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The UK tax system for savings income, including definitions, taxation rates, allowances, and exemptions. It also touches upon the interaction of income tax rates and allowances, and recommendations for simplification. Relevant charts and case studies are provided.
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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 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
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:
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).
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)
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).
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).
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/
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.
approaches. (Paragraphs 1.58 to 1.69)
savings income rates and allowances and the stages needed to get there. (Paragraphs 1.56 and 1.57)
Financial Capability Unit where relevant. (Paragraphs 1.70 to 1.72)
Personal Savings Allowance. (Paragraph 1.73)
in-year, to further streamline and simplify the rules. (Paragraphs 2.14 to 2.17)
financial products and facilitate the provision of new and innovative offerings as well as simplifying tax assessment. (Paragraph 2.29)
tax code for personal pension lump sum withdrawals. (Paragraphs 3.11 to 3. and 3.24 to 3.32)
has bedded down. (Paragraph 4.36)
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 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:
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
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.
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/
2016/17 Savings income Tax Dividends Tax Savings income 11, Dividends 11, Less personal allowance (11,000) -
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.
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
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