Techzone

High earners have faced a restricted pensions annual allowance since 'tapering' was introduced in April 2016.

The annual allowance is reduced if both the 'adjusted income' (AI) and 'threshold income' (TI) are exceeded in a tax year.

From 6 April 2023, the AI and TI limits are £260,000 and £200,000 respectively.

If both are exceeded, the annual allowance reduces by £1 for every £2 of AI over £260,000 until it reaches the minimum amount of £10,000 (i.e. when AI is more than £360,000).

The limits were lower in earlier tax years.

For tax years 2020/21 to 2022/23, the AI limit was £240,000, and the TI limit was £200,000 with a minimum allowance of just £4,000 (i.e. when AI is more than £312,000).

For tax years 2016/17 to 2019/20, the AI limit was £150,000, and the TI limit was £110,000. The minimum allowance for these years is £10,000 (i.e., when AI is more than £210,000).

Understanding what is included in the income definitions is key for those wishing to maximise their pension savings using the current year's allowance and any unused allowances carried forward from the previous three tax years.

What is adjusted income and threshold income?

The income definitions for AI and TI are derived from a combination of the Finance Act (FA) 2015 and the Income Tax Act (ITA) 2007. The starting point is a figure called 'net income' as defined in ITA 2007, but the FA 2015 then makes certain adjustments.

The following calculations start with a figure of 'total income' before any deductions for pension contributions have been made. This means that employee contributions taken from gross pay before tax under the net pay arrangement should be added back too. The same figure for total income can then be used as the starting point for AI and TI.

Although this calculation appears relatively straightforward, there is often uncertainty as to what is included in total income, and what can and can't be deducted.

Many of the reliefs, allowances, and deductions that can be made when calculating an individual's income tax liability are not allowed when computing AI and TI.

For individuals with more complex affairs, such as business owners, accountancy advice may be required to calculate the correct figure, but the common items asked about are listed below.

What is included in 'income'

UK resident and domiciled individuals are taxed on their worldwide income. Income will therefore include:

Gross pay
This will also include any bonus received and benefits in kind. For the purposes of AI and TI, do not deduct anything in respect of pension contributions at this stage.

• For those paying into a SIPP or pension with relief given at source, there's no adjustment to make as individual contributions will not be deducted from gross pay
• Those who make contributions gross and have to make a claim for tax relief, e.g. gross contributions paid into a retirement annuity contract (Section 226), should not deduct the contributions from earnings
• And for those who make individual contributions through net pay, typically those in company schemes where the employer deducts contributions from gross pay before tax, these payments should be added back to total income

Care should therefore be taken when collecting salary information. Which 'gross pay' have you got from the client? The figure before or after any employee contributions under 'net pay'?

Taxable elements of share incentive schemes
Employers may offer employees the chance to acquire shares in their company through tax advantaged schemes such as share incentive plans (SIPs), save as you earn (SAYE), company share options and enterprise management incentives (EMIs). Provided the rules are complied with, there won't normally be an income tax charge under the schemes.

But if certain requirements for full tax advantages are not met, this could result in an income tax charge and the amount assessable to tax should be included in total income. Where shares are offered outside of the schemes mentioned, it's likely there will be an income tax charge, and this should also be included in total income.

Redundancy payments
The taxable element of a termination payment should be included, as should any payments in lieu of notice. The first £30,000 of a qualifying termination payment is tax free and can be ignored.

Income from self-employment
The taxable profits from a trade - i.e., after deduction of the allowable costs and expenses of the business (but before any deductions for pension savings).

Pension income
This includes both private and State Pensions in payment, but excluding any tax free cash element.

Dividend income
Dividends are now received gross, so there's no need to gross them up. However, no deductions should be made for the £1,000 dividend allowance.

Savings interest
Most interest received is now paid gross, but where the payer has deducted tax at source, the payment should be grossed up. The personal savings allowance should not be deducted.

Chargeable event gains on insurance bonds and capital redemption bonds
The whole gain for both onshore and offshore bonds should be added, and there are no deductions for top slicing relief or corresponding deficiency relief. However, if an individual is entitled to time apportionment relief for in respect of time spent abroad, this can be deducted to arrive at the amount subject to UK tax.

Annuities (non-pension)
Payments received from a purchased life annuity will have a tax free amount in respect of capital returned, and a taxable amount. Annuity providers will normally deduct tax from the taxable amount, and therefore any tax taken will need to be added back. Some annuities don't qualify for a tax free proportion and will be fully taxable, in which case the whole payment should be included. Typically, these will be annuities purchased as a result of a will or settlement.

Rental income
Any rental income after allowable expenses have been deducted are included. There are no longer any deductions for mortgage interest when determining taxable profits and the replacement basic rate tax relief is ignored for the purpose of calculating AI and TI.

Income received from a trust
If a beneficiary receives income from a trust, the gross income should be included.

For interest in possession trusts where income is mandated to a beneficiary, the dividend or interest will usually be received gross. If it's not mandated, the trustees must account for income tax before paying it to a beneficiary, and the beneficiary must gross-up the payment received.

If income is distributed from a discretionary trust, trustees must account for tax at the trust rate and the beneficiary will receive the income with a tax credit of 45%. This must be added to the payment received. For example, a beneficiary receives income from a discretionary trust in the form of a cheque for £55 with a tax credit of £45 (this will be shown on form R185E) - £100 should be included in total income for AI and TI.

Income from absolute or bare trusts will be treated as if the individual received the income directly.

Overseas income
Individuals who are UK resident and domiciled will generally be taxed on their worldwide income from both savings and employment. It may be possible that some income is exempt under a double taxation treaty, but treaties provide for tax relief in different ways and clients should seek tax advice to determine what should be included in income.

What deductions can be made

Many items that can be deducted from income before tax is calculated cannot be deducted for the purposes of AI and TI. Those items that can be deducted are less common and therefore will only affect a small number of clients. They include:

Share loss relief
Income tax relief can be claimed when an individual subscribes for 'qualifying shares' and then sells them at a loss. Qualifying shares are those bought under the Enterprise Investment Scheme (EIS) and shares in other unlisted companies that meet certain conditions. Where individuals do suffer such a loss, this may be deducted from AI and TI.

Gifts of shares, securities and real property to charities
A deduction can be made where actual shares are gifted to charities, but other charitable gifts which normally attract tax relief, such as those made under gift aid, cannot be deducted.

Certain business losses
These relate to a number of losses, such as losses made in early years of trading and on termination of a business. This is a more complex area and clients should seek accountancy advice.

What can't be deducted

There are a number of items that can be deducted when computing income tax that should not be deducted when calculating AI and TI. These include:

• Personal allowances
• Marriage Allowance and Married Couple's Allowance
• Gifts to charities made under gift aid
• Top slicing relief on insurance bonds
• Corresponding deficiency relief relating to insurance bonds
• Income tax relief attributable to Enterprise Investment Schemes (EIS), Seed Enterprise Investment Schemes (SEIS) and Venture Capital Trusts (VCT)

Employer contributions

These must be added in to the calculation of adjusted income.

For defined contribution (DC) schemes it will be easy to identify these.

For defined benefit (DB) schemes, the employer contribution is the pension input amount for the tax year concerned, less the amount of any employee contributions to the scheme.

• The input amount = [(benefits at the end of the year) - (benefits at the start of the year, increased by CPI from September of previous year)] x 16 *
• To get the employer contribution, any employee contributions will be deducted from this

* If the scheme provides a separate lump sum, for the start and end of year calculations, the pension should be multiplied by 16 and the lump sum added at face value. The amount at the start of the year can then be increased by CPI. The difference between the start and end figures is the input amount.  

New salary sacrifice arrangements

Salary sacrifice arrangements entered into after 8 July 2015 must be added back for the purposes of threshold income only.

If an arrangement was in place before 8 July 2015 and is subsequently altered, for example to increase the amount sacrificed, then it's likely that a new agreement will replace the old one and the full amount sacrificed must be added back in.

But if future increases were allowed for under the old agreement, then the sacrifice should not need to be added. If there is any uncertainty over the terms of sacrifice in the employment contract, legal advice may be needed, particularly if the inclusion of sacrificed amounts could significantly reduce the annual allowance for an individual and therefore how much they can contribute tax efficiently.

Bonus sacrifice will normally be subject to a new agreement each year, in which case these should also be added back to threshold income.

Bringing it all together

The legislation

The definitions of adjusted income and threshold income can be found in the Finance Act 2015 – Schedule 4, Part 4 and Part 5 respectively.

Both definitions start with the income figure found at 'step 2' of s23 of the Income Tax Act 2007, which sets out how an individual's income tax liability is calculated. There are seven steps to this computation, which effectively means that all deductions, allowances and reliefs given below step 2 when calculating income tax, are disregarded from AI and TI. These include the items in the above list 'What can't be deducted'.

FA 2015 then makes adjustments to this figure to arrive at AI and TI.