Learning Outcomes
This article outlines the principal categories of income subject to UK income tax. It details the characteristics and tax treatment of employment income, trading income, property income, savings income, and dividend income. After reading this article, you should be able to identify different types of income and understand the basic principles governing how they are assessed for income tax, which is necessary for tackling SQE1 assessment questions involving individual taxation scenarios.
SQE1 Syllabus
For SQE1, you are required to understand the different types of income chargeable to income tax and the basis on which they are charged. This includes the key features and calculation principles for common income sources relevant to individuals and unincorporated businesses.
As you work through this article, remember to pay particular attention in your revision to:
- The main categories of income subject to UK income tax.
- Key characteristics and calculation methods for employment income.
- Identifying trading income using the Badges of Trade and calculating taxable trading profits.
- The basis of assessment for property income, including allowable expenses.
- Rules relating to savings income and the Personal Savings Allowance.
- Rules relating to dividend income and the Dividend Allowance.
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.
- Which system is typically used to deduct income tax from employment income?
- What are the "Badges of Trade" used for?
- True or false? Mortgage interest paid by a landlord on a residential letting property is fully deductible against rental income when calculating taxable profit.
- What is the standard Personal Allowance for income tax in the current tax year?
Introduction
Income tax is levied on the total income of individuals, trustees, and personal representatives for each tax year, which runs from 6 April to 5 April. Different types of income are subject to specific rules regarding their calculation and the reliefs or allowances that can be applied. Understanding these distinctions is fundamental to determining an individual's overall income tax liability. This article focuses on the main types of income encountered in practice: employment income, trading income, property income, savings income, and dividend income. Foreign income is also briefly considered.
Key Term: Income Tax Year
The period from 6 April in one year to 5 April in the next, used for assessing income tax liability. It is named after the two calendar years it spans (e.g., 2023/24).
Employment Income
This category covers earnings derived from holding an office or employment.
Key Term: Employment Income
Income received from employment under a contract of service. This includes salary, wages, bonuses, commissions, and taxable benefits in kind.
Employment income is primarily governed by the Income Tax (Earnings and Pensions) Act 2003 (ITEPA). Tax is usually collected at source via the Pay As You Earn (PAYE) system, where the employer deducts income tax and National Insurance contributions before paying the employee their net salary.
Benefits in Kind
Many employees receive non-cash benefits, such as company cars or private medical insurance. These are known as benefits in kind and are generally taxable. Their value, calculated according to specific rules, is added to the employee's cash earnings to determine total taxable employment income.
Allowable Expenses
Employees can claim tax relief for expenses incurred 'wholly, exclusively and necessarily' in performing their employment duties. This is a strict test, meaning few expenses qualify. Common examples include professional subscriptions or travel costs for business purposes (but not ordinary commuting).
Trading Income
This includes profits generated from carrying on a trade, profession, or vocation as a sole trader or partner.
Key Term: Trading Income
Profits arising from self-employment or business activities undertaken with a view to profit.
The determination of whether an activity constitutes a trade is based on case law principles known as the 'Badges of Trade'.
Key Term: Badges of Trade
A set of factors derived from case law used by HMRC and courts to determine if an activity amounts to a trade for tax purposes. Factors include frequency of transactions, profit motive, nature of the asset, and method of acquisition/disposal.
Taxable trading profits are calculated by deducting allowable expenses and capital allowances from the business's chargeable receipts for the accounting period.
Allowable Expenses (Trading Income)
Expenses are deductible if incurred 'wholly and exclusively' for the purposes of the trade. Capital expenditure (e.g., buying premises or machinery) is generally not deductible against income, but relief may be available through capital allowances.
Basis Period
The profits assessed in a particular tax year depend on the business's accounting period and specific rules apply for the opening and closing years of a trade.
Property Income
This category covers income arising from land and property owned by the taxpayer in the UK.
Key Term: Property Income
Income derived from letting property, such as rental income from houses, flats, or commercial buildings.
Taxable property income is the gross rent received less allowable expenses.
Allowable Expenses (Property Income)
Expenses incurred wholly and exclusively for the property business are deductible. Examples include repairs (not improvements), insurance, letting agent fees, and ground rent.
Finance Cost Relief Restriction
For residential properties, relief for finance costs (like mortgage interest) is restricted. Landlords cannot deduct these costs directly from rental income but instead receive a basic rate (20%) tax reduction based on the finance costs incurred.
Rent-a-Room Relief
Individuals renting out a furnished room in their main residence can receive up to £7,500 per year tax-free under this scheme.
Property Allowance
Individuals with gross property income of £1,000 or less do not need to declare or pay tax on it. If gross income exceeds £1,000, they can choose to deduct the £1,000 allowance instead of actual expenses.
Savings Income
This includes interest received from bank and building society accounts, corporate bonds, and government gilts.
Key Term: Savings Income
Income derived from interest-bearing accounts and investments.
Specific allowances apply to savings income.
Personal Savings Allowance (PSA)
Most taxpayers receive a PSA, allowing them to earn some interest tax-free.
- Basic rate taxpayers: £1,000 PSA.
- Higher rate taxpayers: £500 PSA.
- Additional rate taxpayers: £0 PSA.
Interest within the PSA is taxed at a 0% rate.
Starting Rate for Savings
Individuals with low levels of other income (NSNDI) may qualify for the starting rate for savings. This allows up to £5,000 of savings income to be taxed at 0%. However, this £5,000 band is reduced by £1 for every £1 of NSNDI above the personal allowance.
Dividend Income
This refers to distributions of profit paid by companies to their shareholders.
Key Term: Dividend Income
Income received by shareholders from companies in the form of dividends.
Dividends are subject to specific tax rates and allowances.
Dividend Allowance
All taxpayers receive a Dividend Allowance. For the 2023/24 tax year, this is £1,000. Dividend income within this allowance is tax-free (taxed at 0%).
Dividend Tax Rates
Dividends received above the Dividend Allowance are taxed at specific rates, which are lower than the main income tax rates:
- Basic rate band: 8.75%
- Higher rate band: 33.75%
- Additional rate band: 39.35%
Dividends are treated as the top slice of income when determining the applicable tax rate.
Worked Example 1.1
Anya has a salary of £45,000 and receives dividends of £3,500 in the 2023/24 tax year. She has no other income. How is her dividend income taxed? (Assume Personal Allowance is £12,570 and the basic rate band ends at £37,700 taxable income).
Answer: Anya's taxable salary is £45,000 - £12,570 = £32,430. This income uses up £32,430 of her basic rate band (£37,700). She receives £3,500 in dividends. The first £1,000 is covered by the Dividend Allowance and is tax-free (0%). The remaining £2,500 of dividends fall within her remaining basic rate band (£37,700 - £32,430 = £5,270 available). Therefore, the £2,500 is taxed at the dividend ordinary rate of 8.75%. Tax payable on dividends = £2,500 x 8.75% = £218.75.
Foreign Income
Income arising from overseas sources (e.g., foreign employment, rental income from property abroad, interest from overseas bank accounts) is also potentially subject to UK income tax for UK residents. The treatment depends on the individual's residence and domicile status and the applicability of any Double Taxation Agreements. Taxpayers may be taxed on the 'arising basis' (taxed on worldwide income as it arises) or, if non-domiciled, potentially on the 'remittance basis' (taxed only on foreign income brought into the UK). Relief is usually available for foreign tax already paid on the same income.
Key Point Checklist
This article has covered the following key knowledge points:
- Income tax is charged on different types of income, including employment, trading, property, savings, and dividend income.
- Employment income includes salary and benefits, taxed via PAYE, with limited expense deductions.
- Trading income is calculated as receipts less allowable expenses and capital allowances, with the 'Badges of Trade' determining if an activity is a trade.
- Property income is rental income less allowable expenses, with specific rules for residential finance costs.
- Savings income (interest) benefits from the Personal Savings Allowance and potentially the starting rate for savings.
- Dividend income benefits from the Dividend Allowance, with specific lower tax rates applying above the allowance.
- Foreign income is taxable for UK residents, subject to residence/domicile status and double tax relief.
Key Terms and Concepts
- Income Tax Year
- Employment Income
- Trading Income
- Badges of Trade
- Property Income
- Savings Income
- Dividend Income
