Scottish income tax was already set to create a headache for HM Revenue & Customs, pension providers and advisers in 2018, but the Scottish government’s recent proposals to reform it promises to add a new level of complexity.
On 30 November 2016, the Scottish government was granted powers to differ the rates and thresholds for income tax for Scottish residents.
In pensions newsletters, HMRC has outlined how it will identify pension scheme members resident in Scotland using the annual return of individual information submitted by scheme administrators by 5 July each year.
Each January (starting this month), HMRC will electronically tell pension scheme administrators operating relief at source pension schemes their individual scheme members’ residency tax status. Scottish residents will have an “S” identifier. Those unmatched will have a “U”.
Importantly, if a person is identified as a Scottish resident before the start of the tax year, that status is locked in, and even if they move part way through the year to somewhere else in the UK, they will still be treated as Scottish for the whole of the tax year.
HMRC is developing a look-up service for scheme administrators to use for members who joined after July. If the scheme administrator uses the service between April and December they will get the member’s current tax year residency. Between January and April, they also get the residency status for the next tax year.
If the scheme administrator is unable to look up the status before they apply tax relief at source to the first contribution, they must default the residency status to rest of UK and maintain this rate for the whole tax year. HMRC will sort out any shortfall or excess of tax relief at the end of the tax year.
New level of complexity
In December, this issue reached a new level. The Scottish government proposes to develop a five-tier income tax system for Scottish residents, as well as raise the tax rates for some, and reduce it for others (see table).
|Name of band||Band||Rate|
|Basic||Over £13,850 – £24,000||20%|
|Intermediate||Over £24,000 – £44,273||21%|
|Higher||Over £44,273 – £150,000||41%|
For schemes operating relief at source, this immediately raises questions. Currently, schemes receive 20 per cent tax relief direct from HMRC for all pension contributions. Those who pay higher rates of tax can claim any additional tax relief, usually through their self-assessment tax return, although higher rate taxpayers can also notify HMRC direct, who may adjust their tax code to give them this additional relief.
But how will HMRC cope with these new tax rates? If it credits all contributions with a straight 20 per cent, then many more people will have to reclaim additional tax relief. This is business-as-usual for higher and top rate taxpayers, but not for intermediate rate taxpayers. Would someone earning just over £24,000, really be bothered to claim the additional small amount of tax relief?
For a member earning £25,000 a year and paying 5 per cent pension contributions of £1,250 a year, the scheme would receive £312.50 direct from HMRC, giving a total pension contribution of £1,532.50. The member could claim an additional 1 per cent tax relief of £15.63. But the effort to get such a small amount could put them off.
HMRC could automatically give 21 per cent tax relief to pension schemes for these taxpayers. However, Finance Act 2004 sets out the tax relief payment is equal to the basic rate of income tax, and it would be convoluted to change this. The simplest approach may be to automatically adjust these taxpayers’ tax codes at the end of the year.
Those paying 19 per cent tax will receive too much tax relief. Non-taxpayers already receive 20 per cent tax relief on their contributions. But under automatic enrolment, and given current low opt out rates, around 90 per cent of the 893,000 people who fall under the intermediate rate could be contributing to a pension scheme.
The new Scottish income tax bands are still proposals and will not be finalised until mid-February. HMRC will no doubt be working hard to figure out the implications for relief at source schemes. But we need urgent clarification the minute the proposals turn into reality.
Finally, introducing varying rates of tax relief between different parts of the UK may reopen previous discussions on the future of pensions tax relief and whether to sever the link between income tax and pensions altogether.
Rachel Vahey is product technical manager at Nucleus Financial