Tax Credits - Are You Ready?

The misunderstandings and complications that surround the new system of tax credits are unravelled by ELIZABETH LATHWOOD.

WE ARE BEGINNING to see more articles about tax credits as the April 2003 commencement date looms closer. This article is intended to help with what advisers could be doing now and what they will need to be doing once the system is up and running. There is no doubt that such a new system will have its teething troubles, but part of the difficulty with any new system is learning it, and there do seem to be a few misconceptions abounding in the press.

I was finally galvanised to write this article following the newspaper report, mentioned in last week's Taxation:

'Parents will be able to claim tax breaks worth up to £140 per week to help pay for their nanny from next April … the Department for Education confirmed yesterday that plans to give up to £140 in tax credits to certain parents employing a registered childcarer would be extended to all working parents earning up to £50,000 a year.' (The Times Online, 7 November 2002)

Taxation correctly clarified the position on exactly what types of childcare will qualify in Update, 14 November 2002, but there may still be some misunderstanding as to what these credits are and who will be entitled to them.

The Times report came out as the Department of Education and Skills published 'Government review of childcare - good news for children, parents and communities' heralding the childcare review report entitled Delivering for children and families, published by the Strategy Unit of the Cabinet Office. The full text of the report is available on: www.strategy.gov.uk/2002/childcare/report/index.htm. This explained, among many other things, that:

'The new structure of tax credits, announced in the Budget, makes a number of important changes, and the new tax credits will provide help with childcare costs further up the income distribution. These changes should help more people to access help for childcare through the new working tax credit and move into work on a long-run basis.' (Chapter 3, paragraph 3.1.3, Affordability)

The fact that new tax credits will apply further up the income scale is only just being appreciated by many, but there is also some degree of uncertainty as to how the credits are obtained and how they might be taken away. The £140 a week mentioned above, for instance, will only go in full to families where both parents work at least 16 hours a week (or for lone parents where that parent works at least 30 hours a week), where there are at least two children, and where income does not exceed £14,911 (assuming no disabilities in the parents, and no entitlement to aged 50 plus credits).

Childcare tax credit is also available if there is only one child in the family, but the maximum rate is different, at £94.50 a week. This too will start to be tapered away when income reaches £14,911, assuming the same qualifying conditions as those mentioned above.

It should be noted that a lone parent need only be working 16 hours to get the childcare tax credit, but this article assumes that all families get the 30-hour element of the working tax credit for ease of comparisons.

Taper rules

Most new tax credits are tapered away by 37 per cent for every £1 of income over a threshold of £5,060, and since various tax credits are awarded at the same time, the order of reduction is: working tax credit first, childcare tax credit second, child elements of child tax credit last. (Family element of child tax credit is tapered at a different rate.) This means that the childcare element of £140 a week is lost completely once income levels reach £34,588. Families in these circumstances may still get the child elements of their child tax credit. This increases with the number of children, so families incurring maximum childcare costs, and otherwise satisfying all qualifying conditions, will get more than the basic family element of child tax credit (£545 a year, £10.45 a week, the replacement to the old children's tax credit) up to income levels of:

Note that slightly different figures may arise from doing the calculations on a weekly basis. Incomes are basically joint gross taxable incomes, but see below for further information on income for tax credit purposes.

The calculations on which these figures are based are as follows:

A family with income of £14,911 is £9,851 over the threshold of £5,060. Thus £9,851 @ 37 per cent of credits will be taken away, i.e. £3,645, leaving just the childcare element and the child elements (and the family element).

Once the family's income reaches £34,588, the taper becomes 37 per cent of £29,528 (34,588 - 5,060), i.e. £10,925, leaving just the child elements (and the family element).

Once the family's income reaches £42,398, the taper becomes 37 per cent of £37,388 (42,398 - 5,060), £13,815, leaving just the family element.

The article in The Times referred to the credit being extended to all working parents earning up to £50,000 a year. It appears that this limit would only be reached if there were disability and/or 50 plus elements in the working tax credit claim.

Action required

As has been highlighted, in the professional press at least, the time limit for claiming the new credits is three months. Between now and 6 July 2003 therefore, claim forms should be completed by everybody who might qualify, regardless of whether or not they are taxpayers. A late claim will mean the loss of some of the entitlement.

To begin with, the claim form requests details of income for the year ended 5 April 2002. It also requires information as to number of children, working hours and average weekly childcare costs. These details can only be given at the date of the claim, which is partly why, having made the claim, it is necessary to monitor changes in circumstances.

If there is a change in the makeup of the claiming unit, e.g. a single person marries or starts living with someone of the opposite sex, or a couple who had made a joint claim stop living together, or a married couple permanently separates, then the Revenue must be notified within three months of the change or by 6 July 2003 if later (see Regulation 21(3) of the Tax Credits (Claims and Notifications) Regulations 2002). Similarly, if there has been a claim for childcare and the average weekly cost goes down by £10 a week or more for at least four weeks in a row, the Revenue must be notified again within three months of the change or by 6 July 2003 if later. Failure to meet these deadlines could result in a penalty of up to £300 (section 32(3), Tax Credits Act 2002).

Other changes in circumstance may be notified to the Revenue at any time, but if they result in an increase to the amount of tax credit due, for instance the birth of a child, they will only be effective either from the date of birth or from three months earlier, whichever is the later date.

For example, if a couple makes a claim for tax credits for 2003-04 and then has a baby on 9 June 2003, if they do not tell the Revenue about the birth until 5 April 2004, they will only get the additional element for the child from 6 January 2004. If their income is high, they may only lose out on the additional family element, which could be £20.90 a week if this is their first baby, or £10.45 a week if they already have children. The loss will be for the period 9 June 2003 to 6 January 2004. If their income is low enough to qualify for the child element of child tax credit, this means they will also lose out on credits of £27.75 a week for the same period. The loss could be worse if they have used qualifying childcare since June and are late in their claim.

Changes in circumstances which result in a reduction of credits will automatically be backdated to the date of the change by the Revenue, i.e. there is no three-month rule. This may result in overpayment of credits at the year-end.

From the above, it is clear that monitoring changes in circumstance will be vital. The notes accompanying the claim form (TC600) list the changes in circumstances that could be applicable. The award notice that claimants will receive subsequent to a claim will also contain a list of the changes which should be notified.

Income for tax credit purposes

One of the stated intentions of new tax credits was to align tax and benefit systems. Income for tax credit purposes is therefore very nearly the claimants' gross taxable income. It is certainly a lot closer to taxable income than it was under the old tax credits, working family tax credits and disabled person's tax credits, and there are no anomalies, as arose previously, with having to calculate net (of tax and National Insurance) income for certain tax credit purposes.

There are exceptions to the alignment, however. The main ones are:

• Not all benefits in kind are included, i.e., cars, fuel, mileage allowances, goods or assets transferred, discharge of pecuniary liabilities, vouchers and credit tokens are included, whereas living accommodation, beneficial loans, vans, use of assets, to name but a few, are not.
• It is generally the income of the current tax year which is considered, losses and pension contributions and gift aid payments cannot be carried back. But trade losses brought forward can be set against current year trading profits.
• The fact that the claim is based on joint income results in some anomalies, e.g. losses of one spouse can apparently be set against income of the other.
• The first £100 of statutory maternity pay (and their equivalents after 5 April 2003) does not count as income for tax credit purposes.
• Most non-earnings income is aggregated with any partner's in the claim and the first £300 disregarded.
• All foreign income counts - there is no remittance basis.
• There is no top slicing relief for chargeable events.
• There are various anti-avoidance rules: to prevent people depriving themselves of income for the purpose of securing entitlement to tax credits; for treating those who are entitled to income as if they had applied for it; for those providing services at less than market value to be treated as if market value applied (this does not apply to volunteers, or persons engaged by charitable or voluntary organisations, or trainees, if appropriate conditions are satisfied)

As explained above, the initial claim to credits is based on income of a previous year. For 2003-04 this is the year ended 5 April 2002. After 5 April 2004, claimants will be invited to renew their claims by returning details of their actual income for the year just gone. At the same time, their 2003-04 awards will be reassessed. Any drops in income (from 2001-02 to 2003-04) may result in further credits being due. Any increases in income will be ignored to the extent of £2,500, but above this limit will result in a reassessment and possibly a recovery of overpaid credits.

Whether under or overpayments will arise will depend very much on the individual circumstances of the claimants. Many middle-income families (without childcare) will only be entitled to the family elements, and a change in income over a broad range (roughly £23,000 to £50,000 for a two-children family) will not affect their entitlement.

However, there are others where a change may be quite dramatic. Take the situation of a couple where one partner only was working at the time of the claim, but part way through the tax year the second partner goes out to work. The initial award will be on the basis of one income, but by the year-end the total income of the couple for the complete tax year may be considerably more. This may result in an overpayment of credits which can then be recovered from either partner.

Likewise a couple whose income drops dramatically part way through the tax year, perhaps due to the redundancy of one partner, may have to wait until after the next 5 April to get the tax credit due in their new circumstances. Using the tax year as the base for the claim means that you look at their total income from the last 6 April to the next. It may be that it is only when you consider a complete tax year of one source of income that their total income will be sufficiently low to qualify for substantial credits.

Good to talk

In conclusion, as we get used to this new system the whole process will undoubtedly become more transparent. Until then, the moral of the tale seems to be - keep good records and notify changes as soon as possible. The recovery of any overpayment may seem less painful if it occurs in-year, and you do not have to wait, and indeed it may be disadvantageous to wait until the year-end to claim those underpayments. Perhaps the advertising slogan should be 'It's good to talk' - to the Inland Revenue!

Elizabeth Lathwood is technical officer at The Chartered Institute of Taxation. The views expressed are those of the author, and not necessarily those of the Institute.

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