Tax Reducers – Fact or Fiction?
“I wish I was paying less tax” is probably a thought that has crossed the minds of many of us at least once in our lifetimes, and it would not be a surprise at all if many were resigned to that thought. It may come as a welcome surprise for those same taxpayers to learn that something that is designed to reduce your tax is in fact not a mythical concept, but rather something very real and claimable. Enter ‘tax reducers’, forms of reliefs that are designed to lower income tax through the means of deductions.
But before we get into the intricacies of tax reducers, let us quickly skim through the process of income tax calculation. So:
How is my Income Tax calculated?
The entire income tax calculation can be summed up well in 7 distinct steps:
- Identifying the amount of component income that is liable to tax in the relevant tax year. This is mainly income from employment, self-employment, dividends, and savings.
- Deductions are made from the component income or the total income. Unless underlying reliefs apply; typically arising for trading losses, business property losses and qualifying loan interests.
- Personal Allowances are deducted.
- Tax bands and rates are applied to the taxpaying individual’s income for the tax year.
- These amounts are then totalled to produce the total tax liability for the year.
- To find the total amount of tax payable in the tax year, tax reducers are deducted – which we will focus on shortly.
- Any additional tax charges (say, annual allowance) are added, and tax already paid in relation to the relevant tax year is deducted.
More detailed information on the income tax calculations can be found in ITA 2007, s.23.
Types of Tax Reducers
If we go back to the income tax calculation above, you may notice deductions being made during Step 2. Interestingly, tax reducers approach deductions differently by reducing the total tax liability directly instead of being deducted from the component or total income at source.
The following tax reliefs are the main ‘tax reducers’ you should be aware of:
- Married Couple’s Allowance (MCA) and Marriage Allowance (MA) – Excess MCA relief can be transferred to the partner at tax year-end in the interests of preventing the tax reducers from going to waste. Claims can also be made to give at least half the min. MCA tax reducer (calculate at 10% x £3,450 = £345) to partner at tax year-end.
- Enterprise Investment Scheme (EIS) – If a taxpayer subscribes to EIS shares (ie. their employer offers them new shares prior to the date of official issue) a tax reducer is awarded which is based on a percentage (currently 30%) on the lower of the amount invested or £1 million. The latter option actually doubles to £2 million if subscribed shares are for “knowledge intensive companies”.
- Seed Enterprise Investment Scheme (SEIS) – The tax reducer here works roughly similar to the EIS with key differences being that the tax reducer percentage is 50% and applies to the lower of the amount invested or £100,000. Note that “Seed Enterprises” often relate to smaller and younger companies than those qualifying for EIS and must have traded for a short period of time.
- Social Investment (SI) – If a taxpayer subscribes for shares or makes a qualifying debt investment in a social enterprise, a tax reducer of 30% is given on the lower of the investment amount or £1 million. In this instance, qualifying debt investments must be in the form of a debenture that offers no return other than at the commercial rate and carries no charge over assets. It must also rank equally amongst other shares.
- Venture Capital Trust (VCT) – A taxpayer subscribing to VCT shares is given a reducer of 30% on the lower of the invested amount or £200,000.
Order of application
In the event of more than one reducer being applicable (which is not a rare occurrence), there is a prescribed order to which the tax reducers must be deducted. The general rule of thumb is that the tax reducers be structured in order of favourability to the taxpayer. Favourability in this context being whichever order allows for the lowest tax due.
The order is as follows:
- Maintenance payments
- MCA/ MA
How much tax can I reduce?
There is a limit to the total tax reduction applied during Step 6 of the income tax calculation to prevent the deductions from creating a tax repayment. In layman terms, the total amount of reductions is limited to the tax liability incurred. HMRC also stress that where a taxpayer has EIS, SEIS, SI and/or VCT and has made donations to a charity via gift aid, the tax liability cannot be reduced to a zero figure. Income tax must be due which covers the basic rate tax relief at source for gift aid donations. ‘Wasted’ tax reducers (unused tax reducers in the tax year as a result of insufficient income) are determined in accordance with the order described above and may be taken into consideration when discussing the possibility of carrying back or forward tax reducers.
Consider a taxpaying individual who has a tax liability of £35,000 at Step 5 of the income tax calculation. They also have EIS relief of £26,000, SEIS relief of £9,000 and have made net donations of £1,200 to a charity using gift aid. The amount of income tax due from this individual is:
Tax liability (Step 5)
|Less: Step 6 tax reducers|
SEIS relief (limited)
The individual in this scenario would otherwise have their tax reduced to nil if it were not for the gift aid donations. Therefore, the total amount of tax reducers is limited to the amount of basic rate tax at source. As the basic rate is at 20%, the amount of tax payable is calculated by multiplying the donation total by 20 and then dividing by 80 (ie. £1,200 x 20/80). In this case, SEIS is limited as EIS relief is deducted first under the prescribed rules of ordering (ITA 2007, s.27). The unused SEIS income tax relief can be recovered by claiming it on a previous year.