All directors and shareholders in Limited Companies are usually required to file a Self Assessment Tax Return to calculate their personal tax liability.
Commonly, people are surprised when their Self Assessment payments are calculated and they are significantly higher than expected because they have fallen into the Payments on Account system.
When this happens an unfortunate consequence is that people are not prepared for the cash flow implications of paying their taxes earlier than they were anticipating.
Self assessment in general, and particularly HMRC’s payments on account system, is complicated and it is advantageous if you understand the principals so that you are forewarned about whether it may apply to you.
As you will be aware, under Self Assessment tax payers are required to calculate their tax liability for a tax year and settle any associated tax liabilities by the 31 January following the relevant tax year.
For example, for the tax year 6 April 2013 to 5 April 2014, the Self Assessment Return must be submitted to HMRC by 31 January 2015 and any associated tax liability has to be paid by 31 January 2015.
Where an individual has a Self Assessment tax liability to settle, after taking into account tax deducted at source, they may then fall into the HMRC’s Payment on account system.
What are payments on account?
Payments on account are payments of tax (and Class 4 NIC for sole traders / partners) towards the following tax years liability.
Tax payers are required to make payments on account as HMRC believe that you will be in receipt of income which does not suffer enough tax at source, as demonstrated by a final tax liability in the preceding tax year. This could be dividend income taxed at the higher rate, rental income profits or other investment income.
Two payments on account are made and each payment is calculated as 50% of the ‘relevant amount. The ‘relevant amount’ is the tax liability for the preceding tax year, less any amounts deducted at source (PAYE / dividend tax credit / deducted by bank).
Payments on account are due by 31 January during the tax year to which they relate and 31 July after the tax year to which they relate.
For example, payments on account for the new 2013/14 tax year will be payable by 31 January 2014 and 31 July 2014. They will have been calculated by reference to the tax liability for the preceding tax year of 2012/13. If you were not in Self Assessment in 2012/13 you will not have any payments on account to make for the 2013/14 tax year.
Payments of tax made under this system will be deducted from the tax liability for the tax year to which they relate.
For example, when the Tax Return for 2013/14 is prepared the payments made on 31 January 2014 and 31 July 2014 will be deducted from the final liability calculated in order to calculate the amount payable by 31 January 2015.
You should be aware that at this time payments on account for the 2014/15 tax year would be calculated, based on the total tax liability, less any tax deducted at source. Making payments on account does not count as tax deducted at source and as such will not reduce the ‘relevant amount’ for payment on account calculation purposes.
You will not fall into payments on account if:
- Your final tax liability for a tax year is less than £1,000 or,
- You tax liability exceeds £1,000 but more than 80% of the final tax liability was collected at source (via PAYE / dividend tax credit / deduction by bank or building society)
Directors & dividends
It is common among directors of their own company’s to draw dividends from their company that exceed the basic rate band for income tax purposes.
Where you have a total gross income (gross salary / dividends / investment income) exceeding £41,450 in 2013/14 tax year it is likely that you will be required to make payments on account towards the following tax years liability, when your Self Assessment Return is filed with HMRC.
In the first year of trading, if you receive dividends from your company that will be taxed at the higher rates, you will have a final tax liability to settle by 31 January following the tax year end. It is also likely that as you have received income which has not suffered enough tax at source, you will be required to make payments on account.
If you received £10,000 gross dividends (£9,000 net) which were taxable at the higher rates in the tax year ended 5 April 2014, your final tax liability would be £2,250. This would be payable by 31 January 2015.
However, as you received income which did not suffer enough tax at source, HMRC assume you will receive income at the same level in the following tax year ended 5 April 2015.
They will require that you make payments on account of your 2014/15 liability on 31 January 2015 and 31 July 2015. These payments are calculated as 50% of the final tax liability for the previous tax year – 2013/14.
Therefore upon filing your 2013/14 Tax Return you would be required to make the following payments:
31 January 2015 – £2,250 – Final liability for 2013/14
31 January 2015 – £1,125 – 1st payment on account for 2014/15
31 July 2015 – £1,125 – 2nd payment on account for 2014/15
The payments on account made will then be deducted from the liability calculated for 2014/15 when your Tax Return is prepared after 5 April 2015.
First tax year of trading
You should be aware of the payment on account system when putting money aside to cover your tax liabilities as in your first year of trading , assuming you have never been in the payment on account system before, you will effectively have to make a ‘double’ payment of tax to cover any tax which has not been deducted at source on dividend income. Although the tax will be deducted from a future liability, the final payment and payments on account can cause a personal cash flow issue if you are not aware that payments on account will arise.
As a general rule, you should save 25% of a net dividend which will be taxed at the higher rates, to cover the additional tax payable by 31 January following the tax year. If it is your first year of trading and you believe you will fall into the payment on account system, due to the level of dividends received and other income, it would be prudent to save 50% of net dividend to cover your future tax liabilities.
Once you are in the payments on account system, unless your income decreases significantly, you will be required to make payments on account on each 31 January and 31 July going forwards.
If your income increases from one tax year to the next a final payment may be due after deducting payments on account. If you income increases significantly from one year to the next, a final payment may be due after deducting payments on account and also the future payments on account may increase in line with the increase in total income.
Further details on payments on account can be accessed by clients by following this link:
If you have any concerns about future tax liabilities or whether the payment on account system will apply to you, please contact Sherwin Currid Accountancy.