Tax on savings and dividends - more complexity

From Taxation 3rd May 17

IN SUMMARY

• £5,000 savings starting rate of 0% available if non-savings income does not exceed combined amount of the personal allowance and £5,000.
• Basic rate taxpayers can receive up to £1,000 of interest tax free, while those on the higher rate can receive up to £500.
• All taxpayers can receive up to £5,000 of dividends annually at 0% rate of tax, falling to £2,000 from 6 April 2018.
• Trading and property allowances of £1,000 each available from 6 April 2017
• HMRC software is not coping in some cases when savings and dividend income is received.

In the past few years the government has attempted to reduce the tax burden. These changes have not only reduced the tax bills for many individuals, but in some cases they have taken the taxpayer out of self assessment.

Starting rate for savings

In the 2014 Budget, the government announced that it would cut the starting rate of tax for savings income from 10% to 0%. At the same time, the starting rate band was increased from £2,880 to £5,000. These changes were legislated for in FA 2014 and came into force on 6 April 2015.

The types of savings income affected include not only bank or building society interest but also interest from unit trusts, gilts, purchased life annuities and corporate bonds. The usual tax exemptions covering interest from individual savings accounts (ISAs) still apply.

The starting rate of £5,000 does not mean that the first £5,000 of interest received by a taxpayer is tax-free. The personal savings allowance and a person’s entitlement to it depends on the level of non-savings income. This comprises income from employment, self-employment, pension and rents and is subject to income tax before savings and dividend income.

The starting rate for savings is available to the extent that the non-savings income of the taxpayer does not exceed the combined amount of the personal allowance and the £5,000 savings starting rate. For 2016-17, this will be £16,000 when the personal allowance is £11,000. So, if an individual has pension income of £12,000 in 2016-17, ignoring the personal savings allowance for now, they would be entitled to receive £4,000 of interest at the savings starting rate of 0%. Any interest above that amount will be subject to income tax at the rates applied to non-savings income.

Personal savings allowance

After the introduction of the 0% starting rate for savings, the personal savings allowance was introduced in FA 2016 and came into force on 6 April 2016. Since then, bank and building societies have no longer required to deduct 20% tax at source on interest. These measures, coupled with the £5,000 starting rate of savings, have resulted in many savers no longer paying any income tax on their savings income, especially given the low interest rates.

The personal savings allowance is available only to basic and higher rate taxpayers – not those on the additional rate. A basic rate taxpayer is entitled to receive up to £1,000 and one on the higher rate up to £500 of interest tax-free. The allowance is not a deduction but provides for a zero rate of income tax on the relevant income. It is applied before considering the 0% starting rate for savings. When interest is received in a joint account owned by spouses or civil partners, interest is still split equally and each person will need to account for half of the interest towards their own personal savings allowance. If one spouse is a basic rate taxpayer and the other is on the higher rate, 50% of the interest will go towards the basic rate taxpayer’s personal savings allowance of £1,000 and the rest will go towards the other’s personal savings allowance of £500.

Whether a taxpayer is a basic or higher rate taxpayer for these purposes depends on their adjusted net income. Adjusted net income is defined in ITA 2007, s 58 as, broadly, total taxable income less deductions for gift aid and personal pension contributions (both grossed up) plus relief for payments to trade unions or police organisations.

When calculating total interest for the personal savings allowance, foreign interest is included unless it is relevant foreign income for the remittance basis.

As a result of the introduction of the personal savings allowance, a taxpayer could earn up to £17,000 tax free in 2016-17 (£11,000 personal allowance, £1,000 personal savings allowance and £5,000 savings starting rate). Those who do have tax to pay on their savings income will be able to settle theis either through self assessment or an adjustment to their tax code.

It is worth bearing in mind that a taxpayer who has dividend income taking them into the higher rate (as many directors running limited companies do) will suffer more tax as a result of earning interest.  This is because the interest pushes the dividend income (the top slice of income) from the basic rate of 7.5% into the higher rate of 32.5% - an effective rate of 25% on the interest that was perhaps thought by them to be tax free.

Dividend allowance

As one of the tax measures introduced to help savers, the dividend allowance was also introduced in FA 2016. From 6 April 2016, a taxpayer could receive dividends of up to £5,000 a year. However, the allowance is set to fall to £2,000 from 6 April 2018, as announced in this year’s Budget. The other change affecting dividends from 6 April 2016 was the abolition of the longstanding 10% tax credit.

As with the personal savings allowance, the dividend allowance is not a deduction; instead, a zero rate of tax applies to the relevant income. Above this amount, dividends in the basic rate band are subject to income tax at 7.5%, 32.5% at the higher rate and 38.1% at the additional rate.

When added to the savings allowances, a taxpayer in 2016-17 could earn up to £22,000 tax-free (£11,000 personal allowance, £1,000 personal savings allowance, £5,000 savings starting rate and £5,000 dividend allowance).

Foreign dividends are covered by the dividend allowance unless they are relevant foreign income for the remittance basis. Dividends received from shares held in ISAs and pension funds will continue to be free from tax.

Kevin and Martin demonstrate how these measures work for a basic rate and higher rate taxpayer.

Conclusion

It is a matter for concern that HMRC’s systems are not correctly geared up for these changes. Two instances have been identified in which the software does not correctly calculate the personal savings allowance and the dividend allowance.

The first is when non-savings income does not exceed the personal allowance and the starting rate for savings, and savings income is not entirely covered by the personal savings allowance. In this instance, the software does not give the starting rate for savings.

The second affects higher rate taxpayers with dividend income. In these cases, the higher rate band is incorrectly reduced by the £5,000 dividend allowance rather than the amount of the allowance not used in the basic rate band.

The solution provided by HMRC in both instances is for the taxpayer to file a paper tax return. If this cannot be filed by 31 October after the tax year ends but is by 31 January, HMRC will not issue late filing penalties as long as a reasonable excuse claim is submitted with the return and the submission of the paper return accords with the recommended workaround.

Such errors will not fill the profession with confidence – given HMRC’s plans for Making Tax Digital – and it is hoped that they can be resolved quickly.