Income tax

On 1^st November 2017 Theresa May is quoted in Hansard as having declared that the top 1% of earners in this country are paying 28% of the tax burden.  This situation has not improved very much since.

We will be issuing a series of articles on a monthly basis aimed at alerting you as a business person on the full ambit of tax reliefs and deductions that may be applicable to you, to ensure they are not missed and you take full advantage of the opportunities available to you to mitigate your tax.

Perhaps the first step is to understand broadly how your various sources of income are taxed and the various deductions and reliefs available against those sources of income.

One of the objectives of this article is to familiarise you with the types of deductions you may be eligible for and to thereby ensure they are mentioned to your tax adviser and taken full advantage of. We have also focused on how losses can be utilised to relieve tax at the highest tax rate.

It is always a very good idea to seek the advice of your accountant or tax adviser prior to structuring or entering into any transaction, in case there is a way of dealing with it that may save you the greater amount of tax.

Let’s start at the beginning with your income tax computation. We have set out a useful pro-forma with a brief explanation on each step.

The basic Income Tax pro-forma is as follows:

Trading Income

To calculate your taxable income (the profits from your business as a sole trader, your profession or vocation or your share of any partnership trading income), you may have to adjust the accounting profit to arrive at your taxable trading income. 

Start with the profit per the accounts and add back certain expenditure, which is not allowable for tax purposes and deduct any receipts, which are not taxable as trading income e.g. rental income, bank interest or a profit on the sale of plant and machinery or building used in the business .  Finally, you deduct capital allowances which is HMRC’s equivalent to depreciation to arrive at tax adjusted profits required by HMRC. 

Your accountant will have calculated this for you but some examples of expenditure that are generally not allowable as a tax deduction and needs to be added back, are as follows:

1. Depreciation (instead capital allowances may be claimed on plant and machinery and buildings and structures used in your business)
2. Capital expenditure (expenditure of an enduring nature e.g. the purchase price of a factory or plant and machinery)
3. Costs incurred providing business entertainment and gifts to clients (however, if the gift has your logo or an advert and meets other criteria, and is not food or drink, or is staff entertainment, it should be allowable).
4. Costs of traveling from home to your normal place of work.
5. The cost of setting up a website (treated as capital expenditure and therefore not allowable) as opposed to regular update costs (treated as revenue expense and allowable)

A simple proforma to follow is:

Other sources of Income

Employment income is self-explanatory but please note that you may be able to claim deductions for expenses incurred in the course of your employment. This is discussed further under Deductible Payments below.

• Property income is your net rental income from investment properties. 
• Interest income is gross interest received. 
• Dividend income is self-explanatory.

The above added together produce your Total Income for the tax year.

Deductible payments

From Total Income, deductible payments are subtracted, to arrive at net income.

Deductible payments include gross interest paid on qualifying loans. If you are an employee this could include a loan taken out by you to purchase plant and machinery for use in your employment, a loan taken out by you to purchase shares in a close company, loans taken out to purchase shares in an employee owned company or a loan to buy into a partnership. To qualify, these loans must have been taken out by you personally.  There are various conditions for qualification and if you believe that you have a loan that may qualify this should be discussed in detail with your accountant.

Deductible Payments save tax at your highest rate, so if you are a 45% taxpayer this will save 45p per pound of expenditure

From net income, deduct any trading loss relief you may be eligible to deduct. 

Loss Relief Strategies

There are various options to consider when relieving losses.

Our objective is to set the loss against income that generates the highest amount of tax paid. This means we are trying to use the loss against income taxed at 45%, then 40% then 20% and if we are dealing with dividend income 38.1%, 32.5% and 7.5% .

Another consideration is the potential loss of personal allowance and/or capital gains tax allowance. These are both valuable allowances. We do not want to waste them if they can be preserved and the losses used against other income or gains.

The third aspect of planning is timing. We would like to relieve a loss earlier rather than later on since there are some time limits for particular claims. Relieving a loss in an earlier year leaves more net income available to relieve the following year.

Where there are various options available, it is important to utilise your losses by relieving them against the income or gains that attract the highest tax rate to obtain the maximum tax relief.

The available reliefs may depend on whether the trade is a continuing trade, a start-up or a business ceasing to trade.

The loss reliefs can be used by a sole trader or an individual partner of a partnership (being his share of the loss) against his other income.

Some of the loss reliefs are set out below:

Under s.64, ITA 2007 a trading loss may be set against net income of the current year and/or the preceding year. The claims are independent of each other and you may choose to make a claim in one, both or none of the years. For example, once you choose a year you must claim the maximum loss relief against that year. This could result in you wasting your personal allowance in one year but not the other, so you would choose the other to make the claim in and utilise the rest of the loss under one of the other options below.

There is a restriction on the amount of loss that may be claimed under s64. It is the greater of:

• £50,000
• 25% of your adjusted total income which includes generally your total income less the gross amount of any personal pension contribution paid

This restriction may apply cumulatively with other reliefs (see s72 below) but does not apply to S71 or  s83 below.

S71 ITA 2007 and S261B TCGA 1992 allow any excess loss not utilised under full use of the s64 loss relief to be set against capital gains in the year of the loss, after a s.64 claim has been made.

Losses under s.71 are used after current year capital losses but before any capital losses are brought forward from previous years.

The S71 relief will be the lower of:

• The remaining loss after the s64 claim; and
• The ‘relevant maximum’ (i.e. the net gains in the tax year less capital losses brought forward).

Once claimed the full eligible loss must be claimed which could lead to wastage of the capital gains tax-exempt amount.

The tax saving would be either 10% or 20% for most assets but 18% or 28% for residential property gains.

The use of S 71 may by its very nature mean you have wasted your personal allowance under s64 and your capital gains tax exemption under s71. You may therefore prefer to use option 3 below.

S83 ITA 2007 allows you to carry forward losses against future losses from the same trade or partnership. If you believe, you may be paying tax at 40% or 45% next year this may be the better option.

This option may be particularly attractive if you are anticipating making profits the following year at your highest tax rate, since this would then relieve the greatest amount of tax.

S72 ITA relief allows a loss of any of the first 4 tax years of trade to be carried back against net income of the 3 preceding years. Remember, net income includes your employment income and property income.  

The same as S64, this is one of the reliefs where there is a restriction on the total amount of all relevant reliefs that can be deducted in arriving at net income. It is limited to the greater of:

1. £50,000
2. 25% of your adjusted total income which includes generally your total income less the gross amount of any personal pension contribution paid

The section can not be used to set the loss against net income in the year of the loss.

S89 ITA 2007 terminal loss relief is available where a business ceasing to trade or a partner retires, and there are trading losses in that final year.

The loss relief relates to the final 12 months of trading which may not be the same as the loss in the final accounting period.

Personal Allowance

From your net income, after deduction of any trade loss relief, you may deduct your personal allowance.

For the year 2019/20 and 2020/21 it is £12,500.00. This is restricted where your adjusted net income (which is your net income reduced by the gross amount of any gift aid payments or personal pension contributions eligible for relief) exceeds £100,000.00. Your personal allowance will be reduced by one half of the excess above £100,000.00.  Once your adjusted net income exceeds £125,000.00 you will not be eligible for any personal allowance. 

Your taxable income is then taxed at 20% on the first £37,500.00 of your taxable income.  The next £112,500.00 will be taxed at 40% and any excess above that will be taxed at 45%. 

A Case Study

Michael is a barrister and self-employed.  He has trading income of £900,000.00 from his profession as a barrister. In addition, he has employment income of £40,000.00 as a part time lecturer, rents from a flat in Richmond upon Thames of £24,000.00. 

The same year 2019/2020, Michael took out a loan to buy into a new trading partnership of £100,000.00 and paid gross interest in the tax year 2019/20 of £3,000.00.  In that tax year the partnership suffered an adjusted loss of £30,000.00.  The Partnership Agreement says that losses and profits are to be shared equally.

The most appropriate year to take the loss back to was tax year 16/17. He paid tax at his highest rate and would now be due a tax refund. He will not have the opportunity again to take losses back to that year. If the partnership continues to make losses in the first four years of trading, he will be able to set those losses against the preceding 3 years.

It is always useful to know in advance what tax effects your actions may have. This is why we would always advise you to tax advice in advance of any transactions.

It may for example influence you to crystallise a capital loss in a particular tax year if you know that by retaining the asset it will not increase in value, to reduce your tax bill.

Wellers Wealth are very happy to work in conjunction with your independent financial advisor, accountant or legal advisor on such matters.

Please call us on 020 7481 2422 or email us at wellers.wealth@wellerslawgroup.com if you would like to know more.

This article was written by Ingrid McCleave and the law is correct as at 24th November 2020. Please note that tax legislation changes frequently, so this article should not be relied upon without seeking further legal advice.