Income tax - Basis of charge

Learning Outcomes

This article outlines the fundamental principles governing the basis of charge for UK Income Tax. After studying this material, you should understand the statutory basis for the tax charge, identify who is liable to pay income tax, recognise the main categories of income subject to the tax, and be familiar with the concept of the tax year. This knowledge is essential for applying the correct principles when advising clients on their potential income tax liabilities in SQE1 assessments. You should also be able to explain how income is grouped for rate purposes (non-savings, savings and dividend), the high-level steps in Section 23 ITA 2007 for computing liability, the role of the annual Finance Act in setting rates and thresholds for each tax year, and the basis of assessment for trading profits of sole traders and partners (including the opening, current and closing year rules). Finally, you should appreciate how income tax is collected through PAYE and self-assessment, and where reliefs and allowances are taken into account within the computation.

SQE1 Syllabus

For SQE1, you are required to understand the basis upon which income tax is charged in England and Wales. This involves identifying who is liable for the tax and the types of income that fall within its scope. Your understanding will be tested through realistic client-based scenarios requiring the application of these core principles, with a focus on the following syllabus points:

• the statutory basis for the charge to income tax
• identification of chargeable persons and entities for income tax purposes
• recognition of the different categories of income subject to tax
• understanding the concept of the UK tax year
• the basic framework for calculating income tax liability (detailed calculations are covered elsewhere)
• the separation of non-savings, savings and dividend income for rate purposes and the ordering rules
• the basis of assessment for trading profits of sole traders and partners (opening, current and closing year rules)
• the collection of income tax via PAYE and self-assessment (including key dates and payments on account).

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which piece of primary legislation establishes the annual charge to income tax in the UK?
   1. Income Tax (Trading and Other Income) Act 2005
   2. Finance Act (relevant year)
   3. Income Tax Act 2007
   4. Taxation of Chargeable Gains Act 1992
2. Which of the following entities is typically liable for Corporation Tax rather than Income Tax on its profits?
   1. A sole trader
   2. A partner in a general partnership
   3. A private limited company
   4. A trustee of a discretionary trust
3. The standard UK tax year runs from:
   1. 1 January to 31 December
   2. 1 April to 31 March
   3. 6 April to 5 April
   4. The company's accounting reference date

Introduction

Income Tax (IT) is a significant source of revenue for the UK government and affects most individuals and many business structures. As a solicitor, you will encounter IT issues across various practice areas, from advising business start-ups on tax implications to handling aspects of employment or trust law. A basic understanding of who pays IT and on what income it is charged is therefore essential. This article focuses on the basis of the charge to IT, establishing the framework upon which detailed calculations (covered elsewhere) are built. Rates, thresholds and allowances are set for each tax year by the annual Finance Act, and certain rates can vary within the UK, so always ensure you are applying the rules current for the relevant tax year.

The Statutory Basis and the Tax Year

The primary legislation governing Income Tax is the Income Tax Act 2007 (ITA 2007). Section 1 of the ITA 2007 establishes the fundamental principle that income tax is charged annually for each tax year. This charge applies to the income specified within the tax legislation, subject to various reliefs and exemptions. Specific categories of income are charged under specialist legislation: employment income is charged under the Income Tax (Earnings and Pensions) Act 2003 (ITEPA 2003), and trading, property, savings and miscellaneous income are charged primarily under the Income Tax (Trading and Other Income) Act 2005 (ITTOIA 2005). The rates, bands and many of the annual thresholds are set by the Finance Act for the relevant year.

Key Term: Income Tax Year
The period over which income tax liability is calculated. In the UK, the tax year runs from 6 April in one calendar year to 5 April in the next calendar year. For example, the 2023/24 tax year runs from 6 April 2023 to 5 April 2024.

Understanding the tax year is important because income received within that period is assessed for tax in that year, according to the rates and allowances applicable for that specific year. Note that non-savings, non-dividend rates can vary in Wales and Scotland for some categories of income; always check the rules for the specific tax year and jurisdiction.

Chargeable Persons/Entities

Identifying who is liable to pay IT is a fundamental step. The following persons and entities are generally chargeable to income tax:

• Individuals: This is the largest category and includes employees receiving salaries and sole traders earning business profits.
• Partners: Individual partners within a general partnership or a Limited Liability Partnership (LLP) are liable for IT on their share of the partnership profits. The partnership itself is generally treated as 'tax transparent', meaning it does not pay tax, but the individual partners do. Where a partner is a company (e.g. a corporate member of an LLP), that partner is generally chargeable to Corporation Tax on its profit share.
• Trustees: Trustees may be liable for IT on income generated by trust assets, depending on the type of trust.
• Personal Representatives (PRs): PRs administering a deceased person's estate are liable for IT on income arising during the administration period.

Key Term: Chargeable Persons
The individuals or entities identified by legislation as being liable to pay Income Tax on their income.

It is important to note that companies are not chargeable persons for IT. Companies pay Corporation Tax on their profits, including both income profits and capital gains. Unincorporated associations may also be within the charge to Corporation Tax. This distinction is a key reason why the choice of business structure has significant tax implications.

In the context of trading income:

• A sole trader is assessed to IT on business profits using statutory “basis period” rules (see below on opening, current and closing year rules).
• A partnership is assessed similarly, but profits are allocated to partners. Each individual partner’s share is then assessed in their hands.

Types of Income

Income tax is charged on various types of income, which are categorised primarily under the Income Tax (Trading and Other Income) Act 2005 (ITTOIA 2005) and the Income Tax (Earnings and Pensions) Act 2003 (ITEPA 2003). For SQE1 purposes, you should be aware of the main categories:

• Trading Income: Profits arising from carrying on a trade, profession, or vocation. This is particularly relevant for sole traders and partners. Calculating trading profits involves deducting allowable expenses and capital allowances from chargeable receipts (as detailed in other articles).
• Employment Income: This includes salary, wages, bonuses, and certain benefits-in-kind received from employment. Tax on employment income is often deducted at source through the Pay As You Earn (PAYE) system.
• Property Income: Income derived from land and property, most commonly rental income from letting out property (UK property and, for UK residents, overseas property).
• Savings Income: Primarily interest received from bank and building society accounts, and other interest-bearing investments.
• Dividend Income: Income received by shareholders from distributions made by companies out of their profits.
• Miscellaneous Income: A catch-all category for income not falling neatly into the others, such as certain social security benefits, casual profits and some intellectual property receipts.

Identifying the correct category for a particular source of income is important because different rules, allowances (like the Personal Savings Allowance or Dividend Allowance), and sometimes tax rates apply to each category.

Key Term: Non-savings, non-dividend income (NSNDI)
All taxable income other than savings and dividends. It includes trading profits, employment income, pensions and property income.

Key Term: Savings income
Interest and similar returns on money (e.g. bank and building society interest, some bond interest). Taxation of savings income may involve nil rate bands such as the starting rate for savings and the Personal Savings Allowance.

Key Term: Dividend income
Company distributions to shareholders. Dividends are taxed at specific dividend rates after applying the Dividend Allowance.

Key Term: Personal Savings Allowance (PSA)
A nil rate band for savings interest, the amount of which depends on the taxpayer’s overall rate band. Interest covered by the PSA is taxed at 0% but still counts towards the allocation of rate bands.

Key Term: Dividend Allowance
A nil rate band for dividend income taxed at 0% but counting towards the allocation of rate bands.

Key Term: Starting rate for savings
A 0% rate for savings income within a limited band where NSNDI is below a threshold. The band is reduced pound-for-pound by the amount of NSNDI.

The rate structure keeps NSNDI, savings and dividend income in separate “baskets”. In broad terms, you apply rate bands first to NSNDI, then to savings, and finally to dividends, taking into account any nil rate amounts such as the starting rate for savings, the PSA and the Dividend Allowance.

Worked Example 1.1

A client, Sarah, runs a small bakery as a sole trader. She also owns a flat which she rents out, and holds some shares in a large UK company from which she receives dividends. Last year, she received interest from her personal savings account.

Identify the different categories of income Sarah has received for income tax purposes.

Answer:
Sarah has received:

• Trading Income: From her bakery business.
• Property Income: From renting out her flat.
• Dividend Income: From her shares.
• Savings Income: From the interest on her savings account.

Worked Example 1.2

Jon has £28,000 salary, £2,000 bank interest, and £1,500 dividends. Without calculating the final tax, explain how his income would be grouped and the order in which rate bands and nil rate amounts may apply.

Answer:
Jon’s salary is NSNDI. The £2,000 is savings income and the £1,500 is dividend income. Rate bands are allocated first to NSNDI (salary), then to savings (interest), then to dividends. Within savings, consider first whether any starting rate for savings applies (depending on how much NSNDI uses up the threshold), then apply the Personal Savings Allowance to any remaining savings income. For dividends, the Dividend Allowance applies at 0% to part of the dividends, with the remainder taxed at the applicable dividend rates.

The Basic Calculation Framework

While detailed income tax calculations involve specific rates and reliefs covered elsewhere, understanding the basic framework is part of comprehending the basis of charge. The calculation generally involves these steps, as outlined in Section 23 ITA 2007:

1. Calculate Total Income: Aggregate income from all relevant sources.
2. Deduct Allowable Reliefs: Subtract reliefs applicable to total income (e.g., interest on certain qualifying loans, certain trade losses set against total income, grossed-up Gift Aid and personal pension contributions which can affect rate bands). This gives Net Income.
3. Deduct Personal Allowance(s): Subtract the personal allowance (and any other applicable allowances like the blind person's allowance). This gives Taxable Income.
4. Calculate Tax: Apply the relevant tax rates to the different types of income within the taxable income, observing the order of NSNDI, then savings, then dividends and applying nil rate bands where relevant (starting rate for savings, PSA, and Dividend Allowance).
5. Total Liability: Sum the tax calculated for each income type, then deduct any tax already paid at source (e.g., PAYE) to determine tax payable.

Key Term: Total Income
The aggregate of an individual's income from all taxable sources before any deductions for reliefs or allowances.

Key Term: Allowable Reliefs
Specific statutory deductions that reduce total income before calculating tax liability (e.g., relief for interest paid on qualifying loans, trading losses set against total income in certain cases, and amounts treated as extending rate bands such as grossed Gift Aid and personal pension contributions).

Key Term: Net Income
The amount remaining after deducting allowable reliefs from total income. This figure is used to determine entitlement to certain allowances, like the personal allowance taper.

Key Term: Personal Allowance
An amount of income that an individual can receive each tax year without paying income tax. The amount is set annually and may be reduced for high earners based on adjusted net income.

Key Term: Adjusted Net Income
Broadly, net income after deducting certain reliefs (e.g., grossed-up Gift Aid and pension contributions), used for determining the personal allowance taper and some other income-related reductions.

Key Term: Taxable Income
The amount of income on which income tax is actually calculated, after deducting allowable reliefs and personal allowances from total income.

This framework shows that the charge to tax is ultimately applied to taxable income, derived after specific deductions from the total income arising in the tax year. Within Step 4, keep the three baskets separate and apply the nil rate amounts and rate bands in the correct order. Gift Aid and personal pension contributions (if relief at source) may extend the basic rate band, affecting the rates at which savings and dividends are taxed.

Exam Warning

Do not confuse the different stages of the calculation. Total Income, Net Income, and Taxable Income are distinct figures reached after specific deductions. Ensure you understand what is deducted at each stage. Misapplying allowances or reliefs at the wrong stage will lead to an incorrect final tax liability.

Collection and Payment of Income Tax

Tax on employment income and most taxable benefits is usually collected through PAYE by the employer during the tax year. Other income (e.g., self-employment, property income, many forms of savings and dividend income) is reported under self-assessment.

Key Term: PAYE
Pay As You Earn. A withholding system under which employers deduct income tax and employee National Insurance contributions from employment income and remit them to HMRC.

Key Term: Self-assessment
The regime under which taxpayers report their taxable income and gains and self-assess the tax due, filing a tax return by specified deadlines and paying any tax due directly to HMRC.

For self-assessment, paper returns are generally due by 31 October following the end of the tax year and online returns by 31 January following the end of the tax year. Payments on account (two instalments based on the previous year’s residual liability) are usually due on 31 January in the tax year and 31 July after the tax year, with any balancing payment due on 31 January following the tax year. Interest and penalties may apply for late filing or late payment.

Basis of Assessment for Trading Profits (Sole Traders and Partners)

Although income is charged by reference to the tax year, trading profits are assessed using rules that align accounting periods with the tax year. Three key concepts apply to the self-employed and partners:

Key Term: Opening Year Rule (OYR)
In the first tax year of trade, tax is assessed on profits arising from the date trade starts to the following 5 April.

Key Term: Current Year Basis (CYB)
From the second tax year (and for subsequent years until cessation), tax is generally assessed on the profits of the 12-month accounting period that ends in the tax year.

Key Term: Closing Year Rule (CYR)
In the final tax year, tax is assessed on profits from the end of the last accounting period to the date the business ceases, less any overlap profit.

Key Term: Overlap Profit
Profit taxed more than once due to the interaction of the opening and current year rules. Overlap profit is carried forward and deducted on cessation (or when transition rules permit).

For partnerships, the business profits are computed at firm level and then allocated to partners according to their profit-sharing arrangements. Each partner is assessed on their share using the above basis rules. An LLP is fiscally transparent for income tax; individual members are taxed on their share of profits; a corporate member’s share is typically chargeable to Corporation Tax.

Worked Example 1.3

Amira starts trading on 1 September 2023, drawing up accounts to 31 August each year. Profits are £24,000 for the 12 months to 31 August 2024 and £36,000 for the 12 months to 31 August 2025. Identify the profits assessed in 2023/24 and 2024/25 (ignore personal allowance).

Answer:
2023/24 (OYR): profits from 1 September 2023 to 5 April 2024. That is 7 months of the first 12-month period: £24,000 × 7/12 = £14,000.
2024/25 (CYB): the 12-month period ending in 2024/25 is year to 31 August 2024: £24,000. Note: there will be overlap profit equal to the period taxed twice (1 September 2023 to 5 April 2024), to be relieved on cessation or as permitted by transition rules.

Worked Example 1.4

Ben joins an existing partnership on 1 May 2023. The partnership accounts to 30 April. Profits for the year to 30 April 2024 are £90,000, shared equally among three partners. Identify Ben’s assessed profits for 2023/24 and 2024/25 (ignore allowances).

Answer:
2023/24 (OYR for Ben): profits from 1 May 2023 to 5 April 2024. Ben’s share of annual profit is £30,000 (one-third). For 11 months (May–April): £30,000 × 11/12 = £27,500.
2024/25 (CYB): Ben is assessed on the year to 30 April 2024 (the accounting period ending in that tax year) = £30,000. The £27,500 taxed in 2023/24 is overlap profit to be relieved on cessation or as permitted by transition rules.

Further computational structure and interaction with allowances

Several elements regularly interact within the Section 23 framework:

• The personal allowance may be tapered for high earners by reference to adjusted net income.
• The starting rate for savings and the PSA can reduce or eliminate tax on savings interest; they are nil rate amounts and do not remove the income from total income.
• The Dividend Allowance similarly taxes a slice of dividend income at 0% within the rates computation.
• Gift Aid and certain pension contributions made under relief at source are “grossed up” and can extend the basic rate band, potentially affecting the rate at which savings and dividends are taxed.

Keeping the baskets separate and applying nil rate bands and allowances in the correct order is fundamental to arriving at the correct liability.

Exam Warning​

Do not treat nil rate amounts (PSA, Dividend Allowance, starting rate for savings) as exclusions from total income. They tax income at 0% but still use up the relevant rate band. Misclassifying them as deductions from income will distort the rates applied to later income.

Key Point Checklist

This article has covered the following key knowledge points:

• Income tax is charged annually for each tax year (6 April - 5 April) under the authority of the Income Tax Act 2007, with the Finance Act setting rates and thresholds.
• Chargeable persons include individuals (sole traders, employees, partners), trustees, and personal representatives, but not limited companies (which pay Corporation Tax).
• Income is taxed based on its source, with main categories including trading, employment, property, savings, and dividend income; for rate purposes, group income into NSNDI, savings and dividends.
• The basic framework for calculation involves identifying total income, deducting reliefs to find net income, deducting personal allowances to find taxable income, and then applying tax rates in the order NSNDI, savings, dividends (taking into account nil rate amounts).
• Trading profits of sole traders and partners are assessed using the opening year, current year and closing year rules, with overlap profits relieved at cessation or as permitted.
• Most employment income is taxed via PAYE; other income is reported under self-assessment with key filing and payment dates, including payments on account.
• Accurate classification of income and the correct ordering of allowances and nil rate bands are essential to compute the final liability.

Key Terms and Concepts

• Income Tax Year
• Chargeable Persons
• Total Income
• Allowable Reliefs
• Net Income
• Personal Allowance
• Taxable Income
• Non-savings, non-dividend income (NSNDI)
• Savings income
• Dividend income
• Personal Savings Allowance (PSA)
• Dividend Allowance
• Starting rate for savings
• Adjusted Net Income
• PAYE
• Self-assessment
• Opening Year Rule (OYR)
• Current Year Basis (CYB)
• Closing Year Rule (CYR)
• Overlap Profit