Tax Credits - Why do they arise?

Q - I've noticed that the software is giving my client 'tax credits'. Could you explain why and how the tax credits come about?

A - The general (and short) answer is that tax credits arise from the overpayment of taxes in the previous year. A more detailed answer is provided below:

In each year of the plan, the software carries-out 2 sets of tax calculations - firstly, at source and then, subsequently, at the end-of-year.

Taking the example of an individual who is a higher-rate taxpayer, the individual's full personal allowance is applied to employed earnings, in the first instance - tax & NI are calculated and deducted accordingly.

Let us assume that this individual is also making contributions, to a Self-Invested Personal Pension:

The contributions to the SIPP are made from post-tax earnings, and basic rate relief on the contributions is applied at source. Higher rate relief, on the other hand, is granted by the extension of the basic and higher-rate tax bands, at the end-of-year tax calculation (as shown below).

The extension of the basic rate tax band (illustrated above), of course, results in a reduction of tax to be paid at the individual's highest marginal rate. The result is that, when the software carries-out its end-of-year tax calculation, it recognises that the individual has overpaid tax in the current year and is entitled to a refund, as illustrated below.

Think of this as an adjustment to taxes that is made via the client's annual tax return. While it is possible that, in practice, some, or all, of this adjustment might be made via a change to an individual's tax code, the software doesn't model tax codes and all adjustments, therefore, are made annually-in-arrears, via the annual assessment.

Another typical situation in which the software will generate tax credits is one where non-taxpayers have funds on deposit: By default, the software will levy basic rate tax on savings interest and these tax payments will be deducted at source. At the end-of-year calculation, again, the software will recognise that the individual has insufficient income to pay income tax and will give the client a tax credit in the following year.