Mr Darling has mounted something of a three-pronged attack on high earners, comprising increases in both income tax and National Insurance with a withdrawal of the basic personal allowance. However, the measures do not all take effect immediately and are being phased in over the next three tax years. Their gradual introduction provides high earners with a window of opportunity in which they rearrange their affairs so as to shield themselves from the worst of the pre-Budget changes.
As far as tax is concerned, things start to look a bit grim from 2010-11. At present all individuals are entitled to the basic personal allowance, with certain individuals qualifying for higher personal allowances. However, this will cease to be the case from 2010-11. From that date, individuals with gross income (before personal allowances) of at least £100,000 will have their personal allowances reduced.
From 2010—11, the personal allowance is reduced by £1 for every £2 that income exceeds £100,000, up to a maximum reduction of one-half of the personal allowance for that tax year. The allowance is further reduced by £1 for every £2 of income above £140,000 until the allowance is completely eroded.
The effect of this is that some income suffers tax at a marginal rate of 60 per cent.
Where income exceeds £100,000, the allowance is reduced by £1 for each £2 that the £100,000 limit is exceeded to a maximum reduction of 50 per cent of the personal allowance.
Assuming the personal allowance for 2010-11 remains at the 2009-10 level of £6,475, while income is between £100,001 and £106,475, each £2 of income above £100,000 reduces the personal allowance by £1. Once income reaches £106,647, the personal allowance has been reduced by 50 per cent to £3,238. As the last digit of the personal allowance is a 5, where the full 50 per cent reduction applies the remaining personal allowance is rounded up.
On the band of income from £100,001 to £106,475, higher per cent of 40 per cent is payable. The taxpayer also suffers a loss of personal allowance of £3,237. The additional taxable income this generates is liable to tax at 40 per cent (i.e. £1,298.40). Tax at 40 per cent is also payable as normal on the income of £6,475 (i.e. £2,590). The combined effect is that tax of £3,888.40 is payable on income of £6,475, giving rise to a marginal tax rate of 60 per cent.
The same is true once income reaches £140,000 and the remaining personal allowance is abated at the same rate, so that the slice of income between £140,000 and £140,000 plus the basic personal allowance also suffers tax at a marginal rate of 60 per cent.
The Chancellor dealt a further tax blow to those with income of £150,000 and above. From 2011-12 a new rate of income tax of 45 per cent will apply to taxable non-savings and savings income above £150,000. A dividends rate of 37.5 per cent will apply to dividend income above the £150,000 threshold from 6 April 2011.
The changes are not confined to income tax – National Insurance changes also on the agenda. As previously announced, from 6 April 2009, the upper earnings limit is aligned at the rate at which higher rate tax becomes payable. To this end the upper earnings limit for 2009—10 has been set at £844.
The alignment widens the band of earnings liable at the main rate of primary Class 1 National Insurance contributions and effectively shifts earnings from liability at the additional rate of one per cent to liability at the main rate of 11 per cent. The self-employed are similarly affected as the upper profits limit is also aligned with the rate at which higher rate income tax becomes payable (£43,875 for 2009-10).
Class 1 and Class 4 National Insurance contributions are due to increase by 0.5 per cent from 6 April 2011. As a result the main rate of primary Class 1 contributions will be 11.5 per cent, the additional rate 0.5 per cent and the secondary Class 1 rate 13.3 per cent. The main rate of Class 4 National Insurance contributions will increase to 8.5 per cent and the additional rate to 1.5 per cent.
In the aftermath of the pre-Budget report, the outlook for higher earner is gloomy. However, there is time to take action to protect against some of the harsher of the Chancellor’s measures.
Timing is often everything and so too in tax planning. The abatement of personal allowances for those with incomes of £100,000 or more does not take effect until 2010-11. By advancing bonus payments and other income to before 6 April 2009 so as to keep 2010-11 income below the abatement trigger points of £100,000 and £140,000 it may be possible to minimise the loss of personal allowances.
It may also be possible to retain entitlement to personal allowances by making payments into registered pension schemes. Since 6 April 2006 it has been possible to make tax relieved contributions to personal pension schemes up to 100 per cent of earnings, subject to the overall annual allowance limit (£245,000 for 2009—10).
Boosting pension savings will reduce taxable income and can help to preserve entitlement to personal allowances or reduce liability at the 45 per cent rate. This may be particularly attractive where the income would otherwise suffer a marginal rate of 60 per cent.
Taxable income can also be reduced by swapping taxable salary for tax exempt benefits in kind, such as employer-provided childcare, childcare vouchers, mobile telephones, by means of a salary sacrifice scheme. This again is attractive around the personal allowance abatement trigger points where those just above these limits would otherwise suffer tax at a marginal rate of 60 percent.
The capital gains tax regime was reformed from 6 April 2008. Capital gains above the exempt amount are now charged at a flat rate of 18 per cent. This makes capital distinctly more attractive then income from a tax viewpoint, especially with a top rate of income tax of 45 per cent on the agenda. If it is possible to take capital rather than income, for example shares rather than a cash bonus, this represents a tax efficient choice. This is particularly so if the annual exempt amount for capital gains tax purposes would otherwise be wasted.
Although the outlook is bleak, it is far from certain whether the changes will make it to the statute book, especially given that a general election will take place before 2011-12. However, knowing about the increases in advance allows time to take stock and to take steps to minimise their impact. However, it should be remembered that there is often a very fine line between what the Government will accept as tax planning and what they regard as tax avoidance and one can be sure that they will take steps to frustrate any attempts at the latter.