The Scottish Government has published a discussion paper outlining four alternative approaches to the income tax system in Scotland based on suggestions by the main parties, with an announcement expected in next week’s Scottish Budget on 14th December whether to adopt one of these or something else altogether. https://beta.gov.scot/publications/role-income-tax-scotlands-budget/pages/8/
The alternative approaches outlined in the discussion paper include having up to six income tax bands and potentially changing the “basic rate of tax” for Scotland to something different than that for the rest of the UK. This would mean slightly different calculations for pension contributions in terms of tax relief entitlement and annual allowance availability.
There are 770,000 taxpayers in Scotland contributing to pension schemes under relief at source that could potentially be affected by this - (https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/647565/PEN5__2006-07_to_2015-16_.pdf).
How would the new system work?
Where pension members made contributions in the 2016/17 tax year, HMRC will notify pension providers in January if those members are on an “S” tax code (i.e. Scottish taxpayer) or an “rUK” tax code (i.e. rest of UK taxpayers). Providers will then be able to claim basic rate tax relief on contributions and pay tax on income at the appropriate rates from the 2018/19 tax year.
For members who didn’t contribute in 2016/17 or join their scheme after that tax year ended, there will be an online HMRC look-up service that providers can use to obtain the correct tax code. However this currently only allows providers to check the code of one member at a time. The lack of a bulk download provision will make it impractical for providers to use the look-up service in all cases.
In the absence of an “S” tax code, a provider must use the “rUK” code. Therefore, there is a real possibility that, if the Scottish Parliament decides on a Scottish basic rate that differs from the rest of UK basic rate, some Scottish taxpayers will end up being treated as UK taxpayers. This could result in them receiving the wrong amount of pension tax relief and potentially exceeding the annual allowance.
How could this work in practice?
A Scottish taxpayer who is subject to the maximum annual allowance taper, wants to make a gross contribution of £10,000. If the Scottish basic rate has decreased from 20% to 18%, they would pay in £8,200 net to make a gross contribution of £10,000.
However, if the provider still has the member down as a UK taxpayer, they would claim back 20% tax relief. This results in a gross contribution of £10,250.
The result is that the member has now claimed more tax relief than they are entitled to (20% rather than 18%) and they have exceeded their tapered annual allowance by £250.
Gareth James, head of technical resources at AJ Bell, comments:
“If next week’s Scottish Budget confirms a rate other than 20% to be the Scottish basic rate, it will have significant unintended consequences and introduce additional complexities for customers, advisers and pension providers.
“If the Scottish basic rate of income tax was anything other than 20%, this would result in a potentially large number of people automatically receiving too little or too much pension tax relief on their contributions, potentially meaning they will face tax charges or having to jump through additional administration hoops to deal with the consequences. This will be confusing for consumers and create additional work for financial advisers and pension providers.
“Even if the Scottish basic rate of income tax remains at 20%, if Scotland has a larger numbers of income rate bands than exist today or allowances are different, lots of people receiving pensions from their scheme will potentially be taxed on a different basis to the one they were expecting.”
Background to Scottish Government’s tax powers
From April 2016, the Scottish Government has had the power to vary the income tax paid by Scottish taxpayers. This works by taking the UK rates as a starting point and then reducing them by ten basis points. The Scottish Government can then decide how much tax to add back on top of that.
So far, they have simply added the ten basis points back to keep the rates the same as in the UK. However, this could change in 2018/19.