The New Tax Credits

ANDREW GOODALL ATII looks into the future at the new child tax credit and working tax credit.

IMAGINE THIS. YOU are trudging quietly through your 2004 tax return when you are stopped in your tracks by the question, 'Was your child benefit stopped or reduced under the Child Benefit (Unruly School Children) Act 2003?'.

Is this far fetched? The answer is no, not really, as responsibility for child benefit is being transferred to the Inland Revenue and Tony Blair is considering withdrawing child benefit from parents of persistent school truants. The Prime Minister argues that 'conditionality' already plays a part in the benefits system. Whatever the merits of such an apparently simplistic approach, its implementation would be an administrative nightmare and, if you are used to self assessment, you are used to nightmares. Now, I know that child benefit is not taxable, but to double it and make it taxable for those on higher incomes would seem a better solution than the huge expansion of tax credits proposed in the Budget.

The Government is taking the opportunity to apply the new principle of progressive universalism - defined as 'supporting all families with children, but offering the greatest help to those who need it most through a light touch income test'. The intention is that tax credits, wrongly understood by many to be available to only the poorest families, will be extended further up the income scale from April 2003.

Many practitioners will need to gear up for the inevitable questions from their clients. Recent evidence suggests that tax advisers have been reluctant to handle working families' tax credit claims. Under the new régime, families with incomes up to £58,000 - or more where there is a new baby - will receive child tax credit.

This article provides an overview of the new system laid down in the Tax Credits Bill, introduced in the Commons last autumn and now passing through the House of Lords. Explanatory notes are available on the Parliament website (www.publications.parliament.uk/pa/pabills.htm). The Inland Revenue published draft regulations on 9 May and has invited feedback. Several statutory instruments are required to implement the detailed rules for the new tax credits and the consequential changes to social security legislation.

The rates and thresholds for the new credits were set out in Inland Revenue Budget Release REV3. First, there follows a brief summary of the current rules.

The present system

The support now available to families with children and low-income households includes:

• working families' tax credit;
• disabled person's tax credit;
• children's tax credit;
• new deal 50-plus employment credit;
• child benefit;
• child dependency increases to certain non-means-tested benefits; and
• income support and jobseeker's allowance.

Working families' tax credit, which replaced family credit in October 1999, is payable to individuals or couples with dependent children. Generally, the individual or at least one partner in a couple must work at least sixteen hours a week to be eligible. Help with childcare costs is added when certain conditions are met. Assessment of working families' tax credit is based, broadly, on net income after tax and National Insurance contributions, and is fixed for a six-month period.

Children's tax credit was born in April 2001. It is in the form of an income tax reduction under section 257AA, Taxes Act 1988, available when a qualifying child is resident with the claimant during the tax year. For 2002-03 the reduction will be calculated by reference to £5,290, at a rate of 10 per cent. Thus it can be worth up to £529, but it is limited to the tax otherwise payable and cannot be set against National Insurance contributions. This will dismay many self-employed earners on modest incomes following the recent reduction in the Class 4 National Insurance lower limit - as highlighted by James Broom in Taxation, 7 March 2002 at page 552. Children's tax credit is reduced where the claimant has income subject to tax at the higher rate. It is doubled for 2002-03, if a child is born in the year. There are signs that the take-up of children's tax credit will be disappointingly low, particularly among parents who do not receive a tax return.

The new system

The Revenue's consultation document New Tax Credits: Supporting families, making work pay and tackling poverty, issued last summer, attracted more than 170 responses. The outcome is a system of two new tax credits:

• the child tax credit for families with children; and
• the working tax credit for working households on a low income, including households where a worker has a disability.

The stated aim is to create 'a single income-related strand of support for families with children, complemented by a single strand of support for adults in work'. The new credits, and the continuing child benefit, will be under the care and management of the Inland Revenue. Several elements of the existing system, including the working families' tax credit and children's tax credit, will be abolished.

Claims

Entitlement to the new credits will depend on a claim being made. This may be a joint claim made by a married or unmarried couple, or a single claim made by an individual who is not entitled to make a joint claim. An unmarried couple is defined as 'a man and a woman who are not a married couple, but are living together as husband and wife'. The Revenue will be able to disclose to a joint claimant any information relating to the claim, or the award of the tax credit. This appears to allow the Revenue, for example, to explain to Mrs C that the award has been amended because Mr C has already rung to tell them about the new baby.

Where a tax credit claim is made before the tax year starts, the award will be for the full tax year. In the event of a claim being made during the tax year, the award will start on the date of the claim and run to the end of the tax year. An award on a claim will end if and when joint claimants separate and when a single claimant becomes part of a couple and stops being entitled to make a single claim. Such changes must be reported to the Revenue!

Income test

The amount of tax credit payable will depend on the 'relevant income' of the claimant, or the aggregate income of the partners in the case of a joint claim. A reduced amount is payable if income exceeds a threshold. The definition of 'relevant income' is not easy. The Bill provides that this is generally the income for the current tax year, but regulations will allow the previous year's income, or an adjusted measure of the current year's income, to be used instead.

Some confusion may well arise here. In the recent Treasury guide, The Child and Working Tax Credits - The Modernisation of Britain's Tax and Benefits System, eleven pages were devoted to explaining the basis of assessment for the new tax credits and how underpayments and overpayments will be managed. Broadly:

• awards will be based initially on current circumstances and the previous tax year's income;
• there will be no change to the award if circumstances remain the same and there is no significant change in income during the current tax year; and
• actual income will be reported at the end of the current tax year, when the award for that year will be finalised - and this assessment will form the basis of the award for the following year.

An award may be revised, during or after the end of the tax year, to reflect:

• falls in income; and
• increases of more than £2,500, disregarding the first £2,500 in assessing the revised award.

Calculating income

Entitlement is to be based on gross income and the starting point will be the income as defined for income tax purposes, but certain income is to be excluded. For example, several options were considered in relation to benefits in kind and the Government has decided 'to take some of the more common benefits in kind into account'. The benefit of living accommodation is one of several exclusions. There will be no capital limit and no need to include notional income from savings. The whole of any pension contribution will be deductible in calculating income. To save 'imposing a requirement to report small amounts of income from minor sources', the first £300 of investment, property, foreign and notional income will be disregarded.

Notional income will be assessed to bring into account items such as stock dividends (capital treated as income) and income treated as that of the settlor under the settlement anti-avoidance rules. A claimant wishing to 'deprive' himself of income in order to claim a tax credit may find that he is treated as having income he does not in fact have. The Revenue's memorandum on the draft statutory instruments (on the Internet at www.inlandrevenue.gov.uk/drafts/introduction.pdf) gives the example of a claimant 'deliberately' transferring an interest-bearing savings account to a child or some other person who is not his or her partner.

Child tax credit

The claimant(s) must be responsible for one or more children. The following four rules will deal with this requirement:

• a person is treated as responsible for a child who normally lives with him or her;
• competing claims are dealt with on the basis of who has 'main responsibility';
• the main responsibility test can be decided by the parties making an election, or the Revenue making a determination; and
• finally, there are four scenarios in which a child is not treated as the responsibility of any person. (For example, where the child is in the care of the local authority, in prison or is claiming for his or her own child.)

There will be no requirement to be in paid work. In this way, we are told, the new child tax credit will 'span the in and out of work divide'. It will comprise a family element, set initially at £10.45 per week and doubled in the first year of a child's life; an individual or child element of £27.75 for each child; and a disabled child element of £41.30 or more, where appropriate. The Inland Revenue will pay the child tax credit directly to the main carer for the children. A couple can agree who is the main carer, and the Revenue will decide if the couple cannot agree.

Working tax credit

The claimant, or one of the joint claimants, must be in qualifying remunerative work. The age and working hours conditions are not straightforward. Generally, the minimum weekly working requirement will be:

(a) 16 hours for families with children and workers with a disability; and
(b) 30 hours for workers with no children and no disability.

Claimants in group (a) will be eligible for working tax credit from age 16. Those in (b) will be eligible at age 25 or over.

The working tax credit will include:

• a basic element, set initially at £29.20 per week;
• a couple or lone parent element of £28.80;
• a 30-hour element of £11.90, payable where the claimant or one of the claimants works at least 30 hours a week (couples with children may aggregate their hours for this purpose);
• a disabled worker element of £39.15 or more where the claimant, or his or her partner, has a disability;
• a 50-plus element; and
• a childcare element.

The childcare element will meet up to 70 per cent of eligible childcare costs, subject to maximum eligible costs of £135 a week for one child, or £200 per week for two or more children. The Inland Revenue will pay any childcare element of the working tax credit directly to the main carer for the children. Generally, the other elements will be paid to employees by their employer, and to the self-employed by the Inland Revenue.

Maximum amount

The first step in calculating the new tax credits is to add the various elements to arrive at the maximum available amount, before any reduction on account of income. The maximum amount will depend on the individual or couple's circumstances - working hours, number of children, eligible childcare costs, etc. The Treasury guide offers the following example of a couple with one child and a single earner, working full time.

Example of tax credit entitlement

Reduction

If the individual or joint income does not exceed £5,060 a year or £97 a week, there will be no reduction in credits. Where income exceeds this first threshold, the maximum amount above is reduced by 37 pence for every pound of the excess. For those in receipt of child tax credit only, the first threshold will be £13,230 a year or £253.76 a week. The reduction is applied in the following order:

• working tax credit excluding the childcare element;
• childcare element of the working tax credit; and
• child element of the child tax credit.

The family element of the child tax credit will be reduced only if income exceeds a second threshold of £50,000 a year. Where income does exceed that amount, the family element will be reduced by £1 for each £15 of excess income.

Revenue powers

The Revenue will have the power to enquire into any award of a tax credit, within set time limits. Where the claimant is required to file a self-assessment tax return, the time limit will normally expire when the tax return becomes 'final'. There are provisions relating to Revenue decisions and appeals, discovery, official error and information requirements. Penalties of up to £3,000 may be imposed in the event of fraud or negligence on the part of either a claimant or an employer required to pay tax credits. A person knowingly concerned in any fraudulent activity in connection with obtaining tax credits will be committing a criminal offence, punishable at worst by imprisonment for up to seven years.

Impact

This is yet another major change to add to an already tortuous tax and benefits system. The logic of bringing together these two main strands of support appears sound and some aspects of the new régime will be easier than the old, but the transitional period is going to be difficult. The switch from children's tax credit to child tax credit alone will cause widespread confusion.

The Chartered Institute of Taxation has queried whether there is adequate time available before the changes take effect to 'iron out all the practical issues', and warned that the interaction between the tax and benefits systems will cause confusion amongst families.

Independent taxation of married couples saw off the old discredited system in which a married woman's income was treated as her husband's. For once, a married woman was afforded the same degree of confidentiality as her husband. Now, for both working tax credit and child tax credit purposes, partners will have to disclose their financial affairs to each other. There will be some family arguments about this! However, state benefits have long been assessed on the basis of joint income, and this principle was not going to be abandoned.

With regard to the impact on employers, the Revenue's explanatory notes set out the main points of the Regulatory Impact Assessment. Several features are expected to help reduce compliance burdens.

• The new tax credits will be annual awards, compared with the current six-monthly awards.
• Employers will not have to complete certificates of payment when a recipient leaves employment and they will not 'as a matter of course' have to complete an earnings enquiry form.
• The advance funding arrangements are to be simplified.

Although there will be in-year costs for employers when rates of credit are adjusted, overall the Inland Revenue estimates that employer compliance costs will fall by around £11 million a year.

For claimants, the Revenue points out that income for the purpose of the new tax credits will generally be based on gross income in the previous tax year. Employees will be able to refer to their P60 instead of payslips. The self-employed will use the earnings figures submitted for income tax purposes.

Up to six million households will move on to the new system, and around 5,750,000 families will be eligible for child tax credit. The effectiveness of the reforms will depend very much on public awareness. The Child Poverty Action Group is concerned about the lack of publicity given to the existing children's tax credit, and warned recently that 'the problem of the current low take up of tax credits will need to be addressed if the new credit is to reach the poorest families'.

For professional advisers, this is yet another learning curve to climb, and it is to be hoped that the vast Government publicity machine will help to ease the pain. Perhaps there is one blessing - many more clients will have an incentive to provide their tax return information soon after 5 April.

Andrew Goodall ATII is a freelance writer. He can be contacted at www.andrewgoodall.co.uk.

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