University of PortsmouthPersonal Finance for Accountants

(U13763)

Lecture 6 Personal Taxation

Lecture 6 Personal Taxation

• Principals of Taxation

• Tax Evasion, Avoidance and Mitigation

• Personal Tax Allowances and Exemptions

• National Insurance (NI)

• Capital Gains Tax

Principals of Taxation

• One of the earliest and still influential writers on the subject of taxation is Adam Smith. In his ‘The wealth of Nations’ (1776) he laid out his principals for a fair taxation system. He had four principals, these he referred to as ‘maxims’ and today these are described as Adam Smith’s four Canons (codes of law) of Taxation.

• These four principals can be summarised as: equity, certainty, convenience and efficiency.

Principals of Taxation

1. Equity - that individuals should pay taxation in proportion to their income.

2. Certainty - that the method and the amount of the tax payment should be unambiguous.

3. Convenience - easy for the tax payer to make the payment.

4. Efficiency - it should be cost effective to collect the tax.

Principals of Taxation

• In the UK the tax free allowance called the personal allowance keeps the poorest people out of the tax system altogether and then there is a scale of taxation rates where the richest people paying the highest rate of tax.

• Most people pay their income taxes directly through deductions made via their employers payroll. This is a very convenient and cost effective way of collecting taxes.

Tax Evasion, Avoidance and Mitigation

• Our goal in Personal Finance is to be tax efficient. To do this we need to be aware of all tax allowances and exemptions that are available to us. We should chose our investments and savings products taking into account those schemes that keep our interest earned and any capital gains away from taxation.

Tax Evasion, Avoidance and Mitigation

• In pursuit of this goal we need to understand the following definitions:

• Tax Evasion - this is were you deliberately omit some income from your tax return or you have understated it. This is considered a criminal act the penalty for which is a fine or imprisonment.

Tax Evasion, Avoidance and Mitigation

• Tax Avoidance - This is working within the law using any tax loopholes that are available. A Tax loophole is an opportunity to save tax, this may be short lived as the Inland Revenue may close it down.

• Mitigation - This is tax saving that is encouraged by the Government for example putting your savings in a tax free ISA.

• Any tax planning should recommend tax mitigation.

Personal Tax Allowances and Exemptions

• Personal Taxation is administered by the government department called HM Revenue and Customs. It collects taxes through a number of different sources but one of the major sources is directly through a companies payroll in a scheme called PAYE (pay as you earn). The tax is deducted at source by your employer and then passed on to the Revenue.

Personal Tax Allowances and Exemptions

• The other major system for collecting taxes is though the annual tax return. This is aimed at those who are self employed or for those in employment who are higher rate tax payers or have additional sources of income.

• The tax return must be sent to the revenue and the tax paid by 31st January each year or a late fee will be charged.

Personal Tax Allowances and Exemptions

• Each year every one will received a tax free amount ( a personal allowance) currently £6,035 (over 65s get a higher personal allowance).

• After this has been deducted from your income what is left is known as taxable income.

Personal Tax Allowances and Exemptions

• This taxable income is subject to the tax rates detailed below.

Taxable Income (£) Rate of Tax0 - 34,800 20%34,801 40%

• Taxable Income will consist of :

IncomeLess Relief'sLess Personal Allowance.

PAYE Example

• Jessica Jones has income from employment of £20,000. She pays £1000 into an occupational (company) pension scheme. The Personal Allowance for the year is £6,035.

What is her taxation liability?

PAYE Example

Taxable IncomeIncome to be assessed for the purpose of tax can come from several

sources and includes the following:

1. Income from employment or self employment and will include salary, tips, bonuses, fringe benefits (e.g. private health cover) and business profits.

2. Rent from letting out property.3. Income from investments such as interest and dividends.4. Pensions (state, occupational and private).5. Social security payments e.g. Job seekers allowance6. Casual, occasional or miscellaneous income e.g. Freelance earnings.7. Income from a trust.

Non Taxable Income

1. Loans2. Presents and gifts3. Lottery prizes4. Gambling winnings5. Proceeds from selling assets (unless trading)6. Maintenance from former spouse.7. Money you inherit.

Rates of Taxation

Rates of TaxationNote 1 - savings income that falls within the £2,320

starting rate Income Tax band is taxed at 10 per cent

BR - Basic rate currently 20% HR - Higher rate currently 40%

* Non tax payers can have interest paid gross.

** Non tax payers can claim back tax deducted

Understanding your Tax Code

• Your tax code will consist of 3 numbers and a letter e.g. 603L

• The number represents the amount of tax free allowance that you have but you need to add to extra digit so in this example it is £6,035 (the basic personal allowance).

• The letter represents additional tax information, L is the most widespread code and means that you just get the basic tax allowance.

Understanding your Tax Code

Rent a Room Scheme

• A useful tax free source of income is the rent a room scheme.

• In 08/09 you can rent out a furnished room in your own home and receive income tax free up to £4,250 per annum,

National Insurance

If you're employed:• if you earn above £105 a week (the 'earnings

threshold') and up to £770 per week you pay 11 per cent of this amount as 'Class 1' NICs

• you also pay one per cent of earnings above £770 a week as Class 1 NICs

• you will pay a lower amount as an employee if you are a member of your employer's contracted out pension scheme (currently a rebate of 1.6%).

Capital Gains Tax

• When we sell an asset and it has increased in value we create a capital gain and this maybe subject to capital gain tax (CGT). The largest capital gain that we may experience is when we sell our own home. This gain is exempt from CGT because it is classified as our primary private residence (PPR). We can only have one PPR and so if we have a second home this will be subject to CGT.

• Other assets that may be subject to capital gains are shares, unit trusts, land and antiques.

Capital Gains Tax

Exemptions to CGT in addition to your PPR include:• Private car, • Personal Belonging (known as chattels) sold for less

than £6,000.• ISAs & PEPs

There are relief's and allowances to reduce the tax liability of capital gain. Each tax payer has an annual GCT exemption (08/09 £9,600) and so sales of shares for example can be timed to keep below this annual exemption limit. Taxable gains are charged at a rate of 18%.

Seminar Work

1. End of chapter MCQs

2. (a) Lisa Simpson has just graduated and is now in employment where she earns £18,000 per year. She will pay £750 into an occupational (company) pension scheme. The Personal Allowance for the year is £6,035. What is her 08/09 taxation liability?

(b) Charles M. Burns a company executive has income from his employment of £45,000. He will pay £2000 into an occupational (company) pension scheme. The Personal Allowance for the year is £6,035. What is his 08/09 taxation liability?