Income Tax definitions

Income tax definition: economics and your role in paying for the country’s needs

Income tax is an annual payment to the government via HMRC (Her Majesty’s Revenue Collection service). This charge is levied on both earned income and unearned income. Earned income is defined as wages, salary, commission payments or if you’re running your own business or franchise, your earnings for the year. Unearned income includes dividends on shares and interest on savings, as well as some rental income from properties. For more information on the dictionary definition, you can Google ‘what is income tax’ but ensure you are looking at the correct information for the UK, as income tax definitions vary from country to country.

Income tax rates – how much you earn determines how much you pay

Income tax is the most significant source of revenue for the UK government every year. It’s charged on taxable income at the basic rate of 20% up to a set basic rate limit (currently £46,350 for 2018/19 ). Above that limit, taxpayers fall into higher brackets of 40% and 45% respectively. This amount excludes the personal allowance, which is the amount you can earn before you start to pay tax. This is currently around £11,850 (2018/19), which means many of the lowest-paid workers in the country do not have to pay income tax at all.

The Chancellor of the Exchequer sets the personal allowance amount each year during his/her Budget speech to parliament. The 40% rate applies to income above the base rate and up to a limit of £150,000/annum. Above that, you’ll pay the excess rate of 45%.

Why do we pay income tax?

Income tax is used to finance the government’s operations. It’s also structured in such a way to distribute wealth throughout the population more evenly. This is known as Progressive Income Taxation. It also ensures that the country is financed even when the international financial markets are unpredictable (known as an automatic fiscal stabiliser).

This form of revenue generation has been used for centuries and is employed by countries across the world as the most effective way of raising money to pay for everything from infrastructure and defence through to the health service, roads and house building. Everyone who earns an income is expected to pay tax on his or her earnings. Failure to do so can result in a hefty fine.

How does the government collect taxes?

The government collects taxes through HMRC – its revenue collection service. HMRC uses PAYE records and self-assessment returns to calculate the amount of tax due. For those on PAYE (Pay As You Earn), this is taken directly from the monthly payment made by your employer. For self-employed and business owners, online self-assessment forms are completed annually and submitted to HMRC. They then calculate the amount of tax due and a bill is sent out. This is for the previous fiscal year (taxation for self-assessment is always paid in arrears).

Do you have to pay income tax on all your income?

According to the government’s website , there is a comprehensive list of income that you have to pay tax on, and that which is exempt from taxation. You have to pay tax on:

  • Your employment income
  • Profits made if you’re self-employed, including online services provided via websites and apps
  • Some state benefits (this applies whether you’re in work or not)
  • Rental income from both domestic and commercial property lets (with some exemptions for live-in landlords)
  • Trust payments
  • Perks and job benefits (including employee share schemes, etc.)
  • Interest on savings over the set savings allowance levels

You do not have to pay tax on:

  • The first £1,000 of income from self-employment (known as ‘Trading allowance’)
  • The first £1,000 rental income (with exceptions)
  • Income from tax-exempt savings schemes such as ISAs
  • Dividends from company shares (under the dividends allowance rates)
  • Lottery wins

These figures are in addition to your allowance.

UK income tax rates – why do they change every year?

The rate of taxation on income fluctuates according to the levels set by the Chancellor during his/her budget. The rise in the personal allowance usually takes into account the effect of inflation and the overall cost of living. The personal allowance rates are nearly always increased by a certain amount to compensate for the rising cost of living.

How to calculate your payments

The rate of tax you pay is a percentage of your gross income (20%, 40% or 45%). In the majority of cases, HMRC will calculate the amount you need to pay for you. However, to ensure that you are preparing for that tax bill at the end of the fiscal year and to ensure that HMRC has not made a mistake on your calculations (which can and does happen), it’s a good idea to use an online tax calculator to work out how much you’ll owe. These make it very simple to estimate roughly how much your tax obligations are.

Another method to stay on top of your tax calculations is to use an app such as QuickBooks, which acts as an online accountant and allows you to keep a careful watch on how much you owe the Revenue Service throughout the year. You can then put this money aside to cover your bill when it comes to paying it at the end of the financial year.

Self-assessment for business owners

If you are running your own business or have a franchise, then you will need to carry out a ‘self-assessment’ tax return. These used to be paper-based, but HMRC has now gone over to online assessment forms. Forms have to be completed and returned to HMRC by a set date (after the end of the tax year (5th April) the form applies to. Deadlines for online returns are generally at midnight on the 31st January. This is when payment is also due. If you miss this deadline, you will have to pay the penalty.

When you register for online tax returns, you’ll receive a 10-digit Unique Taxpayer Reference (UTR) number. You will need this for all self-assessment forms and to access the self-assessment service.

Taxation and the entrepreneur – what if you’re running a franchise?

If you’ve decided to start up a franchise, then you’ll need to pay tax on your earnings in the same way you would with any other business. Your franchisor may offer support and advice to help you get this right, but it is your responsibility to take care of your own tax affairs – your franchisee won’t do it for you.

The definition of income for tax purposes includes all revenue generated by a franchise holder, regardless of whether they have another source of income or not. So it’s important to understand that you’ll be paying tax on your franchise earnings from the outset. If you are already working and paying tax, this may take you over the threshold for personal allowance and into a higher tax bracket, so it’s important to look at this before you decide to take on a franchise.

Factoring in your tax commitments to your franchise start-up costs

While the concept of running your own business may be very exciting, it’s important to remember that the paperwork is just as necessary as everything else. As the saying goes, two things are certain in life: death and taxes. So you will have to consider all aspects of taking on a substantial financial commitment like a franchise and think about not just the initial investment fee and running costs, but tax payments as well. Bear in mind that you will have to pay National Insurance contributions and may have to register for VAT too. All of these will eat into your finances so make sure you prepare for them.

Stay on top of changes

The rules and regulations surrounding income tax are continually changing, and it’s one of the most complex and challenging aspects of running a franchise. While some franchisors will offer accounting support and help, others won’t, and regardless of whether they do or not the onus is on you to keep your tax affairs in order. The best option is to employ the services of an accountant that specialises in tax and to keep meticulous records of money in and out from the outset. That includes copies of receipts and invoices for both on and offline transactions.

Remember that if your business is online, you will still have to pay tax on any earnings you generate, so make sure you keep good records of all online transactions too.

Invest in some accounting software that will make it easier for you and your accountant to calculate how much tax you have to pay at the end of the financial year so that you avoid any hefty penalties from HMRC.

Talk to your franchisor to find out what kind of accounting support they offer before you pick a franchise, and if you’re concerned then discuss your options with a financial advisor before you sign on the dotted line. It’s also advisable to check HMRC’s websites regularly to find out what changes there are to the UK income tax laws.