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Scottish budget: Implications of UK income tax variation

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2nd Jan 2018
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Last week, Derek Mackay, the Scottish finance secretary, published a draft Budget for Scotland that included proposals for significant changes to income tax for Scottish taxpayers.

The Scottish Parliament has had limited powers to vary income tax for several years but did not use them until 2016-17 when the Scottish rate of income tax (SRIT) was introduced and HMRC put procedures in place to identify, collect and pay over the income tax collected. However, by setting SRIT at 10%, the same amount that standard tax rates had been reduced by for Scottish taxpayers, the net result was no different from income tax rates in the rest of the UK (rUK).

In 2017-18, having gained powers to vary the tax bands themselves, the Scottish Parliament decided to freeze the higher rate threshold and to leave other figures aligned with the rest of the UK. Perhaps it was only testing the waters with such a modest variation in preparation for the 2018-19 proposals that vary nearly all the parameters and introduce two new taxable earnings bands.

Full details of the new rates and bands, and the comparative winners and losers, are covered elsewhere. This article reviews the implications of having different income tax rates and thresholds across the UK both for employers and for pension providers.

Implications for employers

Because Scottish taxpayer status is determined by whether the individual’s main residence during a tax year is in Scotland and has nothing to do with the location of the employer, any employer in the UK could have both Scottish and rUK taxpayers within its payroll at any time. When individuals move across the border in the latter half of a tax year, they will take their status with them to a new employer (assuming no previous relocation).

Scottish income tax variation has the potential to affect all employers, regardless of size and location within the UK. And therefore, it can also affect their agents and payroll bureaux. This affects a number of areas.

Tax calculations

In terms of the payroll calculation, employers should only have to ensure that employees’ tax codes are entered into their payroll systems correctly (and that their system has the required functionality). HMRC identifies Scottish taxpayers and handles any queries about tax codes.

Scottish taxpayers will need to be identified as such before making ad hoc tax calculations when handling employee’s queries or ‘grossing up’, for example, as well as when testing payroll system outputs following an upgrade. Payroll staff will need to be comfortable handling the slightly more complicated calculation: it is the same method but with additional steps to handle all the bands.

HMRC’s tax tables will also change. In previous years, it has published Scottish versions of Tables B to D within the standard booklet; they mostly contained the same values. From April 2018, there will be extra Scottish tables for the additional earnings bands.

PAYE Settlement Agreements

Employers who have PAYE Settlement Agreements (PSAs) with HMRC, whereby the tax due on specified benefits is borne by the employer rather than the employee, must already ensure that their recordkeeping identifies Scottish taxpayers separately in the calculations. These calculations will be made more complicated by next year’s changes.

National Insurance contributions

The Upper Earnings Level (UEL) for National Insurance contributions (NICs) matches the higher rate threshold for income tax in rUK – not the Scottish one – because NI is not a devolved matter. That the higher rate threshold for Scottish taxpayers differs from UEL is more an inconvenience than a technical issue; NICs and income tax must always be calculated separately for other reasons.

Employer Supported Childcare

Another area that the higher rate threshold affects, but which is not devolved to Scotland, is the basic earnings assessment for Employer Supported Childcare. This annual assessment involves comparing anticipated annual earnings against the rUK tax bands to identify the maximum values of tax-free childcare support that an employee can have (typically childcare vouchers).

Employers must ensure that the earnings of Scottish taxpayers are assessed against the rUK higher rate threshold and not against the Scottish threshold.

Implications for pension providers

Individual taxpayers are entitled to income tax relief on their contributions to registered pension schemes so, now that tax rates can vary across the UK, the amount of tax relief available can vary, too.

Pension schemes that use the relief at source method for providing tax relief do so by claiming the tax relief due on individuals’ pension contributions from HMRC and adding it to the individuals’ pot. Relief is claimed at the basic rate and taxpayers with a higher marginal rate can claim any further tax relief from HMRC through Self Assessment.

When the Scottish and rUK tax basic tax rates diverge, RAS pension scheme administrators must claim a different amount of tax relief for scheme members who are Scottish taxpayers than they would for rUK taxpayers. Therefore, pension scheme administrators need to identify the tax residency status of all their scheme members.

To avoid this administrative burden, the government agreed that providers could continue to claim RAS at the rUK basic rate for all scheme members from April 2016 until April 2018, irrespective of any difference between the Scottish and rUK basic rates. HMRC would have made any necessary adjustment through the Self Assessment process or through PAYE coding but, because the basic tax rates have remained aligned, this has not been necessary.

This two-year relaxation ends from April 2018 and pension scheme administrators will have to claim the appropriate rate of tax relief from HMRC for each member. Under the proposals, the basic rates continue to be aligned; nevertheless, administrators must ensure that they have identified which members are Scottish taxpayers. In January 2018, HMRC will send a residency status report to scheme administrators who had sent an annual return of individual information by 30 September 2017 so that they can update their records.

The report will have an extra field for residency tax status that will show ‘S’ for Scottish taxpayer status, ‘U’ for an unmatched record and will be blank for rUK taxpayers.

Pension scheme administrators who do not receive a residency status report must use the rUK rate for all members for the 2018-19 tax year, unless they use the residency tax status lookup service (currently under development).

Draft regulations have been published that change the administration of tax relief at source with effect from the 2017-18 tax year. The deadline for submitting the annual return of individual information will move to 5 July, three months after the end of the year of assessment.

It will also be made a statutory return. Administrators will have to submit the annual claim for repayment by the same deadline and there are procedural changes and interest charges for excessive interim claims. Comments on the draft regulations can be submitted here  by 31 December 2017.

Implications for payroll software providers

Employers rely on their payroll systems to handle changes in tax calculation and the proposed changes in Scottish income tax will be no different. Although the changes seem dramatic, the introduction of new taxable bands is likely to involve additional entries in a few tables of parameters rather than underlying programming changes (plus a great deal of testing, of course). The calculation method itself does not change but some steps will be repeated.

It may seem as if these changes have come out of the blue and that software developers will have insufficient notice to implement the necessary changes. The Scottish government’s discussion paper on the options for income tax changes was only published a few weeks before the draft Budget but there were early indications that significant changes were likely. Last year’s Budget negotiations indicated the strength of opposition parties and their often progressive tax positions – it was perhaps inevitable that income tax policy would need addressing in order to gain parliamentary approval for next year’s Scottish Budget.

Another possible area of concern is their provisional nature. The Budget bill must be laid before the Scottish parliament by 20 January and must be completed by 14 February, which is only weeks before the start of the tax year. However, it is more than likely that representatives of software developers will have been encouraged, in talks behind the scenes, to treat the proposals as near definite, with no need to wait until ratification. It is barely credible that such major changes would be proposed, for implementation so soon, if this were not the case.

Employers, agents and bureaux across the UK should start talking to their software providers now to find out what plans are in place for implementing the changes in April, regardless of whether there are currently Scottish taxpayers on the payroll. It seems unlikely that any payroll software provider would take the risk of deciding not to be compliant with the Scottish income tax regime, but some may charge for the extra functionality.

The CIPP is running a quick poll on its website to gauge how many people believe their existing payroll software will cope with the changes. Perhaps understandably, barely a week after the draft Budget, 51% the respondents said they did not know, while 37% said that it would be ready and the remaining 12% said that it would not.

Conclusion

The Budget bill’s progress through parliament will be keenly watched to see how much the proposals will change, if at all, before they are ratified. Software developers and HMRC will be poised to complete the changes to their systems and associated publications. Employers who have Scottish taxpayers must be ready, too, because there will be little time between software updates and the start of the tax year for testing and staff training.

Either way, employers and payroll systems will have to get used to these changes fairly quickly because Welsh income tax divergence is just around the corner; April 2019 to be precise. And – naturally – the Welsh Assembly’s powers differ from those granted to Scotland. It does not have the power to vary the number of tax bands or the thresholds, but it will be able to vary the three tax rates independently. (It has committed itself to not raising tax rates for the duration of the current Assembly, May 2021).

And what of the future? While Scotland’s system has only modest rate changes for 2018-19, the ground has been laid for future incremental changes that could result in sizeable variation in the treatment of higher taxpayers on either side of the border, in particular. But maybe, as soon as it is free of its statutory tax lock, the UK government will aim to follow suit.

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By neiltonks
02nd Jan 2018 14:11

I think all commercial payroll products will be ready for the start of the tax year - changes to rates and thresholds are something all developers deal with every year at around this time.

The impact might not be entirely limited to new values in tables, though. A consequence of the change is that next year there are three "D" tax codes, but only in Scotland! So we have codes SD0, SD1 and SD2 for Scottish taxpayers, but only D0 and D1 for the rest of the UK. Therefore system validations will have to change to allow for this.

Let's hope that there are no difficulties getting parliamentary approval, though - the change of mind over the 40% threshold for the current tax year caused everyone a load of extra work we could have done without!

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By Donald Drysdale
03rd Jan 2018 15:22

I note what you say, neiltonks, but I wonder whether software developers may find themselves facing unexpected new problems. In the UK we've become accustomed to Budget proposals being enacted without change. However, remember that there are minority administrations in both London and Edinburgh. If the DUP were to withdraw their support at Westminster, or the Scottish Greens were to waver in their support at Holyrood, substantial changes to proposed rates and thresholds might be made at the last minute. For example, how would software developers cope if the Scots were to announce in mid-February that they will change to a six-band regime instead?

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Replying to Donald Drysdale:
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By neiltonks
03rd Jan 2018 15:49

We'd deal with it, like we did last year when the Scottish Parliament changed its mind about the 40% threshold for the current tax year, on the 21st of February. It might involve a lot of stress and midnight oil but that goes with the territory when you work in an area which is very legislation-driven.

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By Donald Drysdale
03rd Jan 2018 15:09

Thanks, terribethel. A very useful article which raises a lot of interesting points.

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