January 30th, 2020
Divergences of the Scottish tax regime
This article was originally produced for Taxation Magazine on the 19th November.
Authors: Shirley McIntosh
Scotland the brave
- Scotland has recently begun to implement a devolved tax system.
- Land and buildings transactions tax and Scottish landfill tax replace the UK equivalents.
- New income tax bands were introduced from 2018-19.
- Scottish residence is determined by the taxpayer’s home or day counting.
- Scottish income tax applies only to non-savings and non-dividend income which can lead to complications.
- The Scottish GAAR applies to fully devolved taxes but has only a single reasonableness test.
This summer saw the 20th anniversary of the establishment of the new devolved Scottish parliament and the transfer of specific powers and responsibilities from Westminster. With the major political uncertainties now facing the UK, the constitutional questions being raised by Brexit, and the wider geopolitical concerns at this time, it seems appropriate to reflect on the Scottish journey over the past 20 years with, of course, a particular focus on tax matters.
Although the Scottish parliament has had tax raising powers throughout this 20-year period, it was not until the implementation of the Scotland Act 2012 that we began to see significant divergence in the tax systems of Scotland and the rest of the UK.
The Scotland Act 2012 provided for the devolution of stamp duty land tax and landfill tax to the Scottish parliament and these, in turn, have been replaced from 1 April 2015 by Scottish equivalents – land and buildings transactions tax (LBTT) and Scottish landfill tax (SLfT). Further, the previous option to vary the rate of income tax by up to 3% in either direction was replaced by the Scottish rate of income tax (SRIT). This provided that all rates of income tax for a Scottish taxpayer were reduced by ten percentage points to be replaced by a single rate set by the Scottish parliament. SRIT operated only for 2016-17 and the rate was set at 10% so, in effect, the rates of tax paid by Scottish taxpayers for that year were the same as in the rest of the UK.
Further devolved powers were introduced through the Scotland Act 2016 which, in relation to direct tax, replaced SRIT with Scottish income tax (SIT). This gave the Scottish parliament the power to set the bands and rates of income tax that apply to the non-savings and non-dividend income of Scottish taxpayers. Their liability to the dividend ordinary, upper and additional rates and the basic, higher and additional rates for savings income remains at the UK rate thresholds, as is the amount (if any) of the personal savings allowance. Further, the Scottish parliament gained the power to charge its own air departure tax in place of air passenger duty and an aggregates levy, although to date neither of these taxes have been implemented.
Allocating VAT to Scotland
The 2016 act also provided for the assignment of a proportion of VAT raised in Scotland – the first 10% of standard rated supplies and the first 2.5% of reduced rate supplies. This measure is due to take effect for the first time in 2019-20. That it has taken several years to be activated is due to the complexity of calculating just how much this represents in cash terms.
From 2017-18, income tax in Scotland has diverged from the rest of the UK. In the first year of operation, 2017-18, SIT differed in only one area. The starting point for the higher rate band was frozen so that Scottish taxpayers earning more than £45,000 paid £400 more income tax than someone on the same earnings elsewhere in the UK. Although the amount itself may seem small, the ramifications of that apparently simple change were much wider. Among other things, National Insurance contributions are reserved to Westminster and the upper limit is tied to the UK higher-rate threshold. This meant that Scottish taxpayers were, in effect, taxed at a rate of 52% on earnings between £43,000 and £45,000.
For 2018-19 further changes were made to introduce new tax bands and alter the rates of tax. These continue in 2019-20 and are summarised in the Scottish Tax Rates table.
What’s all the fuss about?
Many millions of UK taxpayers have very simple tax affairs; they are based solely in one jurisdiction, pay all their tax through the PAYE system and receive pensions tax relief under the net pay scheme. These are not likely to be the taxpayers we currently encounter in practice.
For anyone considered to be a Scottish taxpayer, the increasingly complex UK tax legislation combined with devolved taxes has created a system which is, at best, unwieldy. As practitioners, we may advise individuals relocating around the UK or purchasing holiday homes (and possibly renting them) in other parts of the UK. We may also advise businesses operating across the UK who may encounter LBTT or SLfT and who may also need to take account of the effects of SIT on the recruitment and retention of employees when setting reward packages. At least some knowledge of devolved taxes is therefore important for all of us. While many of the principles of the taxes will be familiar, there are some differences in the detail.
Taxation of individuals
When considering the tax position of an individual, the first question to ask is whether they are UK tax resident. If they are not, they cannot be a Scottish taxpayer. If they are UK tax resident, the next step is to establish whether they are a Scottish taxpayer. The test to be applied is broadly a residence test, but it is not the same as the statutory residence test used to assess UK residence. Instead, the test looks for a ‘close connection’ to Scotland which, broadly, is established either through the location of the taxpayer’s ‘home’ or, if this is not conclusive, through day counting. It is worth mentioning that capital gains tax elections for main residence if the taxpayer owns more than one ‘home’ have no bearing on this residence test.
A subtle change was made to the day counting rules from 6 April 2019 due to the introduction of devolved income tax in Wales from that date. However, the changes are included in the Wales Act 2014 (Commencement No 2) Order SI 2018/892 which was made in July 2018, so you could be forgiven for missing them.
From 6 April 2019, the test compares the number of days spent in Scotland with the number of days spent in each other part of the UK whereas, before that date, the comparison was with the number of days spent in the other parts of the UK in aggregate.
No split-year treatment is available. Consequently, if an individual is a Scottish taxpayer at any point in the tax year, they are treated as a Scottish taxpayer for the whole of the tax year. Thus, if someone is relocating within the UK, there are timing aspects that need to be considered in planning a move.
Income, pensions and gifts
As mentioned above, for a Scottish taxpayer, the SIT applies only to non-savings and non-dividend (NSND) income; in other words, earnings from employment or self-employment, pensions and property income, wherever generated. If the individual has both NSND income and savings and dividend income, the calculation of tax payable is complex.
If a Scottish taxpayer makes pension contributions that are not under the net pay scheme, the contribution of basic rate tax at 20% is still reclaimed by the pension provider from HMRC. If the Scottish taxpayer only pays tax at 19%, no adjustment is required to the contributions. However, if the rate of tax paid is 21% or more, and they are not already within self assessment, the individual will need to contact HMRC to ensure that the correct tax relief is obtained.
For gift aid purposes, it has been confirmed that charities should continue to claim tax repayments based on the UK basic rate so there is no need to establish their donor’s residence status. However, if a Scottish gift aid donor who only pays tax at the 19% starter rate is simply ensuring that they have paid tax on income equivalent to the grossed-up amount of their gift, they may not have paid enough tax to match what the charity recovers.
Property and the anti-avoidance rule
As discussed above, property income of a Scottish taxpayer is subject to SIT regardless of the property’s location. In contrast, LBTT is charged on the purchase of Scottish property regardless of where the purchaser is based. Equally, Scottish taxpayers would pay SDLT on the purchase of a property in England. In both jurisdictions, higher rates of tax apply if a second property is acquired, although relief is available when the second property replaces a main residence. However, under SDLT rules, the period during which the replacement can be acquired and relief obtained is three years compared with only 18 months under the LBTT rules.
Although LBTT was based largely on SDLT, changes were made to more accurately reflect Scottish conveyancing laws. Another difference is the need under LBTT to file returns of commercial leases every three years, which does not have an SDLT equivalent.
Staying with property taxation, the changes introduced to restrict relief for interest paid by owners of let residential property have a greater effect on Scottish taxpayers. With lower starting thresholds to the higher rate bands, the 75% disallowance of interest in 2019-20 will have the effect of pushing Scottish taxpayers into higher rates of tax much earlier than those elsewhere in the UK.
Finally, there is a separate Scottish GAAR which applies to the fully devolved taxes under the power of Revenue Scotland, in other words, LBTT and SLfT. However, SGAAR stands for general anti-avoidance rule compared with the UK general anti-abuse rule. Further, the SGAAR has only a single reasonableness test as compared with the double reasonableness test used by the UK GAAR.
What’s next for Scottish taxes?
The subject of the future of Scottish taxation has been and continues to be widely discussed, but consideration of options requires a broader understanding of the political and economic landscape, not just in Scotland, but across the UK. A full discussion of those topics is beyond the scope of this article and potentially strays into more emotive issues. However, in the interests of context there are a few points that are worth highlighting.
One of the main drivers for the devolution of tax raising powers to the Scottish parliament was to increase the accountability and responsibility to the Scottish people of the parliament in relation to the decisions it takes and the benefits and costs generated. To ensure there was no financial gain or loss to either UK or Scottish governments simply as a result of transferring powers to the Scottish parliament, a fiscal framework was required.
The current Scottish fiscal framework (tinyurl.com/j785d7z) was put in place in February 2016 and it was agreed that it should be reviewed after the next elections in the UK and Scotland which, at that time, were expected to be in 2020 and 2021 respectively. The current framework continues to include the allocation of funding to the Scottish parliament by Westminster through the block grant calculated using the Barnett formula. A block grant adjustment (BGA) is made to take into account the tax raised in Scotland under devolved powers.
The data requirement
One issue has been the lack of appropriate data at the outset on which to base the various estimates and calculations that are required. The data should improve now that the need for more robust figures has been identified but, in the meantime, there is the challenge of sound forecasting based on potentially limited data. This is particularly the case in relation to the assignment of VAT as outlined above. It has proved difficult to establish a basis for the assignment calculation and the current proposal is to use a version of the model HMRC uses for tax gap analysis. However, it is understood that the model reflects the spending patterns of only 360 Scottish households and there is concern over how accurate the result may be.
The Scottish demographic is itself challenging. Of the adult population of 4.5m, only about 2.5m pay income tax. From Scottish government estimates for 2018-19, only 346,000 pay higher rate tax, less than 20,000 pay additional rate tax and between them they account for nearly 60% of all income tax paid. Half of Scottish taxpayers are estimated to earn less than £24,000 a year, with 25% earning less than £17,000. With so much tax generated by a relatively small number of people, there are risks in creating too much divergence in tax rates and bands from the rest of the UK.
There is also a question over just how much autonomy the Scottish government has, even over the taxes that are devolved. The personal allowance is set by Westminster and therefore this dictates the size of the Scottish income tax base. National Insurance is also reserved to Westminster and with the upper limit being tied to the UK higher rate tax threshold, Westminster is able to offset any increase in the latter by the additional National Insurance contributions generated. However, the additional contributions generated from taxpayers north of the border also goes to Westminster not to the Scottish government. These are just two examples.
The Scottish government will soon have responsibility over all social security benefits provided in Scotland and must budget accordingly. Inequality is high on the political agenda and there will be pressure to improve benefits for the low paid and those out of work. Taxation will be key in delivering these policy objectives, but balancing those requirements with the need to avoid encouraging emigration or other taxpayer behaviours that would limit the overall tax revenue raised will be difficult.
On a more positive note, the Scottish parliament and Scottish government have already demonstrated a will to engage in transparent consultation around the future shape of Scottish tax and the processes and procedures through which legislation is made. The Devolved Taxes Legislation Working Group is considering a more strategic approach to the development of tax legislation and its interim report is expected in February 2020 with a final report due next summer. Although the review relates only to fully devolved taxes, the working group is mindful of the benefit of creating processes that could be adapted in the event of further devolution.
With Wales now also entering the arena of devolved taxes and Northern Ireland able to do so when its assembly reconvenes, it seems there is no going back to a single tax regime covering the whole of the UK. And discussions around the future funding of local authorities suggest that there may be even more devolution of tax raising powers across the country. However, what must be high on the agenda is avoiding an even more complicated patchwork of tax legislation than we already have and some collaboration between all parties is highly desirable.
In her article, Shirley McIntosh makes the point that if an individual has non-savings and non-dividend income and savings and dividend income, the calculation of tax payable is complex. The example of Duncan’s Tax Liability from Tolley’s Income Tax illustrates this.
Liability of Scottish taxpayers to the dividend ordinary, upper and additional rates and the basic, higher and additional rates on savings income is determined by reference to UK rate thresholds, as is the amount (if any) of the personal savings allowance. This means, for example, that Scottish taxpayers could be higher rate taxpayers for non-savings income but basic rate taxpayers for savings income.
The Chartered Institute of Taxation makes the point that Scottish taxpayers with earned income of less than £26,993 in 2019-20 will pay less income tax than taxpayers in the rest of the UK earning the same level of income. That said, the reduction is small. Scottish taxpayers with earned income of more than £26,993 will pay more income tax than taxpayers in the rest of the UK earning the same level of income. Scottish taxpayers earning £50,000 a year will pay about £1,500 more income tax than other taxpayers.
Further, the rate of capital gains tax payable will depend on the UK rates and thresholds. Consequently, a Scottish taxpayer with both earned income and capital gains may also have to consider both UK and Scottish rates and thresholds.
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