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Replies to Queries - 2 - Children's tax credit complication

20 January 2003
Issue: 3891 / Categories:

I read Elizabeth Lathwood's article in Taxation on 5 December with interest (see pages 235 to 237), as it touches on an argument I am having with the Inspector of Taxes. Under the section headed 'Income for tax credit purposes' she states, inter alia, that, for the purposes of calculating income, pension contributions cannot be carried back.

I read Elizabeth Lathwood's article in Taxation on 5 December with interest (see pages 235 to 237), as it touches on an argument I am having with the Inspector of Taxes. Under the section headed 'Income for tax credit purposes' she states, inter alia, that, for the purposes of calculating income, pension contributions cannot be carried back.

My client is a higher rate taxpayer, but his partner has no higher rate tax liability. They have a 'qualifying child', who lived with them throughout 2001-02. Our client is considering making a single premium pension payment before 31 January 2003, backdated to 2001-02, and this will eliminate all higher rate tax liability for 2001-02.

Two different tax districts have informed us verbally that the backdated pension contribution will not increase our client's entitlement to children's tax credit for 2001-02. This is in accordance with the Taxation article, but we have been unable to find any statutory basis for this view. Can any readers enlighten us?

(Query T16,141) - Socrates.

There seems no logical argument for the Revenue to say that the carry back of a pension contribution should not increase the entitlement to children's tax credit because the same statutory rules apply to current year personal pension contributions. One wonders if it is more to do with the fact that the carry back relief for the pension payment is given outside self assessment.

This has nothing to do with the information given in the article on new tax credits in the 5 December 2002 issue. New tax credits are covered by a completely different set of rules, operating only from 6 April 2003.

The position for the 'old' children's tax credit, which disappears on 5 April 2003, is governed by section 257AA, Taxes Act 1988, subsection (3) of which gives the £2 for every £3 reduction using income within section 1(2)(b), Taxes Act 1988. Section 1(2)(b) says (for 2001-02):

'... so much of an individual's total income as exceeds £29,400, at such higher rate as Parliament may determine.'

Interestingly, most of the Revenue instructions written in the Independent Taxation Manual refer to this 'basic rate limit' (£29,400) rather than to the 'income chargeable at the higher rate'.

Relief for personal pension contributions (unlike relief for retirement annuity premiums and occupational pensions) is given for basic rate taxpayers at source and for higher rate taxpayers by extending the basic rate band. This applies whether the personal pension payment is in-year or carried back.

For carry back, the rules begin in section 641A(2), Taxes Act 1988, which says:

'Where an election is made under this section … the other provisions of this Chapter shall have effect as if the contribution or part had been paid in the year specified in the election and not in the year in which it was actually paid.'

The 'other provisions of this chapter' include section 639(5A), Taxes Act 1988, which says:

'the basic rate limit for that year shall ... be increased by the addition of the amount of the contributions in respect of which he is entitled to relief under this section.'

Thus, the relief is given by extending the basic rate band rather than by deducting the relief in arriving at total income.

In fact, if one reads sections 257AA and 1(2)(b) in one particularly restrictive way, a taxpayer could have income over the limit of £29,400, thereby reducing his or her children's tax credit, but not actually be chargeable at the higher rate because of pension contributions.

Turning to the Revenue's own instructions to staff, the Independent Taxation Manual gives two sets of instructions on how to calculate the limit at paragraphs 1435 and 1572. Part of the latter is reproduced below.

'The definition of income for this purpose is an individual's income after all allowable reliefs and deductions that can be made in arriving at, and deducted from, total income. It is the individual's net statutory income see [the Revenue's Relief Manual] Re70 onwards - less:

* The personal allowance.

* Any blind person's allowance due.

* Certain payments to trade unions and friendly societies, see Re1510 onwards.

* Corresponding deficiency deductions on certain life insurance policies, see AP3197 onwards.

'The basic rate limit is the level of income above which an individual starts to pay tax at the higher rate. It is the sum of the starting rate band of income and basic rate band of income.'

I can find no examples in the Revenue manuals as to what to do if the basic rate band is extended by things like pension contributions, and it could be on this basis that the Revenue is saying that carry backs of personal pension payments will not affect the children's tax credit due. However, if that is the case then one would expect the self-assessment tax return calculation of the credit to exclude the effect of current year personal pension contributions, since the same legislation/principle applies. But looking at page 16 of the 2001-02 edition of the Tax Calculation Guide, the figure used to restrict children's tax credit is box w130 which is made up of the various bits of income chargeable at the higher rate. This in turn has been calculated using a basic rate band extended by the current year personal pension contributions - see page 4 of the Guide, where boxes 19, 31 and 43 are calculated using box 14, which represents current year personal pension payments and gross free-standing additional voluntary contributions.

The Revenue's practical interpretation of section 257AA(3) is therefore that it is the actual income chargeable at the higher rate, rather than the total income exceeding the standard basic rate threshold which matters. In the light of this, there seems no argument for not using carried back personal pension payments to increase children's tax credit. - Mater.

The problem underlying 'Socrates' query is that there are tax credits and tax credits. For no apparently logical reason, the Chancellor has chosen to brand a range of new benefits, allowances and reliefs (children's tax credit, disabled person's and working families' tax credits, child tax credit, working tax credit and the research and development tax credit) in the same way. Not only do they all work in completely different ways, but none of them is anything like the long-established dividend tax credits - so much for simplification!

Elizabeth Lathwood's article concerned the new child tax credit, which comes into effect from 6 April 2003. That (despite the similarity in the name) is a wholly different animal from the children's tax credit régime that is currently with us. It is the latter that is relevant to 'Socrates' client.

Unlike the new child tax credit, the children's tax credit is wholly integrated into the income tax system. This integration ensures that a carry-back of pension contributions has effect for children's tax credit purposes. Of course, as is typical with recent legislative changes, this obvious and sensible conclusion is not immediately apparent from the legislation itself and instead a series of legislative provisions needs to be followed to obtain the right results. This is perhaps the reason why 'Socrates' has been given misleading advice from the tax offices he has discussed the matter with.

First, one should consider the provision that governs the carry-back (or strictly, the 'relating back') of pension contributions in section 641A, Taxes Act 1988. This ensures that (provided an election is made, etc.) a pension contribution is treated, for the purposes of the rules dealing with pension contributions, as being made in the previous year. In particular, that deeming will apply for section 639, Taxes Act 1988 so that the relief is obtainable in the earlier year. Of course, this deeming is only illusory, since paragraph 2(3) of Schedule 1B to the Taxes Management Act 1970 makes it clear that such a claim relates to the later year and does not affect the earlier year at all. On this basis, one could be forgiven for assuming that the tax offices are right and that the election under section 641A cannot have any effect on the earlier year (and in particular on the entitlement to children's tax credit in that earlier year). However, this is only half the answer.

Paragraph 2(4)(b) of Schedule 1B provides that one should then calculate the tax that would have been payable in the earlier year 'on the assumption that effect could be, and were, given to the claim in relation to that [earlier] year'. So whilst the children's tax credit in the earlier year is not, in the strict sense of the word, affected by the claim to relate back a pension contribution, additional tax relief is nevertheless given as if it were. It is this latter aspect that would be of interest to most taxpayers.

To contrast, as Ms Lathwood correctly states, the calculation of income for child tax credit purposes does not take into account any elections to carry back pension contributions.

This will lead to an interesting position for pension contributions made in the period 6 April 2003 to 31 January 2004, which are related back to the 2002-03 tax year. For child tax credit purposes, these amounts will be deductible from income in the tax year in which they were paid (i.e. 2003-04) and may therefore secure the payment of (increased) tax credits in that year. However, for children's tax credit purposes, the relating back of these contributions will have the effect of reducing the taxable income in 2002-03 and may therefore increase a taxpayer's entitlement to children's tax credit.

This rare opportunity for double tax relief should not be overlooked. - Kalonymous.

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