Savings Income Taxation: Understanding Rates, Allowances, and Exemptions, Study notes of Finance

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Savings income:

routes to simplification

May 2018

Foreword

This is the first broad review of its type into the application of the tax system to savings and investment income. The UK savings tax system works well for most taxpayers, who do not have to consider whether they have to pay income tax on their savings at all. This is because, since 2016, savings income up to £1,000 has been covered by the personal savings allowance and because savers can contribute £20,000 a year to their ISAs on which income is not taxed. However, many taxpayers continue to worry about the tax treatment of their savings income even when they do not in fact have anything further to pay, and there are also many specific complexities which taxpayers find difficult and confusing. In this review, the OTS has found that –

• The tax complexity in savings and investment income is mainly caused by the interactions between the many reliefs and allowances;
• Any solution will need to take a comprehensive view to ensure that these interactions are fully scoped and that the intended benefits for taxpayers from those reliefs and allowances are preserved;
• There are additional opportunities to improve the taxpayer experience through guidance and further communication. The OTS would like to thank the members of the team who have worked on this review, Eileen Rafferty and Andy Richens, under the guidance of David Halsey, the OTS Head of Office. We are also particularly grateful to HMT and HMRC colleagues and many others who have willingly given their ideas, challenge and support. Angela Knight CBE Paul Morton

The Office of Tax Simplification (OTS) is the independent adviser to government on simplifying the UK tax system. The work of the OTS is rooted in improving the experience of all who interact with the tax system. The OTS aims to reduce the administrative burden - which is what people actually encounter in practice - as well as simplifying the rules. These are often of equal importance to taxpayers and HMRC. This paper explores the taxation of people’s savings income, and identifies areas that might be simplified. The paper looks at income from savings held in cash or in stocks and shares. People may choose to invest in other classes of asset (property for example) - these are not the subject of this paper. The taxation of income from savings and investments potentially impacts a substantial number of UK citizens, as approximately 65% of UK adults save some of their income, and many have a private pension (78% of employees, 17% of the self- employed).^1 Nevertheless, it is estimated that around half of the UK population are not saving enough for their retirement,^2 while at the average rate of savings, it

would take 18 years to save a deposit on a first home, or 17 years in a cash ISA.^3

There are clear benefits both to individuals and to society as a whole when people have sufficient savings, and so the UK tax regime offers a range of tax reliefs to encourage people to put money aside for their future needs. These reliefs work well for most taxpayers, but aspects of the regime, including the interaction of various reliefs and allowances, are complex and can produce anomalous outcomes. This paper considers:

1. The taxation of interest and interest-like payments, which are affected by the starting rate for savings (SRS) and personal savings allowance (PSA) (^1) Source: For workplace pensions – Office of National Statistics June 2017 report https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/618843/workplace-pension- participation-and-saving-trends- 2006 - 2016.pdf For private pensions: the Money Charity. http://themoneycharity.org.uk/media/July- 2015 - Money-Statistics-summary.pdf http://themoneycharity.org.uk/households-saving- ratio-lower-time-since-credit-crunch/ 2 Source: The Pensions Advisory Service. https://www.pensionsadvisoryservice.org.uk/news/fewer-than-half-of-people-in-the-uk-are- saving-enough-for-retirement 3 Source: The Money Charity, as above. See this site also for a comparison of savings rates since 1956. https://tradingeconomics.com/united-kingdom/personal-savings 4 There is evidence that the Help to Buy ISA speeds up the process of saving for a first home, particularly in cases where values are below the UK average. https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/702671/Help_to_Buy_ISA_sche me_quarterly_statistics_-_December_2015_to_30_Decemb....pdf

Executive summary

So Gary does not need to worry about tax on his £1,500. In fact, he could put considerably more than this into his savings and still pay no tax. 6 He could additionally invest up to £20,000 in an ISA and still would pay no tax. iii) The tax treatment of pension fund withdrawals is not well understood The recently-introduced pension freedoms allow people over 55 or in poor health to make withdrawals from pension pots, and significant numbers of people have cashed small pension pots. However, there is evidence that people do not always understand the implications of their withdrawals. 7 iv) There is scope for more focus on guidance and awareness Studies show that financial literacy in the UK is relatively low, below the OECD average. 8 Even comparatively clear HMRC guidance in this area 9 will be difficult to follow for the very significant section of the population whose financial capability is not high (in this context the OTS notes that UK individuals who self-assess their knowledge as high fare no better than average when measured against people from higher-performing countries on objective tests). 10 The OTS has started a project to take a strategic look at the approach to taxpayer guidance, in collaboration with work HMRC is itself doing to overhaul its 290 manuals. The government’s Financial Capability Strategy aims to improve financial capacity over time and is building evidence on what works in this context. 11 There is scope to significantly improve guidance and education on the taxation of savings to help citizens make more informed choices, and the OTS strongly urges HMRC to focus on improving this guidance and making it easier to understand, using learning from the Financial Capability Unit where relevant (paragraphs 1.70 – 1.72).

Recommendations for further work

Streamlining the interaction of income tax rates and allowances

The starting rate for savings (SRS), personal savings allowance (PSA), dividend allowance and other allowances and features of the tax system mean that most people pay no tax on their savings, but the interactions between the rates and allowances is sufficiently complex at the margins that HMRC’s self-assessment (^6) Savings returns vary considerably. At rates varying between 0.75% and 1.6% (a range obtained from standard money comparison websites in May 2018) one would need between £133,333 and £62,500 on deposit to obtain this return. Some retail banks offer rates of 0.2% or lower: at this rate, one would need £500,000 to get a return of £1,000. 7 https://www.ft.com/content/46ef41b4-fba3-11e7-a492-2c9be7f3120a https://www.fca.org.uk/publication/research/financial-lives- survey-2017.pdf 8 http://www.oecd.org/daf/fin/financial-education/g20-oecd-infe-report-adult-financial-literacy-in-g20-countries.htm The Money Advice Service: Financial Capability in the UK, 2015; https://prismic-io.s3.amazonaws.com/fincap-two%2Fd08746d1- e667-4c9e-84ad-8539ce5c62e0_mas_fincap_uk_survey_2015_aw.pdf UKCES: Employer Skills Survey 2015 https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/525449/UKC004_Summary_Report__May_.pdf 9 https://www.gov.uk/apply-tax-free-interest-on-savings 10 OECD report on adult financial literacy, pages 20- 2 3. 11 https://www.fincap.org.uk/

computer software has sometimes failed to get it right. It is proving to be very difficult to create an algorithm that calculates the tax correctly in all circumstances and HMRC does not expect to bring the complete calculation online until 2018 - 19. Chart 1.A below illustrates this complexity. Chart 1.A: Chart showing current savings reliefs and allowances 2018/ The OTS considers that it would be useful to open up a discussion about the reasons for the number of rates and allowances (which will be added to by some of the new differences resulting from devolution) and the impacts of possible alternative approaches in this area. The following potential approaches are explored in Chapter 1 (Savings and dividend income)

• Specify the order in which allowances are to be deducted, for example in line with the order in which the components of income are taxed (paragraph 1.58)
• Make the PSA and the dividend allowances true allowances or exemptions (as their names suggest) rather than a nil rate of tax. This would simplify the calculation. Income falling within the allowance would not need to be reported and would not count towards the individual’s total income (for example for the purpose of the higher and additional rates) (paragraph 1.60)
• Exempt savings interest completely, either for basic rate payers only, or for individuals with total income below a certain threshold, or for individuals over pension age (paragraph 1.69)
• Amalgamate the starting rate with the PSA, resulting in a combined allowance of £6,000 for basic rate taxpayers, or £5,500 for higher rate taxpayers. This would reduce the complexity arising from having two separate allowances and would remove the condition attached to the SRS,

Digital Identity

The Open Banking Project will enable customers to allow third parties access to their financial accounts to facilitate price comparisons and money management. 13 Financial providers have suggested that a digital ID for customers would simplify the process. One way of addressing this may be to require the customer’s national insurance number whenever a product is taken out (already required for ISAs) – which may also feed in to HMRC’s digital agenda. More effective use of existing information could also facilitate the simplifications in ISA rules discussed above (paragraph 2.29).

Review guidance relating to pension withdrawals, and the use of the emergency tax

code for lump sum withdrawals from personal pensions

On pension income, particular difficulties arise for taxpayers concerning the treatment of lump sum withdrawals from personal pensions. These are an increasing feature of the pensions landscape. In addition, people who deferred taking the state pension before April 2016 have an option to receive a lump sum payment of deferred income: gov.uk does not explain the special tax treatment of these payments and this cases much confusion. More could be done to help people understand the tax implications of withdrawals from pension funds and the actions they may need to take. The OTS would like to explore this further with HMRC, in addition to working to identify options other than initial tax deduction using emergency tax codes on personal pension lump sums, which generally results in the deduction of too much tax when the payment is made (paragraphs 3.11 to 3.17 and 3. 24 - 3.32).

Conclusion

This paper sets out both the benefits most taxpayers receive from the current tax rules on savings income and evidence of the significant complexity that occurs in some cases. A range of specific suggestions are made for further work. The OTS considers it important not to make piecemeal changes, which risk adding further layers of complexity. For example, the number of rates and allowances for personal savings and dividends is a significant cause of complexity: cutting one or more of the reliefs would be one way to simplify matters, but it would be important to ensure that there are no unforeseen negative consequences. At the moment, it is not easy for a taxpayer (or the OTS) to understand what the plans are for digital tax accounts and how these interact with tax return processes. Official guidance is good in parts but has notable gaps. It is against this background that the OTS suggests a roadmap or plan for changes to the personal tax system, to ensure that future changes may be made in a transparent and planned way over time. (^13) https://www.openbanking.org.uk/home/what-is-open-banking/

In summary: core observations

i) 95% of people pay no tax on savings income. This significantly simplifies the taxation of savings income in the UK, but areas of complexity and confusion remain. ii) There is greater awareness of ISAs compared with the savings and dividend allowances. This different level of knowledge may confuse people making decisions about where to save their money. iii) The tax treatment of pension fund withdrawals is not well understood. iv) There is scope for more focus on guidance and awareness in this aspect of the tax system.

Recommendations for further work

1 Review the savings rates and allowances and the impacts of possible alternative

approaches. (Paragraphs 1.58 to 1.69)

2 Introduce a personal tax roadmap, incorporating a plan for consolidation of the

savings income rates and allowances and the stages needed to get there. (Paragraphs 1.56 and 1.57)

3 Improve guidance on the taxation of savings income, using learning from

Financial Capability Unit where relevant. (Paragraphs 1.70 to 1.72)

4 Consider whether trusts and personal representatives should be entitled to the

Personal Savings Allowance. (Paragraph 1.73)

5 Consider further ISA flexibility, for example allowing partial transfers of money

in-year, to further streamline and simplify the rules. (Paragraphs 2.14 to 2.17)

6 Revisit the rules on early withdrawals from the lifetime ISA. (Paragraphs 2.18 to

7 Consider options for a consistent digital identity, that might be used for all

financial products and facilitate the provision of new and innovative offerings as well as simplifying tax assessment. (Paragraph 2.29)

8 Review guidance relating to pension withdrawals, and the use of the emergency

tax code for personal pension lump sum withdrawals. (Paragraphs 3.11 to 3. and 3.24 to 3.32)

9 Review rules on partial redemption of life insurance bonds once the new system

has bedded down. (Paragraph 4.36)

Definition of ‘savings income’ for income tax purposes

1.5 Tax law defines interest and some other types of income as savings income. 1.6 Income under these headings will be subject to the starting rate for savings, the savings nil-rate, basic, higher and additional savings rates of income tax (see below). Other items of income that may be thought of as arising from savings, for example company dividends or pension income, are subject to different tax treatment, and are discussed separately. 1.7 There are a number of exemptions^1 from income tax for savings income. In particular, some interest received from National Savings Certificates and all interest from investments held in an ISA (discussed in Chapter 2) are exempt from income tax. Savings income Tax law defines the following as savings income:

Interest

Interest is compensation for the use by one person of money belonging to another. Common examples are bank and building society interest, interest on gilt-edged securities issued by UK government, and other securities issued by governments and companies, interest on private loans, on delayed payments and refunds and on offshore accounts and investments. Additionally, treatment as interest is extended to:

• any distributions by building societies
• interest distributions by open-ended investment companies
• interest distributions by authorised unit trusts
• offshore fund distributions
• industrial and provident society payments
• funding bonds – a form of security issued by a public or corporate body in respect of a liability to pay interest. The bond value is treated as the interest payment.
• Financial Services Compensation Scheme payments representing interest
• Discounts – when a reward for lending, not a reduction in retail pricing Other savings income
• Life annuity payments
• Profits from deeply discounted securities - a security where the amount payable on maturity will exceed 0.5% of the issue price per year, up to a maximum of 30 years
• Accrued income profits - public body loan securities which are transferred before the cut-off date for payment of interest
• Gains from life insurance contracts 1 Set out in Part 6 ITTOIA 2005

Taxation of savings income

1.8 To calculate income tax on savings income, it is necessary first to place the components of taxable income in a specified order within a person’s total taxable income. Income other than savings or dividends (non-savings income) is taxed first, savings income is next, and dividends^2 are treated as the highest part of total income. 1.9 Savings income can then be subject to a starting rate for savings (nil %),^3 the personal savings allowance - a further savings nil rate,^4 a savings basic rate, a savings higher rate and a savings additional rate. The examples below provide a demonstration of how the rates work. The dividend rates are set out later in the chapter. 1.10 The starting rate for savings can apply only where taxable non-savings income (effectively earnings, pensions or rental income), is less than the starting rate limit (currently £5,000).^5 In such a case an amount of savings income up to the difference between the taxable non-savings income and £5,000 will be charged at the nil % starting rate for savings (So, if you have taxable non-savings income of £3,000 and savings income of £2,500, £2,000 of the savings income will be taxed at the nil rate). Where the non- savings component exceeds £5,000, then the starting rate for savings cannot apply. 1.11 Additionally, the personal savings allowance (PSA) was introduced by FA

2016.^6 The PSA is more accurately described as a savings nil rate, since the amount of savings income covered by the PSA will still form part of the individual’s total income (for example, for the purposes of the higher/additional rates, or transferring part of the personal allowance to a spouse/civil partner). The same principle applies to the starting rate for savings described in the paragraph above. 1.12 The PSA is only available to an individual, so does not apply to trustees or personal representatives. Where an individual has

• no income chargeable at the higher rate, the PSA is £1,
• income chargeable at the higher rate but not the additional rate, the PSA is £
• any income is charged at the additional rate, the PSA is nil 1.13 The basic calculation for an individual with a small amount of non-savings income is perhaps best illustrated by an example: 2 S16 ITA 2007 3 S7 ITA 2007 4 S12A ITA 2007 (^5) Taxable non-savings income is the amount of non-savings income remaining after deductions and personal allowances are taken into account. 6 S12A, s12B ITA 2007

example because their income falls above the allowances) do not need to make additional declarations. 1.17 Separately from TDSI, there is a continuing general obligation on companies and certain other types of entity to deduct tax at source when they make payments of ‘yearly’ interest. The obligation also applies to any person paying yearly interest to a recipient outside the UK. The definition of yearly interest is found in case law: broadly it means amounts payable on an obligation lasting, or intended to last, for more than one year. 1.18 There are a number of exceptions from this obligation, in particular, it does not apply to interest paid by banks and building societies in the normal course of their business. This means that there is no obligation on banks and building societies to deduct tax from, for instance, interest paid on savings or current account balances (to which TDSI is likely to have applied until April 2016). But the exception does not extend to interest paid as part of a compensation payment, for example for mis-selling. A further exception applies to gilt-edged securities, where payments are made gross, unless the holder of the security makes an application for basic rate tax to be deducted.^9 1.19 There is no mechanism to apply for gross payment of yearly interest in cases where the recipient does not expect to be liable to income tax. 1.20 Payers of some other forms of income not within the savings income definition, such as annual payments^10 (including some reward payments by banks and building societies) are required to deduct basic rate tax in the same way.

Allocation of allowances

1.21 Calculations of tax across the different rate bands and allowances, together with the dividend allowance and rates discussed below, are not straightforward. A tax software provider confirmed the HMRC self- assessment software was producing incorrect results for 2016/17 in a number of scenarios. Again, this is best illustrated by examples: (^9) Chapter 5 of Part 15 ITA 2007 10 Annual payments are certain kinds of payment which arise under a legal obligation lasting more than one year, representing income rather than capital in the hands of the recipient

Table 1.B: Example 2 2016/

In this example, an individual receives 11,000 savings income and 11,000 dividend

income

2016/17 Savings income Tax Dividends Tax Savings income 11, Dividends 11, Less personal allowance (11,000) -

• 11, Dividends £5,000 @ 0% 5,000 0 Dividends £6,000 @ 7.5% 6,000 450 Total tax due per HMRC software 450 However, the most advantageous allocation of allowances is as follows: Savings income 11, Dividends 11, Less personal allowance (5,000) (6,000) 6,000 5, Starting rate for savings £5,000 @ 0% 5,000 0 Savings nil-rate £1,000 @ 0% 1,000 0 Dividends £5,000 @ 0% 5,000 0 Total tax due Nil Source: OTS 1.22 Although it may appear the reason for the error is the interaction of the starting rate for savings and the savings allowance, the error actually arose from a sub-optimal allocation of the personal allowance. While the components of income are assessed in a defined order of priority as explained above, the allocation of personal allowances (and reliefs available against general income, such as sideways loss relief) should be made in the way which will result in the greatest reduction in the liability to tax.^11 1.23 As discussed below, dividends formerly carried a non-payable tax credit which effectively offset the income tax payable on them, so allocation of the personal allowance against dividends would not have resulted in any tax saving. Dividends no longer carry a tax credit, and the ability to allocate the personal allowance against dividend income in preference to other income sources to reduce the tax payable was not accounted for in the HMRC self- assessment calculations. 11 S25(2) ITA 2007

1.27 That would imply the following calculation for Terry: Table 1.D: Table showing tax calculation for Terry 2016/ Pension Savings Dividends Pension 7, Savings 3, Dividends 9, Less personal allowance (7,000) (3,000) (1,000) Taxable 0 0 8, Tax: £5,000 @ 0% 0 £3,000 @ 7.5% 225 Source: Based on a submission to LITRG from an individual on 15 April 2 017 1.28 This would not be the most advantageous calculation. The actual liability is potentially nil, as follows: Table 1.E: Table showing revised calculation for Terry 2016/ Pension Savings Dividends Pension 7, Savings 3, Dividends 9, Less personal allowance (7,000) (4,000) Taxable 0 3,000 5, Tax: starting rate £3,000 @ 0% 0 Dividend: £5,000 @ 0% 0 Source: Based on a submission to LITRG from an individual on 15 April 2017 1.29 A further example of systems failing to cope with the complexities following the introduction of these allowances relates to top slicing relief, is explored in chapter 4 (Life insurance bond withdrawals) below. 1.30 An additional complication arises for Scottish and Welsh taxpayers. As explained above, the savings and dividend rates and allowances are not devolved, leading to an additional step in the calculation. First, the rates applying to UK resident individuals who are neither a Scottish nor a Welsh taxpayer are used to decide what level of PSA is due: one must then go back and apply the relevant Scottish or Welsh rates. The OTS has been unable to find guidance on this matter on official government websites. 1.31 Given the complexities of the multiple rates and allowances set out above, tax charities report a relatively small proportion of savings queries (in one representative organisation in the period 1 April 2017 to 31 August 2017, there were 517 issues raised on the starting rate, compared to 3,185 on

pension income). The rates have the effect that many individuals are kept outside of self-assessment (95% of individuals with savings now have no liability to tax on this income^13 ), while some individuals may not even be aware of its operation.

Deduction of tax on interest and other payments

1.32 A major bank provided details of the different types of income that customers can receive on a savings or a current account, each having a different tax treatment. This is complex for the customer to understand. A summary of the position is shown in Table 1.F: Table 1.F: Table showing tax treatment of interest and other payments Income Type Paid by bank to individual customer Within PSA Reportable by banks to HMRC Deposit interest Gross Yes Yes ISA interest Tax free No Yes Compensation interest Net Yes Yes Cashback Tax free No No Reward payment^14 Net No No Source: OTS 1.33 A single payment can have two components with different tax treatments, for example a refund of overpaid interest plus compensation interest. Compensation interest paid to individuals falls within the definition of yearly interest (paid net of basic rate tax), while refunds of overpaid amounts of interest are not taxable (as they are not interest). Cashbacks and discounts received by ordinary retail customers are outside the scope of income tax and capital gains tax.^15 1.34 The introduction of the PSA and the end of TDSI added some complexity to the collection of tax on savings and related income. The government consulted^16 on the withholding rules as they applied to compensation interest and a range of other payments, and published their response in

2015. The consultation document raised six potential options for change:

1 Retain the current rules for deduction of tax from non-TDSI interest

2 Remove the obligation to deduct income tax from all non-TDSI interest

3 Remove the obligation to deduct income tax from non-TDSI interest paid

to individuals only 13 Number of individuals affected quoted in Tax Information Impact Note: https://www.gov.uk/government/publications/income-tax- personal-savings-allowance-update/income-tax-personal-savings-allowance-update (^14) This rule applies to reward payments that are annual payments – not all reward payments are categorised as annual paments. 15 Statement of practice 4/97: https://www.gov.uk/government/publications/statement-of-practice- 4 - 1997/statement-of-practice- 4 - 1997 16 https://www.gov.uk/government/consultations/deduction-of-income-tax-from-savings-income-implementation-of-the-personal- savings-allowance