The Twin Peaks of Taxation
2nd October 2012
Willie MacKenzie discusses the effect of major changes in the tax systems.
Many dentists will be aware that child benefit is going to be withdrawn from high earners (those with income of more than £50k) with effect from January 2013. In true 'omnishambles' fashion, this is going to be by stealth and will operate by way of a clawback through the tax system. So what one hand giveth, the other taketh away! Unfortunately, the current tax system has become so complicated that we now have a system of marginal rates of tax that zig zags up and down as one progresses up the income scale. We've been here before – when the last Government withdrew personal allowances with effect from April 2011 for those earning above £100k.
As can be seen from the graph, there are two major spikes in tax rates so the primary strategy must be to avoid them where there is scope to do so. The core issue, which causes these distortions, is the phased withdrawal of income tax reliefs and allowances at fairly arbitrary levels of income. For personal allowances – it is the removal of £1 for every £2 of income when income reaches £100k. For child benefit – it's the removal of one per cent of benefit for every £100 of income when income reaches £50k. These withdrawals affect a person's marginal rate (the extra tax paid on each additional £1 of income).
Withdrawal of child benefit
The Chancellor in his wisdom decided that child benefit will retain its universal nature but an additional tax charge - High-Income Child Benefit Charge (HICBC) - will be levied on incomes above £50k such that any child benefit is negated by the tax charge up to an upper limit of £60k. This is essentially a form of clawback.
Clawback operates by reference to partners, not individuals. Taking an 'average' family of four this will mean an additional tax charge of £17.52 per cent - that is £1,752 of HICBC being paid on every £10k of income. Added to the 40 per cent higher rate, this will amount to an effective tax charge of 57.52 per cent on this band of income. The unfairness gets even worse – for a family of three children, the marginal rate goes up to a whopping 67 per cent. It's this phased withdrawal which generates the first tax spike as this creates a higher marginal rate of tax.
Moreover, the basic anomaly remains whereby a dual income couple earning £99k can keep all their child-benefit, while a single income couple on £60,000 lose all theirs. The graph well illustrates the rollercoaster nature of the UK tax system and the somewhat irrational trends which arise as a result of politicians never ending tinkering. More often than not, these problems arise as a result of a messy compromise to try and save money by the Treasury.
Of course, should you not be in the situation of having children then none of this will apply. It only applies to those in receipt of child benefit.
The next hurdle
The second hike in the marginal rate for dentists arises from the gradual removal of the personal allowance when income goes above £100k. The effect of straying into this zone, when one's income falls between £100k and £118,200, is to pay a marginal tax rate of 60 per cent (62 per cent, if you include National Insurance). A similar process as for the first hurdle has to be undertaken to try and keep income below the £100k mark and avoid the nasty tax trap.
Ways around the spikes
For those dentists potentially affected by spike 1, it is very much a question of shifting income so far as possible from one spouse to another to ensure that income is split in such a manner that each spouse's income is kept below £50k. This can be done more easily using a limited company where funds can be retained within the company. For example, dentists could change the dividend strategy to ensure that dividends are diverted from the higher earning spouse. Similarly, in a partnership, profit share could be changed to shift income from the higher earning spouse. Remember, as with all forms of tax planning, the planning has to be done before the event – rather than afterwards, when it is too late.
If your income is well above the threshold – it is difficult to get round these obstacles. However, for those just on the lower end of these income ranges – with some careful planning, it should be possible to develop a strategy to keep out of the danger zone.
Change in additional rate
As most dentists will know, the additional rate has been reduced to 45 per cent but only with effect from April 2013. This provides an ideal planning opportunity and it is the complete reverse of the advice I would have been offering on the introduction of the additional rate in November 2009. This time round, dentists will want to defer income by pushing income into tax year 2013/14 where it will be taxed at the lower rate. So far as dentists operating under the medium of a limited company, this might involve something as simple as taking a dividend after April 2013, rather than before.
Dentists will be completely unaware that the tax system operates in this peculiar fashion. What this crazy graph demonstrates above all else is the complexity of the UK tax code. Two years after a new coalition government it is rather depressing to see that the position is getting worse not better.