TAX STUDY.pdf

Knowledge Taxation Study Guide 2024 Contents How to use this guide........................................................................................................................... 2 Module 1 – Introduction to the UK Tax System and Professional Ethics................

Knowledge Taxation Study Guide 2024 Contents How to use this guide........................................................................................................................... 2 Module 1 – Introduction to the UK Tax System and Professional Ethics........................................ 3 Module 2 – Income Tax Computation – Calculating Taxable Income............................................ 11 Module 3 – Income Tax Computation – Calculating Income Tax Liabilities.................................. 16 Module 4 – Employment Income........................................................................................................ 23 Module 5 – Trading Income................................................................................................................ 28 Module 6 – Capital Allowances.......................................................................................................... 37 Module 7 – Income Tax Losses.......................................................................................................... 44 Module 8 – National Insurance Contributions (NICs)...................................................................... 50 Module 9 – Capital Gains Tax............................................................................................................. 55 Module 10 – Inheritance Tax.............................................................................................................. 64 Module 11 – Corporation Tax............................................................................................................. 70 Module 12 – VAT and Stamp Taxes................................................................................................... 80 Module 13 – Administration of the UK Tax System......................................................................... 88 1 How to use this guide This guide is a short summary of the material in the Taxation course. It aims to bring together key points and concepts from the course to save you from having to check back to the learning material on Advantage. This can be the basis of your revision notes – you may find it helpful to add further points as you work through the practice questions. The assessment Taxation has a 120 minute closed book assessment containing 40 objective test questions worth equal marks. The pass mark is 50%. Set yourself up for success Once you have worked through the course material. The key to passing the assessment is question practice. Make the time to answer all the Knowledge builder and Practice questions at the end of each module. Try and answer the questions without looking back at your notes. The sample paper can also be used for additional question practice. You may find it helpful to attempt it in the same amount of time as you will have in the final assessment. Questions If you have any questions, please use the Discussion Forum to contact the tutor team for help. 2 Module 1 – Introduction to the UK Tax System and Professional Ethics Introduction Welcome to the study guide for Module 1 of the Taxation course. This study guide will help you prepare for the assessment. Syllabus Learning Outcomes 4 Explain the key principles and administration of UK tax. 5 Describe best practice when dealing with clients, other professionals and HMRC. Module Learning Outcomes By completing this module, you will have worked towards the following module learning outcomes: 4.1 Explain the key principles of the administration of the UK tax system for business tax. 4.2 Explain the key principles of the administration of the UK tax system for personal tax. 5.1 Describe best practice when dealing with clients, other professionals and HMRC. This will be achieved by working towards the following performance indicators: 4.2.1 Describe the structure of the UK tax system and the roles and responsibilities of its key stakeholders. 5.1.1 Explain the differences between tax evasion, tax planning and tax avoidance. 5.1.2 Describe the five Fundamental Principles and the five Standards for Tax Planning in Professional Conduct in Relation to Taxation. 5.1.3 Identify the requirements to be met by a tax adviser when taking on a new client. 5.1.4 Describe the responsibilities of a tax adviser regarding money laundering and their importance. 5.1.5 Describe the key requirements of a tax engagement letter. 5.1.6 Describe the risks and responsibilities of the Chartered Accountant when performing tax services. 5.1.7 Explain the circumstances when confidential information can be disclosed to HMRC. 5.1.8 Explain what a Chartered Accountant should do when tax errors are discovered. 5.1.9 Describe the importance of recognising and dealing with conflicts of interest. You will be ‘assessment ready’ for questions in Module 1 when you can confidently complete each of the learning outcomes above. Here is a reminder of the key topics which you looked at in this module. Introduction to Taxation What is taxation and why are we taxed? Taxation is a compulsory government levy on individuals and businesses. The primary purpose of taxes is to finance government expenditure on public goods such as defence, policing, healthcare, education and social welfare. Taxes are levied on income, gains, spending and wealth - they play a crucial role in maintaining a stable and thriving economy and society. Taxes may also be designed to encourage or discourage certain taxpayer behaviours. 3 How does tax happen? The key stakeholders in the UK tax system are the UK government’s tax authority (HM Revenue and Customs - HMRC), taxpayers and their tax advisers. HM Treasury sets the government’s tax policy and the annual budget, parliament legislates the tax laws and HMRC administers the tax system, ensuring the correct amount of tax is collected. What are the main UK taxes? Taxes in the UK are categorized into direct and indirect taxes: 1. Direct Taxes: Income Tax: Charged on the income of individuals from various sources. Corporation Tax: Charged on the total taxable profits of companies. Capital Gains Tax (CGT): Charged on individuals who make gains on the disposal of assets. Inheritance Tax (IHT): Charged on the estate of someone who has died. 2. Indirect Taxes: Value Added Tax (VAT): Charged on the consumers of goods and services. Stamp taxes: Charged on purchasers of property and shares. Insurance Premium Tax: Charged on purchasers of insurance policies. Duties: Charged on certain goods, such as airline travel and sugary drinks. Income tax, capital gains tax and inheritance tax for individuals are assessed based on the fiscal year (or ‘tax year’) which runs from April 6th to April 5th of the following year. VAT is paid by individuals as part of the price when goods or services are purchased. Which taxes apply in different parts of the UK? The following taxes are fully devolved in the UK? 1. Scotland – Administered by Revenue Scotland: Land and buildings transaction tax (LBTT). Scottish landfill tax. 2. Wales – Administered by the Welsh Revenue Authority: Landfill disposals tax. Land transaction tax (LTT). Local taxes such as Council Tax and Business Rates are set by local authorities across the UK to fund local services. Scotland has powers to set rates and bands for income tax for Scottish taxpayers and Wales has powers to vary income tax rates for Welsh taxpayers. In both nations the powers relate to non-savings income only – savings and dividend income are taxed using the UK tax rates and bands for all taxpayers. HMRC administers income tax for Scottish and Welsh taxpayers. What is self-assessment and ‘Making Tax Digital’? Taxpayers are responsible for reporting their income and calculating their tax liability under the self- assessment system of taxation. Taxpayers complete and submit a tax return to HMRC annually, either on paper by October 31st or online by January 31st following the end of the tax year. Taxpayers with complex affairs are usually assisted by a tax adviser. 4 Making Tax Digital (MTD) Making Tax Digital is an ongoing project to transition from annual tax returns to digital record-keeping and quarterly returns direct from the digital records. MTD aims to make the tax system more efficient, effective and easier for taxpayers to comply with their tax obligations. 1. MTD for VAT: Since April 2019, businesses with a taxable turnover above the VAT threshold have been required to keep digital records and submit VAT returns using MTD-compatible software. This requirement was extended to all VAT-registered businesses from April 2022. 2. MTD for Income Tax: Initially, only businesses and landlords with annual turnover of more than £50,000 will have to keep digital records for self-assessment. What are the fundamental responsibilities of taxpayers in the UK tax system? The self-assessment system places the onus on the taxpayer to comply with the law in relation to their tax affairs, including: 1. Submitting complete and correct returns disclosing all relevant information. 2. Paying the correct amount of tax on time. What are the differences between tax evasion, tax planning and tax avoidance? Government (via HMRC) wishes to maximise its tax revenues. Taxpayers wish to pay no more than required by law and are assisted by tax advisers to do this. The conflicting objectives lead to three ways to minimise tax liabilities. Understanding the differences between these three - tax evasion, tax planning and tax avoidance is critical for a tax adviser: Tax Evasion: Illegally reducing tax liabilities by under declaring income or overstating expenses, which is a criminal offence. Tax Planning: Legally organising tax affairs to minimise liabilities within the intentions of the law. Tax Avoidance: Tax planning that is acceptable to the taxpayer and their adviser can arise due to loopholes or complexities of tax law. If the law did not intend the outcome that the taxpayer achieves, HMRC may consider the activity as unethical, ‘unacceptable’ or abusive ‘bending the rules’, especially if contrived or artificial arrangements are involved. Differences of views as to whether tax avoidance is acceptable or not is often left to the Courts to decide. What can the government do to stop unacceptable tax avoidance? The government can: 1. Introduce specific anti-avoidance legislation to close any loopholes that become apparent within the tax law. 2. Apply the General Anti-Abuse Rule (GAAR). This is designed to counteract tax advantages arising from arrangements considered abusive and resulting in outcomes not intended by parliament. The GAAR involves a double reasonableness test asking whether the arrangements put in place to reduce tax liabilities go beyond what could reasonably be regarded as reasonable. 5 3. Tax advisers are legally required to register tax avoidance schemes under DOTAS (disclosure of tax avoidance schemes) and there are penalties for persistent promotion of unacceptable avoidance schemes under POTAS (promotion of tax avoidance schemes). Ethics and Professional conduct for Chartered Accountants providing tax services What are the core ethical principles that a Chartered Accountant must follow in a tax context? CAs must adhere to the ethical standards set out in the ICAS Code of Ethics which underpin the ethical framework within which CAs operate, balancing client service with the public interest and professional reputation. Ethical conduct in taxation is governed by the five Fundamental Principles and five Standards for Tax Planning as outlined in Professional Conduct in Relation to Taxation (PCRT) which all ICAS members advising on tax must adhere to. The five principles are the same five Fundamental Principles from the ICAS Code of Ethics, namely: 1. Integrity: Being straightforward and honest in all professional and business relationships. 2. Objectivity: Not allowing bias, conflict of interest, or undue influence of others to override professional or business judgements. 3. Professional competence and due care: Maintaining professional knowledge and skill at the level required to ensure competent professional service. 4. Confidentiality: Respecting the confidentiality of information acquired during professional and business relationships. 5. Professional behaviour: Complying with relevant laws and regulations and avoiding actions that discredit the profession. These principles are designed to ensure that members uphold the reputation of the profession while considering the broader public interest. The first, third and fifth of these principles are also part of the HMRC standards for tax agents. Members have obligations to their clients including a duty of confidentiality and a duty to act in their best interests. A member should also act in good faith when dealing with HMRC in accordance with the principle of integrity. What guidance is in PCRT about giving tax planning advice? 1. A member must balance their responsibilities to serve their clients with professional competence and due care with their duties to comply with relevant laws when giving tax planning advice. 2. A member must never be knowingly involved in tax evasion. 3. Guidance exists in PCRT to help the member avoid situations involving ‘unacceptable’ tax avoidance. Tax planning advice must comply with PCRT standards. 6 What are the five Standards for Tax Planning? The PCRT supplements the Fundamental Principles with five Standards for Tax Planning to guide members in providing responsible tax advice: 1. Client specific: Tailoring tax planning to the client’s facts and circumstances, alerting them to wider risks and implications of any course of action. 2. Lawful: Acting lawfully and with integrity, basing tax planning on a realistic assessment of the relevant facts and a credible view of the law – drawing attention to tax planning where it is known that HMRC take a different view. 3. Disclosure and transparency: Ensuring that the success of tax advice given does not rely on HMRC having less than the relevant facts. Any disclosure to HMRC must fairly represent all relevant facts. 4. Tax planning arrangements: Avoid the creation, encouragement, or promotion of tax planning arrangements or structures that are contrary to the clear intention of parliament or are highly artificial or contrived and seek to exploit shortcomings in the relevant legislation. 5. Professional judgement and documentation: Exercising professional judgement and keeping adequate and timely documentation to demonstrate how the standards for tax planning were adhered to. What are the implications for a tax advisers own tax affairs? Members should: 1. Not evade their own tax liabilities. 2. Keep their tax affairs up to date. 3. Consider engaging an agent if in dispute with HMRC over their affairs. 4. Consider whether any tax arrangements they might be associated with could bring them or the profession into disrepute. What can HMRC do if tax advisers are dishonest? HMRC can impose civil penalties of up to £50,000 on tax advisers who are proved to be dishonest. It can also request access to a member’s client working papers under certain conditions, including where there has been a conviction for fraud or dishonesty offences or where a dishonest conduct notice has been issued. Professional Ethics and Responsibilities in Client and HMRC Relationships What are the requirements for tax advisers when taking on a new client? A tax adviser: 1. Should have a practising certificate if they are a partner in an accountancy firm or a sole practitioner e.g. not providing services as an employee. 2. Assumes a legal duty of care towards the client for the professional expertise they apply on the client’s behalf. 3. Must understand the duties and responsibilities owed to the client. 4. Must understand and manage the risks of failing to act appropriately. 7 5. Must have requisite knowledge and exercise reasonable skill and care when acting for a client. When taking on a new client, CAs must: 1. Verify the identity of the taxpayer and their business interests, and take steps to ensure that the taxpayer is not involved in money laundering. 2. Ensure that acting for the taxpayer would not create an unacceptable level of risk: considering the taxpayers personal circumstances and business situation; financial standing; integrity and attitude to compliance with tax law generally. 3. Communicate (with the client’s permission) with previous adviser to obtain relevant information about the client’s tax affairs – if this permission is denied by the client, then the CA should decline to act. In addition, it is good practice, though not compulsory for tax, to agree on the scope of work and the responsibilities of both parties in an engagement letter – the HMRC Standard for Tax Agents expects engagement terms to be in place prior to starting to act for a client. This is also usually required for professional indemnity purposes. Why is awareness of money laundering important? CAs must be vigilant to the risks posed by money laundering activities, which involve possessing, concealing or dealing with the proceeds of crime, this includes tax evasion. Tax advisers work in a ‘regulated sector’ and must: 1. Be fully aware of their legal responsibilities in relation to money laundering and the potential dangers they are exposed to as tax advisers. 2. Follow the requirements to report any suspicions or knowledge of money laundering activities, including tax offences, to the appropriate authorities. Given the wide-ranging offences created by the money laundering legislation, it would be prudent for a CA who thinks they may be exposing themselves to the threat of prosecution to obtain expert advice. ICAS has a confidential helpline for reporting and discussing potential offences in this area. What are the key requirements of a tax engagement letter? The tax engagement letter should cover: 1. Scope of Work: The specific responsibilities and the extent of services provided by the adviser. 2. Client’s Duties: The obligation of the client to provide all relevant information accurately and on time. 3. Fees: Clear terms for billing and fee arrangements (ICAS Code of Ethics requires these to be in writing). 4. Money Laundering: The requirement to report any suspicious activities as per anti-money laundering regulations. 8 What risks and responsibilities arise when performing tax services for a client? Submission of tax information and filings: The responsibility for all information provided to HMRC remains with the taxpayer. Tax advisers have the following responsibilities: 1. Ensure the taxpayer reviews the tax returns prepared by the adviser prior to signing them. 2. Ensure that the tax return is accurate based on information provided by the client and draw attention to any judgemental areas in the return. 3. Take reasonable care and exercise professional scepticism to ensure that tax return presents the facts correctly and no attempt is made to mislead HMRC. 4. Consider additional disclosure to HMRC when there is doubt over the correct tax treatment of an item, or where the taxpayer proposes to adopt a different view to HMRC’s known position. The Fundamental Principle of professional competence and due care is critical when managing the risks associated with providing tax advice. A CA should only provide advice when they: 1. have an adequate understanding of the client’s personal and business circumstances and tax position; and 2. fully understand the issues under consideration and the objectives of the advice. When giving advice a CA should refer to relevant tax legislation and the practice of HMRC and give due regard to case law. A CA should always consider if they have sufficient knowledge and experience to give the advice requested. If the advice needed goes beyond the member’s own level of competence, they should either seek help from a specialist in the field or decline to act in the specific matter. Advice given should have the following characteristics: 1. Normally be in writing and set out facts and assumptions, alternatives, risks, caveats and exclusions. 2. Written evidence of how the advice was formulated should be retained on file. 3. Be clear that the advice given is based on the law at the current time and may be affected by subsequent changes in the law. 4. A second opinion should be sought for significant opinions e.g. significant tax at stake, sufficient importance to the client, aggressive tax planning. When can a CA disclose confidential client information? A Duty of confidentiality is owed to both current and former clients. Information can be disclosed where permitted by law and either the Client gives proper and specific authority, or a legal/professional right or duty to disclose exists. A legal/professional right or duty to disclose includes where there is actual or suspected money laundering activity (disclosure is required); or to defend a criminal charge against, or remove suspicion of dishonest activity by, a member. CAs should respond to lawful formal HMRC requests for information - though client permission should be sought, the request must be complied with even if permission is not given. A member can also respond to informal HMRC requests if the client gives permission. What must a CA consider when tax errors are discovered? HMRC errors may give rise to claims for additional professional costs from HMRC. CAs must ensure they do nothing to assist a client in committing or concealing tax evasion. Where errors are discovered that resulted in an underpayment of tax the PCRT help sheet C provides a detailed guide on how to respond. 9 What should a CA do to resolve conflicts of interest? Conflicts are a threat to fundamental principle of objectivity. A CA may face conflicts of interest between themselves and a client or between one or more clients. A CA should take the following actions towards conflicts of interest: 1. Assess the nature, extent and direct and indirect implications of the conflict of interest. 2. Identify all parties whose interests might be prejudiced, informing them of the risk and obtaining their consent to act. 3. Consider ICAS Guidance on Conflicts of Interest. 4. Put safeguards in place when acting for more than one party and review regularly. Study guide checklist Have you completed reading Module 1? Have you completed the knowledge checkers and knowledge builders? Can you confidently complete the module learning outcomes listed on this module? Can you confidently answer the guiding questions? Have you completed the assessment practice questions? Have you used the discussion board to ask questions on areas you are unsure about? 10 Module 2 – Income Tax Computation – Calculating Taxable Income Introduction Welcome to the study guide for Module 2 of the Taxation course. This study guide will help you prepare for the assessment. Syllabus Learning Outcome 1 Calculate a personal tax liability. Module Learning Outcome By completing this module, you will have worked towards the following module learning outcome: 1.1 Calculate a basic income tax liability for an individual This will be achieved by working towards the following performance indicators: 1.1.1 Explain the key components of an income tax computation 1.1.2 Calculate an individual’s taxable income You will be ‘assessment ready’ for questions in Module 2 when you can confidently complete the learning outcome above. Here is a reminder of the key topics which you looked at in this module. Introduction to Income Tax What is the process for calculating income tax? Income tax is a tax levied on the income an individual receives for a given tax year which runs from 6 April to 5 April the following year. The first step in calculating an individual’s income tax liability is to calculate taxable income, the second step is applying the correct rate(s) of tax to the taxable income. This module is concerned only with the first step of calculating taxable income. The first step of calculating taxable income can itself be split into two stages. Firstly, the income earned by an individual which is within the scope of income tax is categorised into three types: non- savings income (which includes employment, pension, property and trading income); savings income (which includes bank and building society interest) and dividend income. These three types of income are combined together to calculate total income. Secondly, the taxpayer may be entitled to certain deductions from total income to calculate net income and may then be entitled to deduct the personal allowance before calculating taxable income. Certain types of income are exempt and will not be included in the total income figure, this includes income from Individual Savings Accounts (ISAs). Correctly categorising income into these three types is important so the correct tax rates can be applied in the second step of the process. 11 Personal Allowance What is the personal allowance and when will it be reduced? The personal allowance represents the amount of income which is tax-free for the taxpayer each year. If the amount is not fully used in the tax year, it is wasted, the unused amount cannot be used in other tax years. If an individual's net income exceeds £100,000, their personal allowance is reduced by £1 for every £2 above £100,000. It is reduced to zero if their net income is higher than £125,140 for the tax year. The available personal allowance is subtracted from the taxpayer’s net income to calculate their taxable income. For the tax year 2023/24 the personal allowance is £12,570. The Income Tax Proforma – Calculating Taxable Income What is the easiest way to carry out a taxable income calculation? The process of calculating taxable income involves completing the following the steps: 1. Gather all sources of income to calculate total income. 2. Deduct specific amounts eligible for tax relief to calculate net income. 3. Allocate the personal allowance to determine taxable income. To take the easiest, structured approach to calculating taxable income the following proforma should be used. Non-savings Savings Dividend Tax paid income income income £ £ £ £ Trading income Employment income Property income Bank interest Dividend income Total income Deductions from total income Net income Personal allowance Taxable income 12 Types of Non-savings and Savings Income What are the main examples of non-savings income? 1. Trading income Individuals running businesses as sole traders or partners in partnerships receive trading income. This income is based on the accounting profit of the business, adjusted for tax purposes. Partners in a partnership are taxed based on their share of the taxable trading profits of the partnership. 2. Employment Income Employment income comprises salary, bonuses and taxable benefits (e.g., company car) and can be reduced by employment-related expenses. This income is received after tax deductions through the Pay as You Earn (PAYE) system. Taxable benefits, typically non-cash payments, are assigned a cash value, and the corresponding tax is generally deducted through PAYE. 3. Pension Income Pension income includes state pensions provided by the UK government and pensions from private schemes. Private pension scheme administrators deduct income tax through PAYE when making monthly payments. 4. Property Income Income generated from renting out property or land is considered property income. Individuals who earn income through property rentals are taxed on their rental receipts after deducting necessary expenses. How is savings income included in the income tax computation? Savings income encompasses interest from bank and building society accounts. Joint accounts and ISAs have unique considerations: Interest on joint accounts is shared equally between account-holders, regardless of their individual deposits. Each person is taxed separately on their share of the interest income. Income received from ISAs is entirely exempt from income tax and is not included in the income tax computation. ISAs offer a tax-efficient way to save and invest, with individuals being able to hold cash and/or shares within an ISA. Contributions to ISAs are subject to annual limits. Deductions from Total Income What are the two types of ‘deductions from total income’ and how do they impact the income tax computation? Certain payments made by individuals are eligible for tax relief as deductions from total income. There are two categories of deductions for this course, qualifying interest payments and gifts of shares, land or buildings to charity. 13 Which interest payments are qualifying interest payments? Interest payments on loans for the following purposes can be deducted from total income for the tax year: purchasing of plant and machinery by a partner for use in the trade of the partnership. acquiring an interest in a close company, or buying a share in a partnership. It's important to note that the interest paid in the tax year is deducted from total income, rather than a specific income source. What are three ways to make tax-efficient donations to charity? 1. Gifts of listed shares, land, or buildings. 2. Donations under a payroll deduction scheme. 3. Donations made under the Gift Aid scheme (detail in the tax liability calculation module). How can gifts of listed shares, land or buildings impact the income tax computation? Donating these types of asset to a charity result in tax relief as a deduction from total income, based on the assets' market value at the time of the gift. How does donating to charity through your payroll work? Employers can offer payroll giving schemes, allowing employees to make tax-efficient donations directly from their gross wages before income tax is calculated. The individuals employment income will be reduced by the amount of the donation for the purposes of the income tax computation. The Income Tax Proforma -Allocating Income to Tax Bands How is income allocated to each of the income tax bands? To accurately calculate income tax, taxable income must be allocated to specific tax rate bands. This step is essential for applying the correct income tax rates, which can change annually. There are three income tax bands: 1. Basic rate band 2. Higher rate band 3. Additional rate band People who have all of their income in the basic rate band are known as basic rate taxpayers. If some income falls into the higher rate band, then they are known as higher rate taxpayers, or additional rate taxpayers where some income falls into the additional rate band. These bands apply to taxable income after deducting the personal allowance. Taxable income is allocated across the relevant tax bands to be taxed in the following order: 1. Non-savings income is allocated first; 2. Savings income is allocated to the bands next based on the remaining available amounts; 3. Finally, dividend income, often referred to as the 'top slice' of income, is allocated to the bands after accounting for non-savings and savings income. 14  Study guide checklist Have you completed reading Module 2? Have you watched all the videos in the module and understood what they demonstrate? Have you completed the knowledge checkers and knowledge builders? Can you confidently complete the module learning outcomes listed on this module? Can you confidently answer the guiding questions? Have you completed the assessment practice questions? Have you used the discussion board to ask questions on areas you are unsure about? 15 Module 3 – Income Tax Computation – Calculating Income Tax Liabilities Introduction Welcome to the study guide for Module 3 of the Taxation course. This study guide will help you prepare for the assessment. Syllabus Learning Outcome 2 Calculate a personal tax liability. Module Learning Outcome By completing this module, you will have worked towards the following module learning outcome: 1.1 Calculate a basic income tax liability for an individual This will be achieved by working towards the following performance indicators: 1.1.1 Explain the key components of an income tax computation 1.1.2 Calculate an individual’s taxable income 1.1.3 Calculate an individual’s income tax liability You will be ‘assessment ready’ for questions in Module 3 when you can confidently complete the learning outcome above. Here is a reminder of the key topics which you looked at in this module. The Income Tax Proforma – Applying the Rates of Income Tax How do the income tax bands impact the income tax calculation? Remember the two main stages of income tax calculation. The process involves: 1. Calculating taxable income. 2. Determining the income tax liability based on that taxable income. Taxable income is first allocated to the three income tax bands: basic, higher, and additional rate bands in the order non-savings, savings then dividend income. Different categories of income are subject to separate rates of income tax across these bands. 16 What are the income tax rates for different categories of income? The proforma below shows the rates of tax across the income tax bands for each category of income. The calculation of tax is as shown below: £ Non-savings income (non-Scottish taxpayer) £ @ 20% X £ @ 40% X £ @ 45% X Savings income (all UK taxpayers) £ @ 0% (savings allowance/starting rate) 0 £ @ 20% X £ @ 40% X £ @ 45% X Dividend income (all UK taxpayers) £ @ 0% (dividend allowance) 0 £ @ 8.75% X £ @ 33.75% X £ @ 39.35% X Total income tax liability X Tax already paid - Tax remaining due X Non-Savings Income (non-Scottish taxpayers) Income in the basic rate band (£0 - £37,700) is taxed at 20%. Income in the higher rate band (£37,701 - £125,140) is taxed at 40%. Income in the additional rate band (> £125,140) is taxed at 45%. It's essential to remember that non-savings income is taxed first, and the rates applied to savings income depend on the level of non-savings income (starter rate) and / or taxable income (savings allowance). Common mistakes to avoid in the Income Tax Calculation Employment Income Always start with the gross employment income figure (include any tax deducted through PAYE in the tax paid column). Calculate the total income tax liability for the year. Deduct any tax already processed through PAYE to determine the remaining income tax due or refund available. Income Tax Rates Ensure that taxable income is allocated to all three bands where necessary. Identify if the starter rate and / or savings allowance applies. Use the correct income tax rates for each band. Remember the dividend allowance always applies if there are dividends. 17 Personal Allowance Note that if total income exceeds £100,000 plus twice the personal allowance (£125,140), the personal allowance is reduced to £0. Note that the personal allowance is reduced by £1 for every £2 of total income between £100,000 and £125,140. When is an individual eligible for a refund of overpaid tax? Entitlement to a refund of income tax can happen when: an employee has had more tax deducted through PAYE than their final liability indicates. when an individual has low income or when some income is ultimately taxed at a lower rate than the tax deducted at source. Savings Income – Rates of Tax and the Savings Allowance How do you calculate the tax liability on savings income? Rates of Tax Savings Income (all UK taxpayers) Income in the basic rate band (£0 - £37,700) is taxed at 20%. Income in the higher rate band (£37,701 - £125,140) is taxed at 40%. Income in the additional rate band (> £125,140) is taxed at 45%. The savings allowance taxes the first portion of savings income at 0% regardless of which tax band the income is placed within. It does not reduce taxable income like the personal allowance. This means that savings income falling within the savings allowance counts towards income levels for the purposes of calculating the remaining basic and higher rate bands for any savings income received in excess of the allowance. The taxable income figure indicates how much savings allowance is available as follows: Basic rate taxpayer: £1,000 savings allowance. Higher rate taxpayer: £500 savings allowance. Additional rate taxpayers receive no savings allowance. Savings Income and the Starting Rate Who does the starting rate apply to? The starting rate for savings income is designed to help individuals with minimal non-savings income pay less tax. It applies to those with taxable non-savings income below £5,000. Savings income at the starting rate is taxed at 0%. The starting rate decreases by £1 for every £1 increase in taxable non-savings income until it reaches zero – when non-savings income is above £5,000. Example: If a taxpayer has £3,700 of taxable non-savings income and £3,500 of taxable savings income, the first £1,300 of savings income is taxed at 0%. With a £1,000 savings allowance, the next £1,000 is also taxed at 0%, and the remaining £1,200 is taxed at 20%. 18 Dividend Income How is income tax on dividend income calculated? Dividend Income rates (all UK taxpayers) Dividend income has an allowance, with everyone entitled to a dividend allowance which taxes first £1,000 of dividend income at 0% regardless of which tax band the income is placed within. It does not reduce taxable income like the personal allowance. Dividends exceeding the dividend allowance are taxed at: − 8.75% in the basic rate band. − 33.75% in the higher rate band. − 39.35% in the additional rate band. Note: Remember that the savings allowance and dividend allowance do not reduce taxable income, they allow a certain amount of taxable income to be taxed at 0%. Dividends falling within the dividend allowance count towards income levels for the purposes of calculating the remaining basic and higher rate bands for any dividends received in excess of the allowance. Full Income Tax Calculation How is an individual's income tax calculated? Here is a reminder of the full income tax calculation proforma: Calculation of taxable income: Non-savings Savings Dividend Tax paid income income income £ £ £ £ Trading income Employment income Property income Bank interest Dividend income Total income Deductions from total income Net income Personal allowance Taxable income 19 Calculation of income tax liability £ Non-savings income (non-Scottish taxpayer) £ @ 20% X £ @ 40% X £ @ 45% X Savings income (all UK taxpayers) £ @ 0% (savings allowance/starting rate) 0 £ @ 20% X £ @ 40% X £ @ 45% X Dividend income (all UK taxpayers) £ @ 0% (dividend allowance) 0 £ @ 8.75% X £ @ 33.75% X £ @ 39.35% X Total income tax liability X Tax already paid (X) Tax remaining due / (to be refunded) X / (X) Tips for accurate income tax calculation Follow the income tax proforma: Adhering to the provided structure ensures compliance with tax legislation and a logical approach to the calculation. Consider savings income: Remember to restrict the personal savings allowance for higher rate taxpayers or omit it for additional rate taxpayers. Account for dividend income: Recognise the dividend allowance and apply it uniformly, regardless of income levels and remember the rates are different from those for non-savings and savings income. Charitable Giving – Gift Aid How does a Gift Aid donation impact the income tax calculation? Under Gift Aid, a taxpayer is treated as if they made a payment to a charity net of basic rate income tax e.g. if someone wishes a charity to receive £1,000, they only need to pay £800 in cash (£1,000 - £200 basic rate income tax). The charity then recovers the remaining £200 from HMRC (the amount of basic rate tax paid by the donor). Higher or additional rate taxpayers can gain extra relief (at 20/25%) by extending their income tax rate bands by the gross donation amount e.g. for a donation of £800 in cash, the gross donation (before deducting basic rate tax) would be £800*100/80 = £1,000. The basic rate band becomes £37,700 + £1,000 = £38,700, and if relevant the higher rate band becomes £125,140 + £1,000 = £126,140. These extended bands are then used when calculating the income tax liability. Conditions for Gift Aid 1. The gift must be irrevocable and a true gift, with no personal benefit to the taxpayer. 2. The taxpayer should have paid sufficient UK tax to cover the 20% basic rate tax top-up paid to the charity by HMRC. If not, HMRC may raise an assessment for the shortfall on the taxpayer. 20 The Marriage Allowance How does the marriage allowance impact the income tax calculation? The Marriage Allowance allows married couples or civil partners to transfer £1,260 of their personal allowance. This transfer can benefit couples when one partner has lower income and does not fully utilise their personal allowance. The recipient spouse deducts 20% of the transferred amount (£252) from their total income tax liability for the tax year. This election is advantageous when one partner has low income or income within the starting rate for savings, savings allowance, or dividend allowance after deducting the personal allowance. The recipient of the transfer must be a basic rate taxpayer. Income Tax Rates for Scottish and Welsh Taxpayers When do different tax rates apply for Scottish and Welsh taxpayers? In the UK, Scotland and Wales have devolved powers to set their income tax rates for non-savings income. It's essential to understand when these different tax rates apply. Scotland Different rates of income tax apply to non-savings income only for Scottish taxpayers. Scotland has five income tax rates: 19%, 20%, 21%, 42%, and 47%. Savings and dividend income of Scottish taxpayers are taxed at UK rates. Wales The Welsh Government has limited powers to set Welsh rates of income tax for non-savings income only. UK rates are reduced by 10% for Welsh taxpayers who then pay income tax at Welsh rates on top of the reduced UK rates. The Welsh government has set rates for Welsh taxpayers at 10% therefore in effect Welsh taxpayers pay the same rates as those in England and Northern Ireland. Determining Taxpayer Status Whether an individual is considered a Scottish or Welsh taxpayer depends primarily on where they live. If an assessment question does not specify, assume the individual is not subject to Scottish rates of income tax. Calculating Income Tax for Scottish Taxpayers The UK income tax bands are applied to determine any savings allowance available and the rates of tax paid on the savings and dividend income of a Scottish taxpayer. A proforma for the calculation of the income tax liability for a Scottish taxpayer is as follows: 21  £ Non-savings income (Scottish rates) £ @ 19% £ @ 20% £ @ 21% £ @ 42% £ @ 47% Savings income (UK rates) £ @ 0% (savings allowance / starting rate) £ @ 20% £ @ 40% £ @ 45% Dividend income (UK rates) £ @ 0% (dividend allowance) £ @ 8.75% £ @ 33.75% £ @ 39.35% Total income tax liability Tax already paid Tax remaining due Study guide checklist Have you completed reading Module 3? Have you watched all the videos in the module and understood what they demonstrate? Have you completed the knowledge checkers and knowledge builders? Can you confidently complete the module learning outcomes listed on this module? Can you confidently answer the guiding questions? Have you completed the assessment practice questions? Have you used the discussion board to ask questions on areas you are unsure about? 22 Module 4 – Employment Income Introduction Welcome to the study guide for Module 4 of the Taxation course. This study guide will help you prepare for the assessment. Syllabus Learning Outcome 1 Calculate a personal tax liability. Module Learning Outcomes By completing this module, you will have worked towards the following module learning outcome: 1.2 Calculate an employee’s employment income. This will be achieved by working towards the following performance indicators: 1.2.2 Explain when employment income is taxed. 1.2.3 Identify the types of income assessable as employment income. 1.2.4 State the common non-taxable benefits. 1.2.5 Calculate the taxable amount for common benefits. 1.2.6 Identify an employee’s employment deductions. 1.2.7 Calculate an employee’s taxable termination payment. You will be ‘assessment ready’ for questions in Module 4 when you can confidently complete the learning outcome above. Here is a reminder of the key topics which you looked at in this module. Calculating an Employee’s Employment Income When is employment income taxed? Employment income is assessed for each tax year (6 April to 5 April). The income which will be assessed in each year is generally the income actually received in the year, however the rules tell us that cash earnings are received for tax purposes on the earlier of: 1. The time when payment is made; or 2. The time when a person becomes entitled to payment. Benefits are generally treated as received when the benefit is provided. What is included in the employment income calculation? Cash Earnings: Salaries, wages, and bonuses or taxable termination payments. Benefits: The value of benefits such as company cars or beneficial loans. Different calculation rules apply depending on the benefit provided. Only taxable benefits are included. Employment deductions: Certain payments and expenses incurred by the employee can be deducted from employment income, these include pension contributions, travel expenses, fees and subscriptions to professional bodies and charitable donations under a payroll giving scheme. 23 The following pro forma can be used to calculate an individual's employment income: £ Salary, fees, bonus (i.e., earnings received) X Benefits (generally non-cash, e.g., company car) X Less deductions (X) Employment income X Which employee benefits are taxable and which are not taxable? Not all benefits provided by employers are taxable. Some non-taxable benefits include: Payments to employees for use of own car for work purposes (approved mileage allowance). A parking space at or near the employee’s workplace. Work-related training. Sport or recreational facilities not generally available to the public. One mobile telephone for the employee’s use. Awards for staff suggestion schemes. Some additional benefits are not taxable provided certain limits are met, these include: 1. Annual staff events which cost no more than £150. The full cost of event taking the total over the limit is taxable. Cost includes VAT, travel and accommodation and is averaged across all attendees. 2. Payments to cover the additional costs of home working. No record keeping is required for costs of up to £6 per week but evidence of additional costs is required for payments above £6 per week. 3. Free or subsidised meals in a staff canteen if provided to all staff, not just certain grades or directors. 4. Childcare account contributions up to £8,000 per child per year, HMRC tops up the account with the basic rate income tax rate amount, giving tax relief of up to £2,000 a year per child. 5. Trivial benefits of no more than £50. There is no restriction of the number of benefits that can be provided in a tax year as long as each benefit is less than £50. Cash cannot be a trivial benefit. How is the value of a taxable benefit assessed? Taxable benefits need a cash equivalent to be calculated so that they can be included in employment income which reflects the value of the benefit provided. The general rule is the cost to employer but specific rules exist for: 1. Private use of company assets 2. Vehicles provided for private use 3. Private fuel 4. Company vans 5. Environmentally friendly transport 6. Beneficial loans 24 The rules for each of the above benefits are summarised below: How is the private use of company assets assessed? Use the general rule: cash equivalent = 20% x market value of the asset when first provided. How are company car benefits assessed? Company car benefits – proforma £ Basic benefit: Price of car × CO2 emissions figure percentage X Reduction for periods of unavailability (>30 days) (X) X Reduction for ongoing contributions to running costs (X) Taxable benefit (cash equivalent) X The CO2 emissions figure percentage increases with the level of CO2 emissions. The CO2 emissions figure provided should be rounded down to the nearest 5g/km and the relevant % found from your tax rates sheet. The price of the car is calculated as: £ List price (actual price paid is irrelevant) X All non-standard initial accessories and any later accessories costing > £100 X Employee capital contributions to cost of car (max £5,000 reduction) (X) Price for benefit calculation X The list price is the manufacturers published price for the model of the car. Market value is used instead of list price for a classic car, defined as - a car which is worth > £15,000, is over 15 years old and the market value is more than the normal list price. How is private fuel assessed? Fuel provided for private milage in personal vehicle: Use general rule (cost to employer) to calculate cash equivalent of the benefit. Fuel provided for private mileage in company car: Benefit = £27,800 x CO2 emissions figure % for the company car. The percentage used is the same percentage as is used to calculate the car benefit. 1. The benefit value is reduced for periods where the car is not available to the employee and/or where a car is shared between two or more employees. 2. There is no assessable benefit if the employee reimburses the employer with the full cost of private fuel for the year; however, there is no reduction in the benefit for partial reimbursement. How are company vans assessed? No benefit if used for business, commuting and insignificant private use only. 25 How is environmentally friendly transport assessed? Certain environmentally friendly transport options are encouraged through tax incentives: 1. Cycle to Work Scheme: Bicycles and cycling safety equipment provided under this scheme are not considered taxable benefits. 2. Electric Cars: The value of the taxable benefit for electric cars is lower compared to petrol or diesel cars, to incentivise environmentally friendly choices. How are beneficial loan arrangements assessed? No taxable benefit if the loan is below £10,000 throughout the tax year. Benefit = Value of loan interest at official rate minus actual interest paid by employee. Two methods to calculate the loan amount: Normal method Alternative method Simple average Weighted average Loan at 6/4 or + Loan at 5/4 or Loan balance 1 x n1/12 when made when repaid x n/12 Loan balance 2 x n2/12, etc 2 Multiply by ORI for the tax year X Less employee contributions (X) Taxable benefit X n = number of months the loan is outstanding. For the simple average calculation, if the loan is fully repaid during the tax year, we take the balance immediately before it is repaid. Taxpayer can choose either method (and in practice will choose the method which gives the lower benefit value), HMRC can insist on the alternative method but will only do this if the normal method gives a significantly different result i.e. a materially lower amount of tax would be payable. Deductions from Employment Income What can be deducted in the employment income calculation? Contributions to an approved occupational pension scheme Contributions made by an employee to an approved occupational pension scheme are deductible from their employment income. This deduction directly reduces the amount of income tax liable under PAYE, providing tax relief at the applicable rate (20%, 40%, 45%, or the corresponding Scottish rate). Employer contributions to the pension scheme on the employee's behalf do not result in a taxable benefit. 26 Necessary expenses Deductions from employment income are permitted for expenses that are: Obliged to be incurred and paid by the employee as holder of the employment. Incurred wholly, exclusively, and necessarily in the performance of their employment duties. Travelling expenses These include travel expenses between work locations or temporary workplaces, but not regular home-to-work travel (commuting). The cost of commuting is not deductible as this is not a part of performing duties, merely putting the employee in a position to start performing the duties. Approved mileage payments are available when an employee uses their own vehicle for business purposes and receives reimbursement form their employer. Reimbursements in excess of the limits are taxable employment income, shortfalls (other than for additional passengers) are deductions from employment income. Calculating a Taxable Termination Payment What is included in a taxable termination payment? The tax treatment of the different types of payments on termination of employment is as follows: Contributions to approved pension schemes: exempt Statutory redundancy payments: exempt Payment in lieu of notice (PILON): taxable as employment income Ex-gratia lump sum payments: May be fully taxable or tax free (up to a limit of £30,000 less statutory redundancy payments) – depending on the circumstances. If the employee has a contractual right or expects (based on past practice of the employer) to receive such a payment (which may include the value of any assets transferred), it will be taxable in full. If the employee has no contractual right or expectation of a payment, up to £30,000 will be tax free, the amount of any statutory redundancy payment (though itself exempt) will reduce the £30,000 tax free limit. Where assets are transferred on termination of employment the market value will be used. Study guide checklist Have you completed reading Module 4? Have you completed the knowledge checkers and knowledge builders? Can you confidently complete the module learning outcomes listed on this module? Can you confidently answer the guiding questions? Have you completed the assessment practice questions? Have you used the discussion board to ask questions on areas you are unsure about? 27 Module 5 – Trading Income Introduction Welcome to the study guide for Module 5 of the Taxation course. This study guide will help you prepare for the assessment. Syllabus Learning Outcome 2 Calculate a direct tax liability for a business. Module Learning Outcome By completing this module, you will have worked towards the following module learning outcome: 2.1 Calculate a tax-adjusted trading profit or loss. This will be achieved by working towards the following performance indicators: 1.2.1 Explain HMRC’s approach in determining whether an individual is employed or self-employed. 2.1.1 Identify whether or not a trade exists. 2.1.2 Explain the trading allowance. 2.1.3 Explain the impact of the choice of accounting date on a sole trader from a tax perspective. 2.1.4 Explain why items will be adjusted within a trading profit calculation. 2.1.7 Calculate a tax-adjusted trading profit or loss. 4.1.1 Describe the three most common business structures used for trading (sole trader, partnership, company) and explain how each is taxed. You will be ‘assessment ready’ for questions in Module 5 when you can confidently complete the learning outcome above. Here is a reminder of the key topics which you looked at in this module. Choice of Business Structure In the UK, there are three primary business structures to consider: sole trader, partnership and company. Each of these structures has its unique characteristics, advantages and disadvantages. What are the key features of a sole trader structure and how is it taxed? Key features A sole trader is an individual who exclusively owns and operates a business under the trader's personal name or uses a different 'business name'. They may or may not have employees. Advantages: The structure is straightforward to set up, and while accounts must be prepared, there is no formal requirement to file accounts. Disadvantages: Sole traders are personally liable for the business's debts and legal obligations, putting their personal assets at risk. Raising capital can be challenging compared to a company or partnership structure. 28 Taxation The business itself does not have a separate tax liability; the sole trader is personally liable for the tax liability (income tax). The sole trader will calculate the tax-adjusted trading profits of the business and include this figure as trading income (a type of non-savings income) within the income tax computation. What are the key features of a partnership structure and how is it taxed? Key Features A partnership is formed when multiple individuals carry on a business together with the intention of making a profit. This relationship can be implied or explicitly agreed upon. The term 'firm' is often used to refer to all partners collectively, contracts can be made in the name of the partnership and the firm can sue and be sued in its own name. Partnerships can operate under the names of the partners or use a distinct 'business name'. Advantages: Partnerships can attract capital from multiple partners, making raising funds easier compared with sole traders and the responsibilities and risks of business ownership are shared among partners, distributing the workload and liabilities. Disadvantages: Partners are jointly and severally liable for the firm's debts and a general partnership has no limitation on liability – the partners personal assets are at risk. Taxation Partnerships do not have their own tax liability, but they must file tax returns. Each partner is individually taxed on their share of the partnerships tax-adjusted trading profit, treated as trading income (a type of non-savings income) within each partners income tax computation. Both sole traders and partnerships are classified as 'unincorporated businesses,' distinguishing them from incorporated companies. What are the key features of a company structure and how is it taxed? Key Features A company is a business entity incorporated under the Companies Act in the UK which has a separate legal identity, distinct from its members (shareholders) and directors. It therefore continues to exist irrespective of changes in ownership or management. Advantages: Members' liability for the company's debts is generally limited, reducing personal financial exposure. Disadvantages: Companies must comply with Companies Act legislation, resulting in additional regulatory compliance and associated time and financial costs. Taxation Companies have their own tax liability and pay corporation tax instead of income tax. A company will pay corporation tax on its taxable total profits which will be disclosed on the corporation tax return. 29 Does a Trade Exist? How do we determine if an individual is employed or self-employed? Employed or Self-Employed? To determine an individual's employment status, we consider whether they have: A Contract of Service: Typically indicative of employment; or A Contract for Services: Typically indicative of self-employment. The distinction may not always be clear-cut, especially in modern working arrangements like the 'gig' economy, where individuals may have multiple clients or part-time jobs. Employment tests HMRC employs several criteria to determine an individual's employment status: Indicators of employment Indicators of self-employment Control over manner of performing work Freedom to achieve objectives and delegate Remuneration without risk duties Contract defines scope of work but not Bears losses but keeps profits conclusive Contract defines scope of work Employer provides tools Responsible for own tools Regular defined hours Freedom to decide work timing and location Employer obliged to provide future work No expectation of recurrence or obligation Payment during illness/holiday Makes own arrangements for illness and Payment regardless of the success of tasks holiday performed Payment dependant on completion of task Integral part of the organisation and can be withheld until task completed satisfactory More than one client, not integral to any of the client’s businesses The 'gig' economy, characterised by short-term contracts and freelance work, has blurred the lines between employment and self-employment. What are the different rights under employment law for someone who is employed, self-employed or a worker? In employment law, individuals can be classified as 'employed,' 'self-employed,' or 'workers,' each with varying rights. However for tax purposes, individuals must be categorised as are either 'employed' or 'self-employed.' The categorisation and corresponding tax treatment relies on the employment tests mentioned earlier. What is a trade and why is it important? For tax purposes, 'trade' encompasses trades, professions and vocations. To determine the correct tax treatment it is vital to distinguish between trading activities (resulting in taxable profits) and non- trading activities (generating investment income or capital gains). We also need to determine whether someone is trading (earning taxable profits) or merely conducting a hobby (not earning taxable income). 30 What are the main badges of trade? Identifying whether a trade is being carried out (as opposed to a hobby or non-trading business activity) is difficult, however the following tests (known as the badges of trade) can be applied: 1. The Subject Matter: Certain types of assets are held for investment (the value growing over time and / or rental income being generated e.g. property), while others are acquired with the intent of reselling for a profit (e.g. toilet rolls). 2. Length of Ownership: Trading assets are typically held for shorter durations than those acquired for personal use or investment. 3. Frequency of Transactions: Repeated, similar transactions over time suggest trading, but one- off transactions can also be trades. 4. Supplementary Work: Modifying assets into a more marketable condition or making efforts to attract purchasers indicate trading. 5. Reason for Sale: Sales motivated by emergencies or immediate cash needs are less likely to qualify as trades. 6. Motive: Transactions undertaken to realise a profit indicate a trade, but many investments are also purchased with profit in mind. In addition to the six badges, it is necessary to consider the method of acquiring assets, how the transaction was financed, and any marketing or advertising efforts. It is likely that no single criteria will determine the outcome on its own, the totality of the circumstances should be considered. What is the trading allowance? There is a trading allowance of £1,000 for individuals. When trading income before expenses (gross income) is below this figure, no declaration of the trading income is required and the income does not give rise to a tax liability. If the gross trading income exceeds £1,000, the taxpayer can either deduct £1,000 from the gross income amount or elect to deduct the actual expenses if that produces a lower taxable amount. Adjustments to Profits What are the main differences between profits of a business per its accounts and for income tax purposes? Unincorporated businesses are taxed on the profits of a trade - which are the profits calculated for accounting purposes, adjusted as required by the tax law. Where accounting and tax rules differ, adjustments to the accounting profit are needed. 31 When adjustments are being made to the accounting profit, are we increasing or decreasing profit? Accounting profit/loss Income Expenses Taxable Not taxable Deductible Not deductible No adjustment Deduct No adjustment Add back Reduces taxable Increases taxable profit/increases profit/decreases allowable loss allowable loss When should accounting profits be adjusted for tax purposes? There are three reasons why the accounting profits may need adjusting: 1. Amounts which relate to capital should be removed (deduct income and add back expenses). 2. Amounts which are taxable or deductible elsewhere in the computation (i.e. not treated as trading income or a trading deduction) should be adjusted. 3. Where there are specific rules in the legislation or case law. Adjusting amount – what is capital and how is this dealt with under trading income? Capital expenditure is defined by case law as “…bringing into existence an asset or advantage for the enduring benefit of a trade”. It can be described as money spent on acquiring or improving non-current assets of the business such as property, plant or equipment as opposed to the general operating costs or consumables of the business. Watch out for the following common items that are classed as capital and will need to be adjusted for: 1. Depreciation 2. Losses / gains on disposal of non-current assets – not inventory 3. Professional fees related to capital transactions (this rule applies even if the transaction never actually takes place) 4. Goodwill written off 5. Initial repairs to assets purchased in a run-down condition 32 Adjusting amount – what items are dealt with elsewhere in the income tax computation? The key items of income that are taxable (but not as trading income) are: 1. Rental income (i.e. property income) 2. Interest income 3. Dividend income These items should be deducted from trading income and will be taxed under another heading in the tax computation. The key items of expenditure that may receive tax relief (but which are not dealt with as part of trading income) are: 1. Charitable donations by Gift Aid 2. Contributions to a personal pension scheme These items should be added back to trading income and relief will be given elsewhere in the income tax computation. Adjusting amount – what are the specific rules in tax law for restricting deductions? In tax law, specific rules exist for adjusting amounts included in accounting profits or losses. These adjustments are necessary because not all expenses are eligible for tax relief. Here, we'll explore the key reasons for making such adjustments: Wholly and exclusively for the purposes of the trade No deduction is allowed for expenses not incurred wholly and exclusively for the purposes of the trade. This rule has two components: Expenses must be incurred wholly for the purposes of the trade, meaning they should have no other primary purpose or a dual purpose; and The expenses must genuinely relate to the trade and be incurred by the trader in that capacity. Business entertainment and gifts: Generally, no deduction is permitted for expenses associated with business entertainment or gifts, even if they are related to the trade. However, there are exceptions which allow a deduction for specific types of entertainment and gifts: Entertainment or gifts where it is the trader’s usual trade to provide these and they are provided as advertising to the public e.g. a restaurant giving a free meal to a restaurant critic or a bakery giving free samples of donuts to customers. Entertainment or gifts provided to employees which is not incidental to that provided to others. Gifts (other than food, drink, tobacco or a gift voucher) with a conspicuous advert for the trader (limited to cost of no more than £50 per recipient per accounting period). Gifts to a charity. Leased Cars: 15% of the lease cost is disallowed for leased cars with CO₂ emissions of over 50g/km. 33 Bad and Doubtful Debts: Specific bad debts written off are deductible, bad debts recovered are taxable. Movements in specific provisions (calculated in accordance with accounting standards) are deductible/taxable and there is no need to make an adjustment to accounting profit. Movements in general provisions (not calculated in accordance with accounting standards) are not deductible/taxable so must be adjusted for. Other rules restricting deductions: Accrued, unpaid remuneration after 9 months from the end of the period to which it relates is not deductible. NICs for employees are deductible, Class 2 and 4 NIC’s for a sole-trader or partner are not. Most tax penalties and interest on late payments are not deductible for unincorporated businesses. Criminal and crime-related payments are not deductible. What are the rules allowing deductions? The tax law specifically allows deductions for: Allowable expenditure incurred within the 7 years prior to the commencement of trade – these expenses are treated as if incurred on the first day of trading. Incidental costs of obtaining loan finance (e.g. fees and commission). Payments for restrictive undertakings to employees/ex-employees. Salary of employees temporarily seconded to charities and educational establishments. Cost of providing counselling and retraining for employees whose jobs have ceased. Statutory redundancy and other ex-gratia redundancy payments made for the benefit of the ongoing trade. Costs of obtaining patents, designs or trademarks for the purposes of the trade. Pension contributions paid on behalf of employees. What other common items might be included in the accounting profit or loss and what is the tax treatment? Allowable / deductible Interest payments if they are wholly and exclusively for the purposes of the trade. Hire purchase interest (not capital payments) for assets used in the trade. Advertising expenses are generally allowable unless capital in nature or can be considered as entertaining (e.g. some types of sponsorship could be considered entertaining). Charitable donations to local charities or charities from which employees likely to benefit. Legal expenses in the normal course of trading (excluding those relating to capital transactions) e.g. debt collection, normal tax fees, renewal of a short lease ( £6,000 The chargeable gain is the lower of: Any chargeable gain is exempt Gain calculated under usual rules Cost < £6,000 Any capital loss is ignored 5 × (gross proceeds − £6,000) 3 The gross proceeds are deemed to be The chargeable gain or capital loss is Cost ≥ £6,000 £6,000 for calculating the capital loss calculated using the usual rules Shares All of the shares held by one individual in one company are generally deemed to be treated as one asset (known as a “pool of shares”). When some shares are sold, it is considered that a proportion of the overall pool of shares have been sold, rather than any specific individual shares. We therefore need a special approach to calculating chargeable gains and capital losses when shares are disposed of by an individual. 60 How do we know which shares have been sold? When an individual sells shares we do not necessarily consider the pool of shares first. Determining which shares have been sold and tracking their associated acquisition costs can be complex. Identification rules dictate the order in which shares are treated as being sold.: 1. Shares acquired on the same day as the disposal. 2. Shares acquired within the following 30 days of disposal (earliest first) to prevent tax-avoidance. 3. Shares acquired before the date of sale using a "pooling" technique. If shares in groups 1 or 2 above are identified as sold, the actual cost of acquiring those shares is included in the calculation. Where shares of the pool are identified as sold, the cost of the shares is based on the following calculation: Number of pooled shares sold Cost of shares in pool × Total number of pooled shares Shares received by way of a bonus or rights issue are matched with the original shareholdings that gave rise to them for the purposes of the identification rules. CGT Reliefs Does an individual have to pay tax when they dispose of their home? Private residence relief (PRR) provides relief for gains on properties that have been the individual’s only or main residence throughout their ownership period. If the property meets these criteria, there’s no need to calculate chargeable gains or losses. Where the property has not been occupied or has been occupied for only part of the ownership period, a gain must be calculated and the amount of the gain eligible for PRR determined. There are certain periods of absence which can be counted as occupation (‘deemed occupation’) which are shown on your rates sheet as follows: Up to three years for any reason* Any period working abroad as an employee* Up to four years working elsewhere in the UK either as an employee or self-employed * Final 9 months of ownership *To qualify as deemed occupation these periods must be preceded and followed by actual occupation. The PRR is deducted from the chargeable gain, the amount of PRR is calculated as: Period of occupation (actual and deemed) Chargeable gain × Period of ownership Therefore, the longer the period of occupation relative to the period of ownership, the greater the PRR deduction will be. What is gift relief and how does it work? Gift relief defers chargeable gains on certain types of assets when they are gifted or sold for less than market value. It is often used for business transfers within a family. This course only considers the situation when assets used for a trade are gifted, although gift relief can apply to shares in certain circumstances. If a whole unincorporated business is gifted the gains on each chargeable asset are calculated individually and gift relief is applied (if a claim is made). Gains on investment assets do not qualify for gift relief. 61 If a business asset is fully gifted (e.g. no cash proceeds) then the entire amount of the gain can be deferred under gift relief. The rationale here is that if there was no cash received by the donor, it is not reasonable to expect them to pay a tax bill. If the business asset is sold at less than market value (e.g. a partial gift), the receipt of partial consideration (e.g. cash) means that it may not be possible to use gift relief to defer the full gain. The amount chargeable immediately is the lower of the gain (e.g. disposal value (MV) less cost) or the excess of actual proceeds over cost. A gift relief claim can be made for the balance of the gain. For example, if an asset costing £50,000 is sold for £60,000 when MV is £100,000, the gain is £50,000 (£100,000 - £50,000) and the excess of proceeds over cost is £10,000 (£60,000 - £50,000). The gain chargeable immediately is £10,000 (lower of £50,000 and £10,000), the remaining £40,000 gain can be deferred using gift relief (if a claim is made). The amount of the gift relief claimed reduces the chargeable gain for the donor and reduces the cost of the asset in the hands of the new owner. This ensures that the gain deferred is ultimately subject to CGT on a future disposal of the asset (although if gifted in the future – gift relief can apply again). Continuing the above example, the individual acquired an asset worth £100,000 and £40,000 of a gain was deferred, the revised cost (for CGT purposes) would be £60,000 (£100,000 - £40,000). Suppose that individual now sells the asset in the future to an unconnected person for £110,000 – the chargeable gain at that time would be £50,000 (£110,000 - £60,000). A joint claim for gift relief must be made within four years of the end of the tax year of disposal. What is Business Asset Disposal Relief (BADR)? BADR applies when an individual sells or gifts a qualifying business asset. In this course only the disposal of a whole unincorporated businesses is considered, there are other types of assets that can qualify for BADR. BADR takes the form of a taxing gains at 10%, irrespective of the level of taxable income, up to a lifetime allowance of £1 million of gains. The following points needs to be considered: The disposal of a whole unincorporated business will only qualify for BADR if the taxpayer has owned the business throughout the 24-month period ending with the date of disposal. If there are BADR and non-BADR gains in the same tax year, BADR gains are deemed to use up any remaining basic rate band first and taxed at 10%. Non-BADR gains are then subject to 10% in any further remaining basic rate band and 20% for any gains above the basic rate (or 18/28% respectively for gains on residential property). The AEA and any capital losses should be allocated to non-BADR gains first to minimise the CGT liability for the year. A claim for business asset disposal relief must be made within 12 months of 31 January following the tax year of the disposal. 62  Study guide checklist Have you completed reading Module 9? Have you watched all the videos in the module and understood what they demonstrate? Have you completed the knowledge checkers and knowledge builders? Can you confidently complete the module learning outcomes listed on this module? Can you confidently answer the guiding questions? Have you completed the assessment practice questions? Have you used the discussion board to ask questions on areas you are unsure about? 63 Module 10 – Inheritance Tax Introduction Welcome to the study guide for Module 10 of the Taxation course. This study guide will help you prepare for the assessment. Syllabus Learning Outcome 1 Calculate a personal tax liability. Module Learning Outcome By completing this module, you will have worked towards the following module learning outcome: 1.5 Calculate a basic inheritance tax liability arising on death. This will be achieved by working towards the following performance indicators: 1.5.1 Calculate the valuation of the death estate. 1.5.2 Calculate inheritance tax due on the death estate. 1.5.3 Calculate business property relief. 1.5.4 Identify inheritance tax filing and payment dates. 1.5.5 Explain basic principles of inheritance tax planning. You will be ‘assessment ready’ for questions in Module 10 when you can confidently complete the learning outcome above. Here is a reminder of the key topics which you looked at in this module. The Death Estate Computation Inheritance Tax (IHT) is a direct tax on the transfer of wealth. It is charged primarily when someone dies and their estate is transferred to their beneficiaries. This course looks at the fundamentals of the calculation of an IHT liability for a death estate. What steps must be followed to calculate the IHT on a death estate? Step 1 Calculate the value of the deceased individual's net chargeable estate. To complete this calculation, we must consider: 1. Which assets to include. 2. How to value the assets. 3. Which debts owed by the individual can be deducted. 4. Whether any exempt transfers have been made out of the estate (exempt transfers can be deducted). Step 2 Consider whether the residence nil rate band (RNRB) will be available to the individual and deduct it from the value of the net chargeable estate, if applicable. Step 3 Calculate the value of any nil rate band (NRB) available. This amount is taxed at 0%. Step 4 Tax the remaining estate at 40% (or 36% where there has been a large enough charitable donation (legacy) from the estate). 64 What is included in a death estate computation? The first step in computing IHT on a death estate is to calculate the value of the deceased individual's net chargeable estate. The general valuation rule is to use market value of assets at the date of death. There are some special situations regarding life assurance policies, quoted shares, land and buildings. Reasonable funeral expenses, including the cost of a tombstone can be deducted. There are no exempt assets for IHT so even assets which may be exempt from CGT such as cars and small chattels will be included in the death estate. A proforma for this is shown below: Proforma death estate calculation £ Property X Less outstanding mortgage (X) Stocks and shares X Life assurance policy proceeds* X Cars X Personal chattels X Debts (e.g. repayments of tax) due to deceased X Cash and savings X Less debts owed by deceased (X) Less funeral expenses (X) Net estate X Less exempt transfers (X) Net chargeable estate X *Life assurance policies A life insurance policy is set up with the "life assured" (the person whose death will trigger a payout from the policy) and the "beneficiary" (the recipient of the policy payout). If the life assured and beneficiary are the same (i.e., the deceased), the policy proceeds are part of the death estate, and IHT is chargeable on them. The policy proceeds will be included within the net chargeable estate calculation. If the life assured is the deceased, but the beneficiary is someone else, the policy proceeds are not part of the death estate, and no IHT is chargeable on them. The policy proceeds will not be included within the net chargeable estate calculation. Quoted shares Market value is used for quoted shares in the death estate. However, if quoted shares are sold within 12 months of death and their market value has fallen since the date of death, a claim can be made to value them in the estate using the gross proceeds of sale instead. The claim applies to all quoted shares sold within the 12 months after death, not just the loss-making ones. 65 Land and Buildings A similar rule applies to land and buildings that are part of the death estate and are sold for a lower value within 3 years of death. The election to use the gross proceeds applies to all land and buildings sold in the three years after death. Exempt transfers The transfer of assets are exempt from IHT if the beneficiary is a spouse or civil partner, a UK- registered charity, or a major UK-recognised political party. The value of exempt assets will be deducted in the death estate computation to reduce the value of the net chargeable estate. What is the residence nil rate band? In the second step of the calculation, we consider whether the residence nil rate band (RNRB) is available to reduce the value of the net chargeable estate. The RNRB potentially applies when the death estate includes residential property that was the deceased's home. To qualify for the RNRB, the property must be left to a direct descendant, e.g. the deceased's children or grandchildren/great- grandchildren. The RNRB is deducted from the overall net chargeable estate value and is not a relief set against the property's value specifically. The RNRB applied is the lower of: The net value of the property (after deducting any outstanding mortgage); and The residence nil rate band applicable at the date of death, currently £175,000. What is the nil rate band? In Step 3, we calculate the value of any nil rate band (NRB) available and tax this amount at 0% (effectively deduct if from the chargeable estate value). The NRB serves to remove many people from the scope of IHT entirely. To prevent individuals from avoiding IHT by transferring assets out of their estate before death, lifetime transfers made within 7 years of death must be considered when calculating the available NRB. The amount of NRB, before considering any lifetime transfers is currently £325,000. The amount of the available NRB subject to IHT at 0%, with the value of the net chargeable estate above that figure taxed at 40%. How much of any unused NRB/RNRB can be transferred to a spouse or civil partner? The proportion of the NRB and/or RNRB that is not used when a person died can be transferred to be used in the calculation of the death estate of their spouse or civil partner. An election must be made by the executors of the second estate to utilise this rule. Taxing the Death Estate What rates of tax are normally applied to a death estate? In general, IHT is charged at a rate of 0% on the available NRB amount and 40% on any amount above that figure. 66 When is 36% used instead of 40%? IHT may be charged at a lower rate of 36% (instead of 40%) when a substantial portion of the estate is left to a UK-registered charity. Remember a donation to a UK charity is an exempt transfer. The potential reduction in the rate of IHT is to further encourage charitable giving. This reduction applies if the charitable gift is at least 10% of the 'baseline amount'. The baseline amount is the net chargeable estate before deducting any RNRB or the charitable gift but after deducting any available NRB. If the donation is less than 10% of the baseline amount, the donation amount is still an exempt transfer (to be deducted as part of the net chargeable estate calculation) but the IHT rate remains at 40% above the NRB. If the donation is equal to or greater than 10% of the baseline amount the donation amount is also still an exempt transfer (to be deducted as part of the net chargeable estate calculation) but the 36% IHT rate applies above the NRB. Business Property Relief (BPR) Business Property Relief (BPR) is a mechanism to reduce the value of certain 'relevant business property' included in the deceased's estate. BPR rates are either 100% (fully relieved) or 50% (partially relieved). How does business property relief work? For BPR to be available, the following conditions must be met: 1. Relevant business property must be included in the estate. 2. Ownership conditions must be satisfied. 3. A binding sale contract must not be in place. 4. The relief is reduced where "excepted assets" exist. BPR applies automatically if the conditions are met. BPR can apply to both lifetime transfers and for the death estate though you are not expected to deal with BPR on lifetime transfers in this course. What is relevant business property and what rates apply? BPR is applicable to the following types of relevant business property (located anywhere in the world): Sole trade or partnership share – the whole business / partnership share must be transferred (100% relief). Shares in unquoted companies, including AIM listed companies (100% relief) Securities (e.g. loan stock) in an unquoted (including AIM listed) company held by a controlling (>50%) shareholder (100% relief) Land, buildings, machinery, or plant owned by the donor/deceased used in the donor/deceased’s partnership or controlled company (50% relief) Shares/securities in a quoted company held by a controlling (>50%) shareholder (50% relief). In all categories above, the business of the sole trader, partnership or company must be a trading business. Shares in investment businesses will not qualify for BPR. 67 What other conditions must be met for BPR to be available? Ownership period The property must have been owned by the donor/deceased for at least 2 years prior to the date of death. There is no partial relief for ownership for less than this time. Where the relevant business property was inherited from a spouse or civil partner, the period of ownership of the first spouse/civil partner is included to determine whether the ownership period condition is met by the second spouse/civil partner on their death. Binding contract for sale No BPR is available where a binding contract for sale of the releva