Higher skills

This article is relevant to those of you sitting the TX-UK exam in the period 1 June 2022 to 31 March 2023, and is based on tax legislation as it applies to the tax year 2021–22 (Finance Act 2021).

You can expect to see questions set at TX-UK which focus on higher skills. Typically, such a question will cover more than one syllabus area or more than one tax, bridging the gap between TX-UK and ATX-UK. However, where a question covers more than one tax you will be given clear guidance notes as to exactly which taxes you need to consider.

Income tax, corporation tax and national insurance contributions (NIC)

A typical scenario might be consideration of whether an individual should operate as a sole trader or trade via a limited company. The following example is much longer and more detailed than could possibly be set as an exam question, but it does cover several possible scenarios.

EXAMPLE 1
Newt is going to commence self-employment on 6 April 2021, but is unsure whether to run his business as a sole trader or to trade via a limited company, Amphibian Ltd.

In either case, Newt’s tax adjusted trading profit for the year ended 5 April 2022 will be £100,000 (before taking account of any director’s remuneration or employer’s class 1 NIC if trading via a limited company).

If Newt trades via a limited company, then he is considering three alternative approaches to extracting profits from Amphibian Ltd:

• The entire profits will be withdrawn as director’s remuneration (after allowing for employer’s class 1 NIC of £11,055 (Amphibian Ltd is not entitled to the NIC annual employment allowance since Newt will be the sole employee)).
• The entire net of tax profits will be withdrawn as dividends (after allowing for corporation tax).
• Newt will pay himself gross director’s remuneration of £8,000 and dividends of £50,000. Amphibian Ltd will make a pension contribution of £10,000 into a company pension scheme on behalf of Newt, with the balance of the profits remaining undrawn within the new company.

Self-employment
Newt’s income tax liability will be:

·      Class 2 NICs will be £159 (52 x 3.05).

• Class 4 NICs will be:

Limited company – Director’s remuneration

• Newt’s income tax liability will be:

• Newt’s employee class 1 NICs will be:

• There is no corporation tax liability for Amphibian Ltd because the entire profits of the company have been withdrawn.

Limited company – Dividends

• There will be no class 1 NIC.
• Amphibian Ltd’s corporation tax liability will be £19,000 (100,000 at 19%).
• Dividends of £81,000 (100,000 – 19,000) will be paid to Newt.
• Newt’s income tax liability will be:

Limited company – mixed remuneration package

• Newt's income tax liability will be:

• There will be no class 1 NICs because the earnings of £8,000 are below the NIC lower threshold.
• Amphibian Ltd’s corporation tax liability will be:

Conclusion
The total tax and NIC cost under each alternative is:

The mixed remuneration package appears to be the most beneficial, although £16,420 (100,000 – 8,000 – 10,000 – 50,000 – 15,580) of Amphibian Ltd’s profits remain undrawn within the company. This is not an issue if profits need to be retained within the company (maybe to fund future capital expenditure), but otherwise distorts the comparison.

Also, Newt will not receive any benefit from the £10,000 pension scheme contribution until he retires. However, this approach to pension saving is more beneficial than Newt personally making contributions out of his taxed income.  The pension contribution reduces Amphibian Ltd’s taxable total profits (obtaining corporation tax relief at 19%) and there are no tax implications for Newt personally.

The total tax and NIC cost of a mixed remuneration package could be further reduced if Newt restricted his dividends to a level so that there was no 32.5% higher rate income tax liability, but this would mean retaining even more profit within Amphibian Ltd.

The following scenarios could all be examined based on what has been covered in example 1:

• Deciding whether an individual should operate as a sole trader or as a limited company.
• Deciding whether to incorporate a sole trader business.
• Deciding how much profit to extract from a limited company by way of salary compared with taking dividends.

A scenario need not necessarily relate to a single person, and could, for example, deal with the incorporation of a partnership.

To keep a question at the appropriate length, you will often be given some aspects of the answer. For example, you might be given the tax and NIC cost if an individual operates as a sole trader, and then have to calculate the cost of operating as a limited company. Alternatively, you might be given some of the separate tax or NIC costs. It is very important that you appreciate which figures you have already been given so that you do not waste a lot of time calculating them for yourself.

The interactions involved in this type of question can often cause problems. For example, note that director’s remuneration reduces the taxable total profits of Amphibian Ltd, but is then taxed as income in the hands of Newt. In contrast, the payment of dividends does not affect the calculation of Amphibian Ltd’s corporation tax liability. There are a couple of basic principles that you should remember:

• If all of a company’s profits are paid out as director’s remuneration (and related employer’s class 1 NIC) then there will not be any corporation liability.
• If profits are only drawn as dividends (or if director’s remuneration is below the NIC lower threshold) then there will be no NICs.

Inheritance tax (IHT) and capital gains tax (CGT)

Although the interaction of IHT and CGT is not examinable at TX-UK, the two taxes could be examined within the same question and the information given could be relevant to both taxes.

For a lifetime gift of unquoted shares, the IHT transfer of value will be based on the diminution in value of the donor’s estate. In contrast, for CGT purposes the valuation will be based on the market value of the shares gifted.

EXAMPLE 2
On 4 May 2021, Daniel made a gift to his son of 15,000 £1 ordinary shares in ABC Ltd, an unquoted investment company. Before the transfer, Daniel owned 60,000 shares out of ABC Ltd’s issued share capital of 100,000 £1 ordinary shares. ABC Ltd’s shares are worth £18 each for a holding of 60%, £10 each for a holding of 45% and £8 each for a holding of 15%.

Although Daniel’s son received a 15% shareholding valued at £120,000 (15,000 x £8), Daniel’s transfer of value is calculated as follows:

In contrast, for CGT purposes the valuation will be based on the market value of the shares gifted, which is £120,000.

As far as tax planning is concerned, a lifetime gift can avoid or reduce the IHT that would arise if assets were retained until death. However, the potential IHT saving must be weighed against any immediate CGT cost. There are no CGT implications if assets are retained until death because transfers on death are exempt disposals. CGT is not an issue if a cash gift is made.

EXAMPLE 3
On 20 June 2021, Craig made a gift to his grandson of a residential property valued at £250,000. The gift of the property resulted in a chargeable gain of £145,000.

The value of the property is expected to increase to £300,000 by 31 December 2023, and to £340,000 by 31 December 2028.

Craig is an additional rate taxpayer. He will not make any other disposals during the tax year 2021–22, and he has not made any previous lifetime gifts. Craig has an estate valued in excess of £2,000,000 for IHT purposes.

CGT liability
Craig’s CGT liability for 2021–22 is:

Craig dies on 31 December 2028
The gift of the property is a PET. If Craig lives until 31 December 2028, then the PET will be exempt because he will have survived for seven years. The IHT saving will be £136,000 (£340,000 at 40%), so a lifetime gift would appear to be beneficial despite the immediate CGT cost of £37,156.

Craig dies on 31 December 2023
If Craig were to die on 31 December 2023, the IHT saving (ignoring annual exemptions) would be:

Note that although there will be no IHT liability in respect of the PET, the PET will reduce the amount of nil rate band available against Craig’s death estate.

The lifetime gift no longer appears to be beneficial because the immediate CGT cost of £37,156 outweighs the IHT saving of £20,000.

Investment alternatives

Another type of scenario which could be examined is where you are required to advise an individual on the tax implications of a number of investment options.

EXAMPLE 4
Tobias has recently inherited the residue of his aunt Mildred’s estate. He will use this inheritance for the following purposes:

Tobias will make the maximum possible amount of additional tax relievable personal pension scheme contribution for the tax year 2021–22, having already made contributions of £10,000 during this tax year. His adjusted income for the tax year 2021–22 will not exceed £240,000. Tobias has been self-employed since 6 April 2019, and has been a member of a personal pension scheme from the tax year 2020–21 onwards. Tobias’ trading profits and gross personal pension contributions since he commenced self-employment have been as follows

• Tobias will make a cash gift of £100,000 to his daughter when she gets married on 29 March 2022. He has not made any previous lifetime gifts.
• Tobias will invest the maximum possible additional amount into an individual savings account (ISA) for the tax year 2021–22. He has already invested £5,400 into a cash ISA during this tax year, having previously invested £6,200 into a cash ISA during the tax year 2020–21.

Personal pension contribution
Although the maximum contribution which will qualify for tax relief is £68,000 (net relevant earnings of £78,000 less the £10,000 of contributions already made), the maximum amount of tax relievable personal pension contribution will effectively be restricted to the available annual allowances of £44,000.

Gift to daughter
The gift will be a potentially exempt transfer of £89,000 (£100,000 less the marriage exemption of £5,000 and annual exemptions of £3,000 for 2021–22 and 2020–21).

If Tobias dies before 29 March 2029 (within seven years of making the gift), then the amount of nil rate band available against his estate will be reduced by £89,000.

Individual savings account
Since Tobias has already invested £5,400 into a cash ISA, he can invest a further £14,600 (20,000 – 5,400) into an ISA in 2021–22. This could be in a cash ISA, a stocks and shares ISA, or any combination of the two.

Married couples
Various tax planning opportunities may be available to married couples (and also to a couple in a civil partnership).

As far as income tax is concerned, tax can be saved by allocating savings and dividend income between spouses to make best use of the savings income and dividend nil rate bands. This can be achieved by ether transferring the income producing assets between spouses or by putting assets into joint names.

Once nil rate bands have been utilised, savings and dividend income (and also property income) should be received by the spouse paying the lowest rate of tax.

EXAMPLE 5
Nigel and Nook are a married couple. For the tax year 2021–22, Nigel will have a salary of £160,000 and savings income of £400. Nook will have a salary of £65,000 and dividend income of £3,800.

Nigel is an additional rate taxpayer, so he does not receive any savings income nil rate band. Nook, as a higher rate taxpayer, has an unused savings income nil rate band of £500. Transferring the savings to Nook will therefore save income tax of £180 (400 at 45%) for 2021–22.

Nook has fully utilised her dividend nil rate band of £2,000, but Nigel’s nil rate band is unused. Transferring sufficient investments to Nigel so that he receives £1,800 of the dividend income will therefore save income tax of £585 (1,800 at 32.5%) for 2021–22.

As far as CGT is concerned, tax can be saved if one spouse has not utilised their annual exempt amount and/or basic rate tax band for a particular tax year. An asset could be transferred to that spouse before its disposal, or put into joint names prior to disposal.

EXAMPLE 6
Adam and Zoe are a married couple. Before taking account of any tax planning measures, you have prepared a forecast of the couple’s tax position for the tax year 2021–22.

Adam
Adam will have an income tax liability of £29,482. This is based on total income of £106,000, consisting of gross director’s remuneration of £94,000 and dividend income from quoted shares of £12,000.

He has an unused capital loss of £12,600 brought forward from the tax year 2020–21.

Zoe
Zoe will have an income tax liability of £1,086. This is based on total income of £18,000, consisting entirely of employment income.

She will also have a CGT liability of £3,713. This is in respect of the disposal of quoted shares which will result in chargeable gains of £47,000. The disposal will not qualify for business asset disposal relief.

Tax planning measures
After a meeting with Adam and Zoe, you have identified two tax planning measures which the couple could undertake for the tax year 2021–22:

• Adam’s quoted shares will be put into joint names so that Zoe receives 50% of the dividend income of £12,000.
• Zoe’s quoted shares will be put into joint names prior to their disposal.

After taking account of the tax planning measures, the couple’s revised tax liabilities will be:

Adam – Income tax computation 2021–22

Adam – CGT computation 2021–22

Zoe – Income tax computation 2021–22

Zoe – CGT computation 2021–22

Tax saving
The overall tax saving for 2021–22 if Adam and Zoe undertake the two tax planning measures is £5,470

Note that the tax planning in this example is based on 50:50 joint ownership. Because Adam is a higher rate taxpayer, with Zoe only paying tax at the basic rate, there would be a further tax saving if Adam transferred shares to Zoe so that the dividend income was split £2,000 to Adam and £10,000 to Zoe. Similarly, there would be a further CGT saving if the share disposal was such that Adam had chargeable gains of £24,900, with Zoe having gains of £22,100. This would mean that Adam’s capital losses of £12,600 are fully used (24,900 – 12,300 – 12,600 = £0).

Working at the margin

Questions could be set where you are expected to work at the margin – using a taxpayer’s marginal rate of tax rather than preparing full tax computations.

Working at the margin will not only be much quicker, but will also make it easier to keep track of the various figures, especially when it comes to drawing a conclusion. However, a full income tax computation will be equally acceptable should you opt for that approach.

EXAMPLE 7
Harold and Ingrid are a married couple.

Harold is currently self-employed, and his forecast trading profit for the year ended 5 April 2022 is £100,000. He does not have any other income. Ingrid does not have any income, although she does a considerable amount of unpaid work for Harold’s business.

The couple want to know if it would be beneficial to form a partnership from 6 April 2021, with profits being shared 75% to Harold and 25% to Ingrid.

Harold – Tax saving

Ingrid – Tax cost

The overall tax saving for the tax year 2021–22 is therefore £6,466 (10,500 – 4,034).

More than one tax year

You could be required to consider more than one tax year. Although this might seem complicated, the tax rates and allowances for the tax year 2021–22 will always be used throughout, so it may be easier to think of this in terms of having to cover two or more different scenarios for the current year.

EXAMPLE 8
Kim is currently employed at an annual salary of £200,000. Kim will continue to earn the same salary until she retires on 5 April 2025, at which point her income will reduce to annual pension income of £55,000.

Kim has the opportunity to undertake £40,000 of work on a freelance basis during the year ended 5 April 2022, and she will do this work via Mik Ltd, a newly formed limited company. This freelance work will not involve any expenditure and will last for just one year.

After allowing for corporation tax, the entire net of tax profits will be withdrawn by Kim as dividends either during the tax year 2021–22 or during the tax year 2025–26.

Dividends withdrawn during 2021–22

• Mik Ltd’s corporation tax liability for the year ended 5 April 2022 will be £7,600 (40,000 at 19%). 
• Kim will receive dividend income of £32,400 (40,000 – 7,600) and the income tax payable on this amount will be £11,582 ((32,400 – 2,000) at 38.1%).           

Dividends withdrawn during 2025–26

• Mik Ltd’s corporation tax liability for the year ended 5 April 2022 will remain unchanged at £7,600.
• For 2025–26, Kim will be a higher rate taxpayer (55,000 – 12,570 = £42,430), so the income tax payable in respect of her dividend income will be reduced to £9,880 ((32,400 – 2,000) at 32.5%).
• The overall tax saving from postponing the withdrawal of dividends until 2025–26 will be £1,702 (11,582 – 9,880).

Written by a member of the TX (UK) examining team