Authors | Alexander Garden & David Welsh of Turcan Connell | June 2015
Recent years have seen an exponential increase in the amount of political time and energy being devoted to further devolution of taxation powers to the Scottish Parliament. But long before the independence referendum campaigns were in full swing, the Westminster Government passed the Scotland Act 2012 which included, amongst other things, new powers relating to income tax, due to come into effect from April 2016. However, due to an inevitable focus on the referendum and the constitutional matters associated with that, the taxation powers included in the 2012 Act were not given the publicity that one might have expected of such a profound change.
The aim of this article is to examine the changes being brought about in relation to income tax by the 2012 Act and, in particular, to review the way in which these provisions might act as a foundation for future devolution of taxation powers to the Scottish Parliament, especially in light of the Smith Commission’s suggestions on the matter. For the purposes of this article, it will be assumed that the 2012 provisions will come into effect as planned.
Income Tax Changes Under the 2012 Act
The 2012 Act provisions, once they come into effect in April 2016, will use the rates of income tax set at a UK level as a starting point each year. Each rate will then have ten percentage points deducted from it for all Scottish taxpayers and the Scottish Government will be under an obligation in its budget to set a Scottish rate of income tax. If the Scottish Government wants the rate of income tax to remain the same in Scotland as it is in the rest of the UK, it will need to set the Scottish rate of income tax at 10%. If, however, the Scottish Government sets the Scottish rate of income tax above or below 10%, the rate of income tax paid by Scottish taxpayers will differ from that paid by taxpayers elsewhere in the UK.
The incentive for the Scottish Government is that it receives the revenue from the Scottish rate of income tax but clearly there is an economic disadvantage to driving workers out of Scotland with higher rates of taxation. There is, as always, a balance to be set and it remains to be seen whether the rates in Scotland will be lower or higher than in the rest of the UK or, indeed, if there will be no difference at all.
The 2012 Act provisions come with some obvious restrictions. For example, the Scottish Government sets only one rate and it is applied across all income tax rates. It does not have the power to increase the basic rate of 20% whilst reducing the higher rate of 40%; if it increases one rate, all rates will increase by the same amount. This is one of the restrictions that the Smith Commission suggested ought to be removed but, as of yet, no legislation has yet been introduced that will have that effect.
Similarly, without going into unnecessary detail, the Scottish rate of income tax will not apply to all types of income. It will not apply to interest earned on bank deposits nor will it apply to dividend income, both of which will continue to be taxed at UK rates. It will be clear already that the income tax regime for Scottish taxpayers has the potential to become much more complicated than for those who live elsewhere in the UK.
One of the most interesting aspects of the 2012 provisions is the definition of a Scottish taxpayer. Broadly speaking, in order to be a Scottish taxpayer for the purposes of the Scottish rate of income tax, the following must apply:-
- The individual must be resident for income tax purposes in the UK. This will require the UK statutory residence test to be applied where this is not obvious. Only if one is resident in the UK first of all can one subsequently be a Scottish taxpayer.
- The individual must then either:
- have his or her only or main residence in Scotland (main residence is calculated on a “more time spent at that property than the others” basis);
- spend more days in Scotland than in any other part of the UK if he or she does not have a residence in the UK; or
- be an elected representative for a constituency in Scotland.
It should be noted that the “main residence test” specifically refers to a calculation of the aggregate time spent at each available residence in each part of the UK for the taxpayer and takes no account of the reason for the person being at that particular property. For many individuals, this could bring about an unexpected result if that test were to be the determining factor for them.
Take, for example, an individual who works in London and has a small studio flat where he stays during the week but whose family home is in Edinburgh where his wife and children live, work and attend school and where he spends his holidays and every weekend. He could find that the number of days that he spends in the London home easily exceeds the number of days that he spends in the Edinburgh home. As a result, he would not satisfy the definition of a Scottish taxpayer for the purposes of the Scottish rate of income tax and his personal income tax would continue to be levied at UK rates. His wife in those circumstances, however, is very likely to be a Scottish taxpayer so could find herself subject to different rates of income taxation from her husband.
Smith Commission Recommendations
The Smith Commission published its report on 27th November 2014. The Commission had been given the task of detailing heads of agreement on the further devolution of powers to the Scottish Parliament. In relation to taxation, the Commission provided broad heads of terms for further negotiation between the Westminster and Holyrood Governments and we await the publication of draft legislation in order to determine to what extent the recommendation have been successfully negotiated. It is useful in the meantime, however, to consider a summary of the recommendations as set out in the Commission’s report insofar as they relate to personal taxation.
With regard to income tax, the Commission suggests that this should remain a shared tax between the two Governments but that the Scottish Government should have more authority to set and amend the rates of tax for Scottish taxpayers, not being bound by the single Scottish rate of income tax as provided for in the 2012 Act discussed above. The Scottish Government would, instead, have the ability to alter all rates independently as well as changing the level at which each rate is payable although this would apply only to certain types of income in the manner already set out in the 2012 Act. The Scottish Government would then receive all of the income tax paid by Scottish taxpayers on their relevant income although the collection of income tax would continue to be administered by HM Revenue & Customs.
The report suggests that the Scottish Government should not have the ability to alter the tax free threshold for income tax purposes for Scottish taxpayers and nor should it have the ability to introduce or amend income tax reliefs nor the definition of income for the purposes of income tax.
The Commission recommends that all inheritance tax and capital gains tax matters should remain within the sole competence of the Westminster Parliament. National insurance contributions will also remain reserved to Westminster. The Commission also recommends some technical amendments in relation to the way in which receipts from VAT are divided between the two Governments but it does not appear that this will have any effect on the rates that will be paid by individuals on the purchase of goods and services.
Wider Use of These Provisions
In a post Smith Commission Scotland, if further devolution of taxation powers to the Scottish Parliament is to occur, to what extent might the provisions of the 2012 Act be used as a starting point for future provisions?
The truth is that we cannot state with any certainty what will happen if any additional powers are to be devolved to the Scottish Parliament. We can, however, hypothesise that a draftsman may find it simplest to begin with legislation already in place. In the event of capital taxation being devolved to the Scottish Parliament, could the definition of “Scottish taxpayer” as outlined above become the mechanism by which taxpayers are differentiated for those taxes too?
Take, for example, capital gains tax. If the rates of capital gains tax were to diverge for those north and south of the border, it would, on the face of the matter, make sense for the determining factor for which rate is to be applied to be the residence of the taxpayer at the time of the chargeable disposal giving rise to the capital gains tax liability. In the example set out earlier of the family where the husband works in London and the wife works in Edinburgh, there may be scope for them in a year where a large disposal was likely to take place to alter their place of residence for tax purposes.
That being the case, will the Westminster or Holyrood Governments regard it necessary to include anti-avoidance provisions that prevent taxpayers changing residence in that manner? If so, that will be further complication of the tax code at a time when the UK Government’s stated aim is supposed to be a simplification of the existing provisions.
Of even more concern would be the use of such a residence test as part of a person’s inheritance tax affairs. Inheritance tax liability is governed by a person’s legal domicile. It is already the case that a person has his or her domicile in one of the constituent parts of the UK rather than having a “UK domicile” as such. On the face of it, therefore, there would appear to be little scope for this to be affected by a residence test.
However, current UK legislation includes a deemed domicile provision where an individual may not satisfy the current legal test of having acquired a domicile-proper in Scotland but, due to the fact that he or she has been resident there for a specified number of years, he or she will be “deemed” to be domiciled in Scotland notwithstanding the strict common law position. That deemed domicile is based on being resident so, if a person is deemed by the legislation to be domiciled somewhere in the UK by way of those provisions but he or she splits his or her time between Scotland and another part of the UK, does the location of that domicile within the UK fall to be determined using the Scottish taxpayer test? At the moment, the answer to that is clearly no but, in the event that further powers are devolved and the Scottish Government acquires an incentive to have inheritance tax paid north of the border, it is not difficult to see how such a test could then play an increasingly important role.
What should taxpayers be doing?
It should be borne in mind that we do not yet know what rates of tax will apply either side of the border and whether there will be any difference in those rates at all. However, for taxpayers who know that they are likely to lie on the margins of being either a Scottish taxpayer or a taxpayer elsewhere in the UK, the whole matter will undoubtedly come down to record keeping.
If the test centres on where a person spends the majority of his or her time, there will be little to no scope for HM Revenue & Customs to challenge a claim that he or she is resident in one jurisdiction or another if he or she is able to present a carefully kept log of his or her movements, where he or she stayed each week and the travelling between the two jurisdictions. If the “time spent” test is exclusively determinative, as it will be for a large number of people, that record keeping could be crucial.
It is to be expected that there will be a whole raft of circumstances not envisaged when the legislation was drafted that will be presented before the tax tribunals and a body of interpretative rulings will emerge over time, providing more and more clarity as to what will be determinative of a person’s residence. However, until such a time, the best advice must be simply to remain vigilant to the powers that are devolved and the way in which one is determined to be liable to the respective taxes.
From an asset perspective, if there is to be a change to the way in which capital is taxed, there may come a time where, for example, the gain on an asset needs to be apportioned between a gain incurred under one set of rules and a gain incurred after a new set of rules was introduced. For such matters, records of valuations will be very important when entering into discussions with HM Revenue & Customs, particularly if the taxpayer does not simply want an equal apportionment of the gain across the whole of his or her ownership of the asset. The importance of professional advice in such matter cannot be overstated.
We do not know if and when there will be a divergence of income tax rates or if and when there will be devolution of any other taxes to Holyrood. It is an interesting time to have an interest in Scottish taxation and we look forward to seeing how the matter is dealt with by the Westminster and Holyrood Parliaments, especially in an 18 month period that will see elections to both Parliaments taking place at a time when political views are as polarised as they have been for a very long time.
If the tax liability of whatever kind is likely to be significant and the residence of the taxpayer or the location of the asset is uncertain and will make a difference to the liability, professional advice should always be sought at an early stage to avoid unnecessary difficulties and costly complications later in the process.