of 46.67 per cent as shown in Example 1.
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Example 1 |
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Mrs Davis, who has a qualifying child, has total income (after all allowances) of £34,400 and makes a personal pension payment of £5,000 gross. |
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Her tax liability is therefore: |
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£1,880 @ 10 per cent |
188.00 |
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(£27,520 + £5,000) @ 22 per cent |
7,154.40 |
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Less children's tax credit |
-520.00 |
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Total |
6,822.40 |
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If she had not made the pension contribution, her tax liability would have been: |
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£1,880 @ 10 per cent |
188.00 |
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£27,520 @ 22 per cent |
6,054.40 |
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£5,000 @ 40 per cent |
2,000.00 |
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Less children's tax credit restricted |
-186.67 |
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Total |
8,055.73 |
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Higher rate tax relief on the pension payment is therefore: |
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£8,055.73 - £6,822.40 |
1,233.33 |
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This represents a rate of 24.67 per cent, which together with the basic rate relief of 22 per cent deducted at source from the pension payment gives total tax relief of 46.67 per cent. |
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The strange result arises from the rules for determining who is entitled to children's tax credit where a couple have a child living with them. Where one or both has income taxable at the higher rate, under the provisions of Schedule 13B to the Taxes Act 1988, only the partner with the higher total income is entitled to claim the children's tax credit. This is supposed to ensure that the tax credit is withdrawn by reference to the partner whose income would result in the greatest withdrawal. However this is not necessarily the result, as Example 2 shows.
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Example 2 Mrs Davis's husband has total income (after allowances) of £33,000 and does not make any pension payments. Mrs Davis has the higher total income and is therefore entitled to claim the children's tax credit. This is so whether or not she makes the pension payment shown in Example 1, because the pension payment does not reduce total income. If, therefore, she makes the pension payment, she is entitled to the full amount of children's tax credit. Mr Davis is not entitled to the tax credit because he is the lower-earning partner, even though the tax credit would have been restricted by £240 ((£33,000 – £29,400)/15) if he had been the partner entitled to claim.
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Gift aid donations produce the same result. It would seem that this effect is unintended. Before the introduction of the concept of tax relief by extending the basic rate band, the partner with the higher total income would always have been the partner with the larger amount of income liable to higher rate tax.
Top slicing relief
An instance where gift aid donations and personal pension payments appear to produce different results is in the interaction with top-slicing relief for life insurance gains under section 550, Taxes Act 1988. For reasons that are not apparent to the writer, the extension to the basic rate band by an amount equal to the grossed-up donation does not apply for the purposes of computations under section 550(2)(a) or (b) (proviso to section 25(6), Finance Act 1990). This means the higher rate tax relief on the donation is ignored for the purpose of the comparison between the tax on the whole gain and the tax on the 'appropriate fraction' of the gain (by reference to the years the insurance policy has run). There is no equivalent provision in the personal pension relief legislation and so it would seem that higher rate relief for personal pension payments is to be taken into account in the top slicing computation. However, the writer has seen the opposite view expressed.
And the Revenue wants people to self assess!
