Certificate for Introduction to Securities & Investment (Cert.ISI) Unit 1 Lesson 40:  Tax  Distinction between gross and net interest payments  Calculation of net interest due 40cis

Income attracts income tax Under UK tax rules, interest paid on deposit accounts is treated as income  It is therefore subject to income tax The “headline” interest rate is before deduction of tax  It is also known as the “gross” interest rate Interest will be deducted by the bank or building society at source  Tax is deducted at a flat rate of 20%, regardless of the saver’s actual tax rate  This is known as “net” interest

Tax and the private investor Private investors are liable to pay tax on income generated by savings and investment. Taxable income includes:  Interest on bank deposits  Dividends paid on shares  Income distributions by unit trusts  Interest on government and corporate bonds Dividends include:  Dividend payments from unit trusts  Dividend payments from OEICS  Dividend payments from companies Interest includes:  Interest on gilts  Interest on corporate bonds  Interest on cash deposits Gross: No tax deducted Net: Tax deducted Investment income can be paid either gross or net:

Gross and net Interest on cash deposits is usually paid net of tax  Tax is deducted by the bank at a rate of 20%  Higher rate tax-payers then have to pay the additional tax when they submit their annual tax return Interest on gilts can either be paid gross or net  If paid net, tax will be deducted at a rate of 20%  Higher rate tax-payers then have to pay the additional tax when they submit their annual tax return Dividends are paid net of tax  Including dividends earned by unit trusts and OEICS  Unit trusts and OEICS investing principally in bonds pay an interest distribution which is treated as interest income These tax rates are applied after the personal allowance of £6,475 has been deducted from the income

Tax on savings The 10% starting rate of tax applies to savings income only  If the tax-payer has savings income of – say – £10,000 a year, the first £2,440 would be taxed at 10% and the remaining £7,560 would be taxed at 20%  However, if the tax-payer had non-savings income above this limit – say a pension of £5,000 a year – the 10% band would not apply and all of the £10,000 savings income would be taxed at the standard rate

Rates of tax on savings Banks and other savings institutions in the UK will normally deduct tax on interest “at source” – i.e. before paying the interest to the saver Example: Mrs Jones has £200 on deposit at Supa-Steady Bank for one year at 5% interest Mrs Jones will earn £200 x 5% = £10 gross on her deposit before deduction of tax Supa-Steady Bank will pay Mrs Jones net interest of £8 Supa-Steady Bank will pay £2 tax on behalf of Mrs Jones to HM Revenue and Customs At the end of the tax year, Supa-Steady Bank will send Mrs Jones a tax certificate confirming that the basic rate of tax has been paid on her behalf  The “headline” rate of interest quoted by deposit-takers is before deduction of tax  This is referred to as gross interest  The rate of interest after tax is deducted is referred to as net interest

Rates of tax for high earners Example: Mr Ritchie has £50,000 on deposit at Snooty Bank for one year at 6% interest Mr Ritchie will earn £50,000 x 6% = £3,000 gross on his deposit before deduction of tax Snooty Bank will pay Mr Ritchie net interest of £2,400 Snooty Bank will pay £600 tax on behalf of Mr Ritchie to HM Revenue and Customs At the end of the tax year, Snooty Bank will send Mr Ritchie a tax certificate confirming that the basic rate of tax has been paid on his behalf High earners pay tax at 40% on earnings over £37,400 (from 6 April 2010 income over £150,000 a year will be taxed at 50%) Higher rate taxpayers face an additional tax liability on their savings income, because it has been taxed at source only at the basic rate of 20% When he fills in his annual tax return, Mr Ritchie will declare gross interest of £3,000, calculate a tax liability of £1,200 (40% x £3,000) and pay a further £600 to HMRC  This is calculated by multiplying gross amount of interest by 40% and then deducting the tax paid already to HMRC

Low-earning savers Savers with very low incomes (i.e. less than £125 a week) are likely to have no tax liability at all.  Non-taxpayers can apply to have their interest paid gross by the bank – no interest is deducted at source by the bank  Non-taxpayers must submit an HMRC form known as an R85  This is much simpler than having the tax deducted at source and then having to fill out and submit a tax reclaim form.

Exercises Exercise 1 Mr Stevens is a basic rate tax-payer. He has had £1,500 on deposit at Supa-Steady Bank for a year, earning 4% gross interest  How much interest does Mr Stevens receive?  How much is deducted at source on his behalf? Miss Diamond earns £125,000 a year. She has had £20,000 on deposit at Snooty Bank for a year earning 7.5% gross interest  How much interest has the bank deducted at source and paid to HMRC?  How much additional tax will she have to pay when she files her tax return? Exercise 2 Exercise 3 Alan is 12 years old and his father has just submitted an R85 form on his behalf. Alan has had £400 on deposit at Supa-Steady Bank for a year, earning 3% net  What will be the gross interest rate Alan will now receive on his savings?

Exercise solutions Exercise 1 Mr Stevens is a basic rate tax-payer. He has had £1,500 on deposit at Supa-Steady Bank for a year, earning 4% gross interest  How much interest does Mr Stevens receive? A: £48  How much is deducted at source on his behalf? A: £12 Miss Diamond earns £125,000 a year. She has had £20,000 on deposit at Snooty Bank for a year earning 7.5% gross interest  How much interest has the bank deducted at source and paid to HMRC? A: £300  How much additional tax will she have to pay when she files her tax return? A: £300 Exercise 2 Exercise 3 Alan is 12 years old and his father has just submitted an R85 form on his behalf. Alan has had £400 on deposit at Supa-Steady Bank for a year, earning 3% net  What will be the gross interest rate Alan will now receive on his savings? A: 3.75%