Optimal allocation of the personal allowance when foreign tax credits available

[FigNewton]

Section 25 (2) of the Income Tax Act 2007 states: 'At Steps 2 and 3, deduct the reliefs and allowances in the way which will result in the greatest reduction in the taxpayer's liability to income tax’.

This has made me think about the following issue regarding the allocation of the personal allowance.

Suppose I have US source dividends for which a 15% tax credit is available for the US tax paid. This dividend income lies outside the dividend allowance and I am taxed at 32.5%, leaving an effective UK tax rate of 32.5-15=17.5%. Since 17.5% is less than 20% it would appear advantageous to allocate my personal allowance to some of my 20%-taxed wages in preference to this foreign dividend income. But HMRC software does not do this. So does Section 25(2) really mean

"... which will result in the greatest reduction in the taxpayer's liability to income tax, but only up to the point before reliefs after Steps 2 and 3 are computed (e.g. double taxation relief)"?

Or is HMRC failing to apply Section 25(2) correctly?

[robbob]

But HMRC software does not do this

I would be surprised ** if this is happening if you are entering the "to be claimed as deduction from your tax liability" credit as you will need to do. On the system there will be two boxes one showing the overseas tax deducted and another where you are detailing the amount to come off your liability - could it be this second box needs completing?

** Note there are plenty of situations now where a paper return must be filed as the computer simply can't do the correct calculations - for 16/17 the list is available here.
http://www.sa2000.co.uk/2017-exc-indi.pdf


There is a final possibility that this method is actually saving you tax even though you don't realise it ! I have known dividends slot into the personal allowance when i have not expected that to generate a saving but is has done - one up on the computers that test all the variations in those circumstances.

[FigNewton]

The situation occurs where, say, I have 15% tax credit available on £1,000 of foreign dividends (£150), but because £1,000 of personal allowance has been allocated to those dividends I have no UK tax to pay and my foreign tax credit is useless.

I would be better off by placing some of the £1,000 of personal allowance against my basic rate income, leaving the taxed dividend income to be 150/0.325 = 461.54. This would mean I could use my entire £150 tax credit. My total tax bill will decrease by 20% of (1000 - 461.54).

I queried this with the HMRC Customer Support on twitter. The reply was:

"The web tool is correct. There is no legislation available that enables you to choose how to allow the allowance."

I queried this quoting ITA 2006 Section 25 (2) and received the reply

"Relief for foreign tax is a tax reduction at S26 ITA 2007 and comes in at step 6 of the calculation at S23. It does not form part of the calculations at steps 2 and 3."

Helpful as the twitter service is, I know one cannot rely on HMRC support being 100% correct in all cases. Thoughts?

[robbob]

I would agree with hmrc in that normally the allowable foreign tax credit is restricted to the additional tax due on that line item of income when treated as an additional add on to the tax calculated without that line being included. I think i would need a complete worked example to follow this through to the answer as how i would expect it to work.

[FigNewton]

When I completed my return on 14/01/18 the HMRC tool was not calculating any foreign tax credit relief, leaving the box filled as 0, and forcing the tax-payer to manually calculate a figure using the lengthy "Foreign Tax Credit Relief working sheet". Interestingly, returning to online SA today and playing with amending my return, I find that there have been several software changes. One change is that the tool now creates a foreign tax credit relief figure during the "View your calculation" stage. I have been able to check it is correct: it is the minimum of (a) my foreign dividend tax paid, and (b) the difference between the tax calculated with and without inclusion of the foreign dividend income.

It's a pity HMRC did not have this part of the tool working properly at the time people were submitting 2016-17 returns!