Bruce Connelly: Tax code extras that could take most by surprise

IT WAS Oscar Wilde who said to expect the unexpected showed a thoroughly modern intellect. And never is that more pertinent than in dealings with HMRC.

February and March are traditionally the months when people up and down the land collectively sigh at the arrival of the new pay-as-you-earn (PAYE) tax codes, and this year is no different, with codes for tax year 2010-11, starting on 6 April winging through letterboxes.

But if previous years are anything to go by, somewhere around 4.5 million workers can expect to be paying the wrong amounts of tax when these codes come into operation. In March 2009, a reported 20 million queries were made about tax codes, and that marked a 25 per cent increase on the previous year. This translated into around 4.5 million people paying hundreds of millions too much tax and a further 1.5 million said to have underpaid.

But this year, evidence suggests the taxman should be primed for a new range of challenges based on some eye-catching entries included for the first time, the implications of which might not be immediately apparent to the unsuspecting public.

Yes, it would appear that the humble tax code finds itself at the forefront of HMRC's efforts to accelerate the tax take for the Exchequer. And why is that important? It's because under the self-assessment system, the alternative mechanism for collecting tax, payments to HMRC are only twice a year at the end of January and July, or in some cases just once a year, in January.

Clearly, for a government operating under recessionary pressures, this is fairly disastrous for cash flow, creating peaks and troughs of tax flowing into the Exchequer's coffers. On the other hand, the good old (this year is its 66th birthday) PAYE system provides a steady stream of tax deducted each week or month from pay packets of the UK's 23 million employees. Against this background, it's not difficult to understand why government prefers to see tax collected under PAYE.

And so what ploy does HMRC have this year to help bulge the pockets of the Treasury? In crude terms, it's collecting tax on income, the amount of which is estimated, before it has been received, and up to 23 months earlier than might otherwise be the case.

The tell-tale signs are codes with the following entries:

&149 Savings income taxable at higher rate;

&149 Interest without tax taken off (gross interest);

&149 Other income (not earnings);

&149 Savings income taxable at 40 per cent;

• Or property income.

What's happening is HMRC has opted to collect tax on various forms of investment income through salary deductions instead of waiting for it to be paid through self-assessment – good for the taxman but bad for the taxpayer.

For most workers in employment, the PAYE system collects the correct amount of tax (and national insurance), but the self-assessment system kicks in when this is not the case, or particularly if there are other sources of income where a direct tax payment is necessary. That would apply to savings income that has not borne any tax at all before it is paid, for example "gross" interest on deposits, or property rents, and also income that although having basic rate tax (20 per cent) deducted before it is paid, is liable to 40 per cent tax, for example "net" interest on deposits.

Under self-assessment, tax on these sources would typically be paid on 31 January following the end of the tax year. For income in 2010-11 that would be 31 January 2012. In some circumstances, where income from investments is high enough, tax must to be paid on account. For 2010-11 that would be on 31 January and 31 July 2011, with any balance payable on 31 January, 2012. It's a system that works well.

Tax codes have always been used to collect tax on items such as PAYE underpayments (the limit on these has been put up from 500 to 2,000 in recent years), state pensions, company car tax, casual earnings, etc but these new charges on investment income are a change in direction and, importantly, they mean that take-home pay will be less. HMRC says it will cap the income so taxed at 10,000, which for a 40 per cent taxpayer will cost 330 a month. To avoid this trap, an eagle eye is required to put "X" in two boxes of the self-assessment tax return.

Failing that, anyone receiving such a tax code who is unhappy with paying tax this way should ask for these entries to be removed and to revert back to paying under self-assessment. If appeals beat last year's total of 20 million, the taxman only has himself to blame!

Bruce Connelly is head of tax at Anderson Strathern Solicitors