Savings income in the UK is treated differently to other sources of income for tax purposes. Although it is aggregated with other income to ascertain the applicable tax rate, there is a separate starting rate of tax for savings income and different tax rates apply to dividend income. There are various ways in which taxpayers may make tax efficient investments to receive income free of tax, though some of these involve making investments that carry a greater level of risk.
When computing an individual’s tax liability for a year, the non-savings income is regarded as the lowest layer and savings income as the top layer. This means that where the non-savings income is at or above the £37,400 threshold for the higher 40% rate of tax (for 2010/11), the higher rate will apply to savings income. Otherwise, the 20% rate will apply.
There is a 10% “starting rate” for the first £2,440 of savings income in 2010/11, but this will only apply where taxable non-savings income is less than that amount. To determine if this starting rate applies, the taxpayer can set personal allowances first against non-savings income. The starting rate may be useful for pensioners who have some savings income in addition to their pension and can offset their annual personal allowance first against the pension income, leaving some savings income to be taxable at the 10% rate.
Taxation deducted from interest received
Individuals receive most bank interest income net of 20% basic rate tax. This applies not only to the interest received from banks and building societies but also to loan interest received by individuals from company debentures, and to the interest element received on a purchased life annuity. The only exceptions are interest on UK government bonds (gilt-edged securities) and interest on certain products from National Savings and Investment, such as a Direct Saver account, Income Bonds or an Investment Account. Interest on these is paid gross.
A person whose total income is likely to be below the level of their personal allowances in a tax year, so they do not expect to pay tax for a particular year, can apply to have their bank interest paid to them gross. A Form R85 must be completed and given to the bank. Taxpayers should remember that although the interest is received gross it should still be included on their tax return.
Taxation of dividends received
UK dividends (and foreign dividends, subject to certain conditions) carry a “tax credit” of one-ninth of the dividend received, so if a UK company pays a dividend of £90 this carries a tax credit of £10 and the gross dividend, subject to tax, is £100. However the tax credit is deductible from the tax payable on the dividend.
Dividends received that fall into the basic rate band for tax purposes are taxed on the individual at 10%, so the tax credit on such dividends will usually be enough to cover the tax payable. However if the tax credit exceeds the tax on the dividend (for example because the dividend is covered or partly covered by the annual personal allowance) it cannot be repaid to the taxpayer. Dividends that fall within the higher rate band are taxable at 32.5%, and the tax credit can be set against this tax liability. Individuals paying income tax at the new 50% rate pay tax on dividends at 42.5%.
Individual savings accounts
The most straightforward tax efficient savings mechanism is the Individual Savings Account (ISA). An ISA can be opened by anyone who is aged over 16 and resident or ordinarily resident in the UK. A person can open a “cash ISA” or a “stocks and shares ISA”. Each year, a person may invest in an ISA up to a defined limit which for 2010/11 is £10,200, of which up to £5,100 may be invested in a cash ISA. Interest and dividends on the funds within an ISA are exempt from income tax, and any capital gains arising (for example in a stocks and shares ISA) are exempt from capital gains tax.
A person can withdraw funds from an ISA without losing the tax relief already given, but cannot add more than the maximum amount to the ISA each year even if some funds are withdrawn. Funds can be transferred from cash ISAs to stocks and shares ISAs without any effect on the amount that can be invested in the ISAs in the year.
Other tax efficient investments
An individual who subscribes for shares in a venture capital trust can receive tax relief of 30% on investments up to £200,000. The income of the venture capital trust is tax exempt, and no capital gains tax charge arises for the individual on disposal of the shares, however the shares must be retained for at least three years to qualify for the tax benefits. The venture capital trust invests in small companies and these are a high risk investment.
An individual subscribing for shares in a company that qualifies for the Enterprise Investment Scheme (EIS) obtains tax relief at 20% on the amount of the investment (up to £500,000). A capital gain on the shares is exempt, while a capital loss is allowable to offset against taxable income as well as capital gains. A taxpayer can defer capital gains on other assets by rolling them over against the EIS shares. Qualifying companies are small trading companies and the investments carry high risk. To qualify for the tax relief the shares must be held for at least three years.
Community investment tax relief allows tax relief of 5% a year for up to five years on an investment in a community development finance institution, which invests in social enterprises. These are also generally high risk investments.
HM Revenue and Customs www.hmrc.gov.uk
National Savings and Investment www.nsandi.com
“Taxation” by Alan Melville, fifteenth edition, FT Prentice Hall, 2010