Taxation is one of the most complex and important topics that underpins much of financial planning – and it’s the topic that causes most consternation for those studying for their exams. Angelo Kornecki, technical director Redmill Advance provides some pointers in key areas where candidates can trip up.
Tax is tested across multiple papers of the diploma and advanced diploma modules. It can seem complicated, but mostly it is about following a process or set of rules. Writing these down, drawing them out on mind maps, creating tables and lists, or having examples written down on cue cards can help bring them to life. Once you know the rules, you should be well on your way to exam success.
Here we examine a few of the areas that typically cause confusion or trip up students.
Chargeable gains on non-qualifying, onshore, life policies, such as single premium life assurance bonds, are subject to higher or additional rates of income tax, not capital gains tax (CGT).
Onshore bonds are taxed internally at 20% so, once the gain is added to other taxable income, if the person remains a basic-rate taxpayer, there is no further tax to pay.
If, however, the gain takes them into a higher- or additional-rate tax band, there may be further tax to pay. This is where we can use top slicing.
Top-slicing relief aims to reduce the tax liability for someone who, if it was not for the chargeable gain, would be in a lower tax bracket. The general principle is to make it a little fairer and allow gains from bonds to be spread over a number of years.
One area of confusion is around how spreading works, and the number of years you divide the gain by. In the calculation below, this value is ‘N’.
For full surrenders of both onshore and offshore bonds, the N value dates back to the start of the bond.
For partial surrenders of onshore bonds, the N value is usually the number of years back to the last chargeable event. If there have been no chargeable events, it dates back to the start of the bond.
For partial surrenders of offshore bonds, it depends on when the bond was set up. Before 6 April 2013, the N value is the number of full years back to the start of the policy. After 6 April 2013, it depends on the residency status of the individual.
The final thing to remember is the process of calculating the tax liability on full surrender of a bond using top-slicing relief. It is the same for both onshore and offshore bonds.
Follow these steps to calculate tax liability
- Calculate the tax liability on the total taxable income for that tax year, including the gain.
- Work out the tax on the gain based on the tax bands it falls into as you calculate step 1. Take off the 20% basic-rate tax classed as already paid. This leaves the additional tax that needs to be paid on the gain. This is called the individual’s liability.
- Calculate the sliced gain, known as the annual equivalent, by dividing the gain by N, the number of years.
- Calculate the tax liability on the sliced gain and deduct the 20% tax already paid. Multiply the answer by N to get total liability, which is called the relieved liability.
- Deduct step 4 from step 2 to find the
top-slicing relief. Use that to reduce the total income tax liability calculated in step 1. For onshore bonds, deduct the 20% basic-rate tax already paid on the gain. The result is the final tax liability.
Income tax also features in a number of exams. A common stumbling block is understanding how to calculate income tax.
First of all, make sure you read the question properly. If it states the person has taxable income, then this is income after considering the available allowances.
Income that falls within available allowances is not taxable. The first £12,500 of income falls within the current personal allowance (the allowance changes to £12,570 from April 2021).
Use this guide for calculating income tax
- Calculate gross income from all sources in this order:
• earnings, including pensions and income from rental property;
• savings income, but not chargeable gains from life assurance policies;
• chargeable gains.
- Deduct any reliefs from income, such as business losses or interest on a loan to invest in a partnership.
- Deduct the personal allowance. This is reduced for those earning more than £100,000 of adjusted net income, and lost completely at £125,000 or more. Extend the basic- and higher-rate tax bands if necessary, for example by the gross amount of pension contributions made via the relief-at-source method.
- Work out the tax on the income, using the extended tax bands if applicable.
- Finally, apply any tax reducers, such as a transferred personal allowance.
Employer pension contributions
Employer pension contributions are typically classed as a business expense. They can then be used to reduce corporation tax for limited companies or income tax for sole traders or partnerships by way of tax relief.
HM Revenue & Customs says a large contribution must be spread over a number of periods if the following applies:
• the contribution exceeds 210% of the contribution the employer made in the previous period (known as the chargeable period);
• the amount by which the contribution exceeds 110% if the previous contribution is £500,000 or more. This is known as the excess.
The spreading is based on the excess. When this is between £500,000 and £999,999, the tax relief is spread over two accounting periods, so divide the excess by two. If between £1m and £1,999,999, the relief is spread over three periods, so divide the excess by three. If £2m or more, divide by four.
Here is an example to see whether spreading should occur. Company X made a pension contribution of £700,000 during the last period. This year it makes a £2,000,000 contribution. Firstly, does the new contribution exceed 210% of the previous contribution? Let’s see: 210% x £700,000 = £1,470,000. As the new contribution of £2,000,000 is greater than £1,470,000, the first point has been met.
Residency has a bearing on the tax position of an individual across income tax, capital gains tax and inheritance tax
Now for the second. Is the amount by which the new contribution exceeds 110% of the previous contribution £500,000 or more? Let’s see: £2,000,000 – (£700,000 x 110%) = £1,230,000. This is more than £500,000, so spreading needs to occur.
The excess amount of £1,230,000 falls between £1m and £1,999,999, so it is divided by three, and a payment of £410,000 is given in each of the next three periods. The first is given in the current period, along with 110% of the previous year’s contribution, so in this case £770,000. The total relief is £1,180,000 in the current period.
This has a bearing on the tax position of an individual across all three of the main taxes – income tax, CGT and inheritance tax (IHT). There are two states of residency. A person is automatically resident if either:
• they spent 183 or more days in the UK in the tax year;
• their only home is in the UK – they must have owned, rented or lived in it for at least 91 days in total – and they spent at least 30 days there in the tax year;
• they work in the UK full-time.
A person is automatically non-resident if either:
• they spent fewer than 16 days in the UK in the tax year (or 46 days if they were not classed as a UK resident for the three previous tax years);
• they worked abroad full-time (averaging at least 35 hours a week) and spent fewer than 91 days in the UK, of which no more than 30 were spent working.
• It is also necessary to understand the difference between residence and domicile, as they determine the tax position of an individual and whether they are subject to UK taxation. There are several types of domicile: domicile of origin, domicile of choice and deemed domicile.
Residence nil-rate band
The residence nil-rate band (RNRB) is an additional nil-rate band for IHT, currently £175,000, which is on top of the standard nil-rate band of £325,000. It is used to offset some of the value of a main residence but not buy-to-let or second properties, lifetime gifts or the remaining estate.
RNRB can only be used if the property is left to a direct descendant – a child, stepchild, adopted or foster child – or a direct lineal descendant, such as a grandchild.
The RNRB cannot be used when passing the main residence to a spouse or partner, as they are not classed as a direct descendant.
Like the standard nil-rate band, the RNRB can be transferred to a spouse or civil partner, giving a total of £350,000 (£175,000 x 2) on second death subject to the direct-descendant rule.
The RNRB can only be used to offset the net value of the property, after deducting any mortgage. If the property is worth £250,000 after deducting the mortgage, then only £250,000 of the RNRB can be used. The remaining £100,000 cannot be used against the rest of the estate.
The RNRB is reduced or tapered for estates that have a net value of £2m or more. It is reduced by £1 for every £2 of value above the £2m threshold.
Redmill Advance is a learning provider and e-learning specialist offering CII and CISI exam support.