Any Answers Answered: Use of personal allowance

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In a special Any Answers Answered video this month Giles Mooney and Tim Good tackle an issue that is asked time and time again on AccountingWEB.

The TAXtv hosts explain the “minefield” that is the allocation of the personal allowance, the interaction of interest of dividends and of earnings.

In the video below Tim Good explains that if an individual has multiple sources of income, the first thing to do is allocate them to the rate bands, ignoring any allowances or reliefs, to the basic rate, higher rate and additional rate.

Good said you allocate first non-savings income (first to basic rate, higher and then additional), followed by the savings income which can be broken into two (interest which is the first part of the savings and then finally dividends). Nothing has changed here, he said.

However, the issue then is the offset against the different types of income of the personal allowances and any other reliefs that go against general income.

Good said: “But of course many taxpayers will have qualifying interest if a director had borrowed money to invest in shares in the company, or a partner borrowing for the business, or there may be sideways loss relief, anything that is available against general income will be added together with the personal allowance.

“And the allowances and reliefs have for a very long time under section 25 of the Income Tax Act 2007 been able to be offset in the way most favourable to the taxpayer,” he added.

Good said it was easy to assume that the allowances and reliefs should be offset in the same hierarchy against non-savings income, savings and then dividends, but the complications introduced by George Osborne in the form of the personal savings allowance and the dividends tax allowance, mean that in a large number of cases it is not advantageous to offset the allowances and reliefs in that order.

Watch the video below to find out the various complications on this topic and whether it’s better to set them off against dividends in priority to non-savings income and interest.

Giles Mooney also recently gave AccountingWEB a couple of examples to illustrate the issue for 2016/17.

Example 1

Salary £38,000, dividend £10,000

The obvious way to do it is salary minus personal allowance leaves £27,000 taxable at 20%

£5,000 dividend at 0%

Final £5,000 dividend taxed at 32.5%. Total bill £7,025.

...but

Personal allowance of £6,000 against salary and £5,000 against dividend leaves:

£32,000 of salary taxed at 20%

£5,000 dividend at 0%

Total = £6,400 saving £625

Example 2

£11,000 savings, £11,000 dividend

Rather than using the personal allowance against the savings, leaving dividend to be taxed at 7.5% (after the first £5,000), the total bill is £450.

Use the personal allowance £6,000 dividend and £5,000 savings. Then you’re left with £5,000 dividend and £6,000 savings.

You must tax that savings then dividend (after the personal allowance) so the £6,000 interest is covered by the starting savings rate band and the personal savings allowance and then £5,000 dividend at 0% (first taxable £5,000 dividend)

 

For the latest episode of TAXtv visit PTP Interactive. TAXtv is a monthly tax update programme available as an annual subscription from £199, (11 issues plus special editions) to view online, download from the internet or watch on DVD.

About Robert Lovell

Business and finance journalist

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    avatar
    17th May 2017 10:57

    so much about tax simplification!!

    Thanks (0)
    17th May 2017 11:04

    Does SA software allow you to choose which order the PA is allocated?

    I don't think the HMRC SA software does - and that's what many small sole traders accountants use.

    Thanks (0)
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    to buttercup books
    17th May 2017 11:36

    It doesn't - but it appears to try to optimise the allocation of PA itself.

    With bizarre results!

    Thanks (0)
    avatar
    17th May 2017 11:15

    I understand the allocation of allowances etc but how do you actually put this into practice?

    Any taxation software i have seen doesn't have the ability to do this and neither does the HMRC tax calculation.

    Thanks (0)
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    By Ammie
    17th May 2017 11:29

    Very interesting.

    Highlights the dangers of using software that calculates everything automatically and does not always allocate in the most beneficial way, which until Osborne's brainstorm was set out in a clear order.

    Well worth keeping an eye on how software tackles this and more importantly if deeper interaction is required to gain the optimum result.

    Admittedly, I have fallen in the trap of accepting the allocation order as gospel, clearly not the case. Something to investigate further.

    Thanks (0)
    avatar
    17th May 2017 12:32

    If this is correct, example 1, is at odds with all my calculations to date!?

    Furthermore it is at odds with the HMRC example 6, hence confused!!

    https://www.gov.uk/government/publications/dividend-allowance-factsheet/...

    Thanks (1)
    avatar
    By Pygmy
    17th May 2017 13:10

    Calculation 1. (if correct) would be the result of a strange definition/application of the £5000 dividend allowance such that the discounted £5000 of dividend is still pushing subsequent dividend income into higher tax bands

    The saving of £625 (12.5% times £5000) results from moving the remaining £5000 of formerly dividend income below the discontinuity that appears to have been introduced in the income tax calculation.

    Thanks (1)
    avatar
    17th May 2017 13:12

    Just tried it in IRIS with £40k salary and £32k dividends for 16/17 and it DID do it in the fashion described at Example 1 above i.e.....

    Salary £40k less PA £8k = £32k @ 20%
    Divi £32k less PA £3k less £5k tax free = £24k @ 32.5%

    The point is by using less PA against salary, there is additional tax at the BR of 20% as a result. However, this PA not used (£3k here) then goes against divis that otherwise are taxed at 32.5%. So the saving doing it this way is the £3k @ 12.5% = £375.

    Thanks (0)
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    to andrew1211
    17th May 2017 14:26

    So why didn't IRIS allocate all of the PA to the dividends?

    Thanks (0)
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    to emanresu
    17th May 2017 14:48

    The tax would have risen

    Thanks (0)
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    to andrew1211
    17th May 2017 15:59

    Good point!

    Thanks (0)
    avatar
    By Ammie
    17th May 2017 16:02

    Have I missed something here. I have looked into it and I cannot see anywhere giving licence to a free allocation. It still appears to be in a prescribed order.
    Please point me to the authority. It all seems too charitable from HMRC.

    Thanks (0)
    avatar
    to Ammie
    17th May 2017 16:30

    It's true. I can't remember the specific legislation but have a look at the second paragraph of section 5 of https://www.gov.uk/government/uploads/system/uploads/attachment_data/fil...

    "... If it's more beneficial to move deductions and allowances to dividends in the higher rate range to increase tax at the basic rate, but reduce tax at the higher dividend rate ... Overwrite the amounts in the middle column to deduct the reliefs and allowances in the way which will result in the greatest reduction in your liability to Income Tax."

    Thanks (4)
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    By Ammie
    to emanresu
    17th May 2017 17:45

    Well blow me down. I am speechless.
    Now I will need to fathom out how to do this correctly on the software, where it doesn't calculate this way.
    The mind boggles how many taxpayers will be overpaying and how many accountants will miss the opportunity.
    Thank you for the pointer, greatly appreciated.

    Thanks (0)
    avatar
    By ShayaG
    17th May 2017 16:33

    As a point of principle, I think this is just plain wrong. Surely the tax you pay should be a function purely of your income, and not of how good you are at recording *exactly* the same substantive income on a tax return! Genuinely bothered by all those filling in their own online SA returns who will loose out here.

    Thanks (1)
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    to ShayaG
    17th May 2017 16:56

    ................

    Thanks (0)
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    to ShayaG
    17th May 2017 16:52

    That's a valid view - write to your MP.

    By the way, if you really want to flatten the playing field - don't forget to ask your MP to campaign for reducing taxable savings income tax to compensate for the effect of inflation.

    [based upon yesterday's inflation data, a basic-rate saver would need an interest rate of 4.4% just to keep up with RPI]

    Thanks (0)
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    By raycad
    17th May 2017 18:05

    It wasn't that long ago that HMRC were running an advertising campaign with the strapline "Tax doesn't have to be taxing". Yes, indeed - thank God we don't have to hear it right now!

    As an aside, it's all very easy to pin the blame on George Osborne for this state of affairs but I'll bet an pound to a penny that he merely rubber-stamped a "cunning plan" that was put to him by senior Revenue officials. HMRC have form in this area. Remember the hideously complicated methodology brought in to cap pensions tax relief about 6 years ago? Not to mention the fiasco-like Nil CT starting rate band, back in Gordon Brown's day. Plus ca change and all that!

    Thanks (0)
    17th May 2017 19:34

    I first became aware of this issue last December and I noticed that none of the tax software allocated the personal allowances in the most tax efficient manner. I have recently checked Taxfiler and it DOES now take Tim Good's advice into account, so as to generate a lower tax liability. I've yet had a client with the right mix of income to enable me to test whether HMRC will accept the calculation, but at least the submitted calculation is correct.

    The example I tested was salary of £40,000 and dividends of £9,000 in 2016/17. Using the personal allowance in the traditional way would lead to a tax liability of £7,100
    i.e. £29k (£40k salary less £11k PA) @ 20% plus £4k (£9k divis less £5k all'ce) @ 32.5%

    Taxfiler now limits the amount of PA allocated to salary such that the taxable salary is at the upper limit of basic rate and the tax liability then falls to £6,725
    i.e. £32k (£40k salary less £8k PA) @ 20% plus £1k (£9k divis less £5k all'ce less £3k PA) @ 32.5%
    This moves £3,000 from the 32.5% to the 20% band, saving 12.5% on £3,000; i.e £375.

    Thanks (2)
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    to charliecarne
    14th Jun 2017 16:46

    charliecarne wrote:

    Taxfiler now limits the amount of PA allocated to salary such that the taxable salary is at the upper limit of basic rate and the tax liability then falls to £6,725
    i.e. £32k (£40k salary less £8k PA) @ 20% plus £1k (£9k divis less £5k all'ce less £3k PA) @ 32.5%
    This moves £3,000 from the 32.5% to the 20% band, saving 12.5% on £3,000; i.e £375.

    Just as a matter of interest, how long did Taxfiler take to produce that result. Instantly, seconds, ... ?

    Thanks (0)
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    14th Jun 2017 14:18

    A very good article on a tricky subject, we have ended up in a very bad palce.

    How do we find a way out.... OOOhh i was waiting for George Osborne's name to pitch up, it did not take long.

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