Scottish income tax was already set to create a headache for HM Revenue & Customs (HMRC), pension providers and advisers this year. But the Scottish government’s recent proposals to reform income tax for Scottish residents promises to add a new level of complexity to an already thorny area.

In November 2016, the Scottish government was granted powers to differ the rates and thresholds for income tax for Scottish residents. Firstly, this means HMRC has to be able to identify Scottish residents.

In its pensions newsletters, HMRC says it will identify pension scheme members resident in Scotland using the annual return of individual information, which is submitted by scheme administrators by 5 July each year. Each January, starting this month, HMRC will electronically tell pension scheme administrators operating relief at source pension schemes their individual scheme members’ residency tax status. Scottish residents will have a ‘S’ identifier. Those unmatched would have a ‘U’.  Importantly, if a person is identified as a Scottish resident before the start of the tax year that status is locked in. Even if they move part way through the year to somewhere else in the UK, they will still be treated as Scottish for the whole of the tax year.

HMRC is developing a look-up service for scheme administrators to use for members who joined after July. If the scheme administrator uses the service between April and December they will get the member’s current tax year residency. Between January and April, they also get the residency status for the next tax year. If the scheme administrator is unable to look up the status before they apply tax relief at source to the first contribution, they must default the residency status to rest of UK and maintain this rate for the whole tax year. HMRC will sort out any shortfall or excess of tax relief at the end of the tax year.

In December, this issue reached a new level. The Scottish government wants to develop a six-tier income tax system for Scottish residents, as well as raise the tax rates for some, and reduce it for others. The proposed income tax system looks like this:

Name of band Band Rate
Starting £11,850 - £13,850 19%
Basic Over £13,850 - £24,000 20%
Intermediate Over £24,000 - £44,273 21%
Higher Over £44,273 - £150,000 41%
Top Over £150,000 46%


Download: Pensions and Scottish rates of income tax fact sheet

For schemes operating relief at source this immediately raises questions. Currently, schemes receive 20 per cent tax relief direct from HMRC for all pension contributions. Those who pay higher rates of tax can claim any additional tax relief, usually through their self-assessment tax return, although higher rate taxpayers can also notify HMRC direct who may adjust their tax code to give them this additional relief.

But how will HMRC cope with these new tax rates? If it credits all contributions with a straight 20 per cent, then many more people will have to reclaim additional tax relief. This is business as usual for higher and top rate taxpayers, but not for intermediate rate taxpayers. Would someone earning just over £24,000 really be bothered to claim the additional small amount of tax relief?

For a member earning £25,000 a year and paying 5 per cent pension contributions of £1,250 a year, the scheme would receive £312.50 direct from HMRC giving a total pension contribution of £1,532.50. The member could claim an additional 1 per cent tax relief of £15.63. But the effort to get such a small amount could put them off.

Another option could be for HMRC to automatically give 21 per cent tax relief to pension schemes for these taxpayers. However, the Finance Act 2004 sets out the tax relief payment should be equal to the basic rate of income tax, and it would be convoluted to change this. The simplest approach is to automatically adjust these taxpayers’ tax codes at the end of the year.

Those paying 19 per cent tax will receive too much tax relief. Non-taxpayers already receive 20 per cent tax relief on their contributions. But under automatic enrolment, and given current low opt-out rates, around 90 per cent of the 893,000 people who fall under the intermediate rate could be contributing to a pension scheme.

The new Scottish income tax bands are still proposals, and won’t be finalised until mid-February. HMRC will no doubt be working hard to figure out the implications for relief at source schemes. But we need urgent clarification the minute the proposals turn into reality.

Finally, introducing varying rates of tax relief between different parts of the UK may reopen previous discussions on the future of pension tax relief, and whether to sever the link between income tax and pensions altogether.

This article first appeared in the 18 January issue of Money Marketing