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Payments on Account
1. INTRODUCTION
If you file a personal tax return, and if your tax bill for the most recent tax year was £1,000 or more, chances are you're now part of HMRC's payments on account system. I've found the system a source of headaches, because while the concept itself is simple, many accountants, myself included, find it hard to explain to an intelligent layman.
Many accounting and tax concepts are like this. Much easier to explain face to face with your client, armed with a notepad, some colour pens for diagrams, and a big pot of strong coffee. But much harder to explain via an email, and worse still on the phone.
This is my attempt to set it out on paper.
2. WHY HAVE A PAYMENTS ON ACCOUNT SYSTEM AT ALL?
Most taxpayers in the UK do not need to make payments on account of the type I am writing about. Indeed nor are they required to file tax returns. And most of them do not need an accountant. This is because most UK taxpayers are still in PAYE jobs, and receive monthly payslips. Effectively they are making their own "payments on account" every time they receive a payslip and they see that their employer has deducted income tax, and paid it over to the HMRC on their behalf.
Now we come to clients of my firm, for whom this article is written; the majority of Jon Chapple & Co clients, who are either (a) director-shareholders of their own limited company or (b) self employed as sole traders.
Under UK law, both company directors and self employed traders MUST file a tax return. And, if their tax liability is more than £1,000, they must make payments on account toward their next tax bill.
3. EXAMPLE 1 - Mr A
(i) Mr A - 2013/14 (Mr A's first year)
In April 2013, Mr A quit his old PAYE job and set up a limited company, A Ltd, as a consulting business. Mr A is sole Director and 100% shareholder of A Ltd. Between 6 April 2013 and 5 April 2014, A Ltd pays Mr A a salary of £9,440 and gross dividends of £55,555. Mr A has no other taxable income for this period.
Mr A's 2013/14 tax return shows total taxable income of (£9,440 + £55,555) = £64,995.
Mr A's tax liability on this £64,995 of taxable income for 2013/14 is £5,298, and this £5,298 is payable on or before 31 Jan 2015.
While completing his 2013/14 tax return, Mr A sees that his tax liability for 2013/14 is £5,298, BUT he also sees that HMRC are asking him to make two additional payments, each of £2,649.
These two additional payments of £2,649 are each exactly 50% of Mr A's £5,298 2013/14 tax liability. Each is a payment on account towards HMRCs estimation of Mr A's likely tax liability for the next tax year (2014/15).
HMRCs estimation process is simple. They assume that Mr A's tax bill for the coming year will be exactly the same as that for the year just gone.
Payment on account no.1 (first £2,649) is due 31 January 2015, and payment on account no.2 (second £2,649) is due 31 July 2015.
Hence Mr A needs to pay (£5,298 + 2649) = £7,947 on 31 January 2015, and £2,649 on 31 July 2015.
(ii) Mr. A - 2014/15 (Mr A's second year)
Jump forward in time one year and Mr A is completing his 2014/15 tax return. Mr A's consulting business has been going well and Mr A has chosen to take a small pay rise (his salary he receives as Director of A Ltd is £10,000 for 2014/15 and the company also pays him shareholder dividends of £77,777.
So Mr A has taxable income of £87,777 for 2014/15. The tax due on this income (Mr A's 2014/15 tax liability) is £10,330 and this is payable on 31 January 2016.
BUT (good news) - Mr A has already made two payments on account towards his 2014/15 tax liability - £2,649 on 31 January 2015 and £2,649 on 31 July 2015.
AND (bad news) - HMRC are by now expecting Mr A to make future payments on account towards his NEXT tax liability.
Remember, HMRC's model will now assume that Mr A's tax liability for next year will be £10,330. And will therefore expect Mr A to make two payments on account, each of £5,165 (£5,165 being 50% of £10,330), towards his estimated 2015/16 tax liability.
Hence MR A will now need to pay the following:
by 31 January 2016
| 2014/15 Tax liability |
£10,330 |
| LESS: POA 1 for 2014/15 (made 31 Jan 2015) |
(£2,649) |
| LESS: POA 2 for 2014/15 (made 31 July 2015) |
(£2,649) |
| ADD: POA 1 for 2015/16: |
£5,165
|
|
TOTAL DUE 31 January 2016
|
£10,197
|
|
AND DUE by 31 July 2016: POA 2 for 2015/16: |
£5,165
|
If you have not run away screaming yet, you can probably see that by the end of the second year, things settle down to a more steady state of affairs whereby Mr A will make payments each January and each July.
If Mr A's taxable income (and hence his tax liability) increases year on year, then Mr A’s payments on account go up. If however Mr A's tax liability decreases, then his payments on account will have been too large. And any overpaid amounts are then returned to Mr A by way of a tax rebate (with interest).
4. CLAIMING TO REDUCE PAYMENTS ON ACCOUNT
HMRC recognise that their assumption behind the payments on account system is a simplistic one. Namely that a taxpayer's tax liability will be the same year on year.
And so they offer the taxpayer (as part of the tax return filing process) to elect to REDUCE their payments on account. The taxpayer can choose to reduce the payment on account by any amount, including all the way down to a £NIL payment on account.
IF however, these payments on account have been reduced to such a level that they prove insufficient to cover the coming year's tax liability, the HMRC retrospectively charge interest on the underpaid payments on account. At the time of writing, the interest rate is 3% per annum.
Let's do a second worked example.
5. EXAMPLE 2 - MR B
(i) Mr B - 2013/14 (Mr B's first year)
Mr B is in exactly the same position as regards taxable income as Mr A.
Hence his taxable income and resulting tax liabilities are the same as in the previous example (in blue type), but in this example, Mr B elects, when filing his 2013/14 tax return, to reduce his payments on account from the HMRC suggested amounts (2 x £2,649).
He elects to reduce the payments on account from £2,649 to £NIL.
Remember, for 2013/14 Mr B had taxable income of £64,995 and his 2013/14 tax liability was £5,298.
So Mr B pays just his £5,298 on 31 January 2015. And he makes NIL payments on account toward his 2014/15 tax liability on 31 January 2015 and 31 July 2015.
Right now Mr B is feeling very pleased, as he has only paid HMRC £5,298 (in our previous example Mr A, who had exactly the same taxable income and tax liability as Mr B, paid £5,298 plus £2,649 on 31 January 2015 and a further £2,649 on 31 July 2015)
As with Example One, we'll now jump forward a year to 2014/15.
(ii) Mr B - 2014/15 (Mr B's second year)
For 2014/15 Mr B's taxable income is £87,777.
His tax bill for this tax year is £10,330
Mr B pays the £10,330 on 31 January 2016. He then receives a demand from HMRC, for just under £120.
This is made up of:
£2649 x 3% for 365 days (interest on the £2649 Mr B should have paid on 31 January 2015) = £80
£2649 x 3% for 184 days (interest on the £2649 Mr B should have paid on 31 July 2015) = £40.
If Mr B was financially under pressure during this time, he may well consider £120 of interest an extremely good price to pay for use of £2,649 for a year (from 31 Jan 2015 to 31 Jan 2016), and another £2,649 for 6 months (31 July 2015 to 31 January 2016).
Effectively he has "borrowed" the money from HMRC at 3%. Most banks right now might want 10%. And most credit card companies ask for considerably more.
However, if Mr B was in a net savings position, and he had no other use for his money and it was sat at the bank, earning (say) 1% interest, then Mr B would more likely choose to make the full HMRC payments on account, and avoid the 3% interest charge.
6. CONCLUSIONS
At first glance the payments on account system can look needlessly complex, and unfair. Especially to a taxpayer who has previously only ever known the PAYE system, and is in his/her first two years as a Director-shareholder of his own limited company.
At a closer look however, we can see that it is all in the timing. Mr A and Mr B do not actually pay ANY personal tax between the start of their new business (6 April 2013) and 31 January 2015 - a period of a nearly 22 months.
In comparison, the majority of UK taxpayers, during that same 22 months, will have had 22 "payments on account" removed from their payslips and made over to HMRC.
The trick, when you are Mr A or Mr B, is in reserving the right amounts for not only your personal tax liability for the tax year in question, but also for your likely future payments on account.
I hope this article goes some way towards helping Mr A, Mr B, and all our clients who need to file personal tax returns.
Finally, my thanks to BC, whose questions around this issue inspired me to write this.
Jon Chapple
24 February 2015