45% top tax to be introduced

The top rate of tax will remain at 40% for the next two tax years, but In 2011/12 a new top rate of 45% will be introduced. The new rate will apply to taxable income in excess of £150,000. The increase will 'bite' at the same time as increases in NIC and changes to personal allowances and those earning over £100,000 a year will see significant falls in net income.

Baker Tilly analysis

This measure is undoubtedly designed to demonstrate the Chancellor's intent to recover the cost of tax cuts given now to provide a fiscal stimulus to the UK economy. It will see a greater level of complexity returning to the UK tax system and will increase significantly the tax take from the highest earners. It will however mean that the cost of pension contributions will fall with a gross contribution of £1,000 costing £550 as opposed to the current £600. However, that potential saving will be restricted by the freeze on pension contribution limits and lifetime allowances, see our comments on this at 'Pension schemes limits frozen at 2010/11 levels until 2016'

The measures will also extend to trusts where the rate will apply to all trust income in excess of £1,000. The exact impact on the beneficiaries will depend on the precise nature of the trust and the distribution policy.

In detail

The new rate will add an extra 5% income tax to the top slice of income of one percent of UK taxpayers. However, its effects will be much more widely felt than simply among the top individual taxpayers because the new top rate will also apply to trusts. Trusts pay tax at the top income tax rate on all their income over £1,000 per year.

The 45% rate will apply to all earnings and savings income as well as to 'chargeable events', withdrawals from life insurance policies in excess of 20% for each year that the policy has been held, up to the amount originally invested in the policy.

The new top rate will further reduce the attractiveness of investment bonds that are taxed at income tax rates as compared to investments whose returns are subject to capital gains tax at 18%.

Dividends will also be subject to a new top rate of tax, 37.5%. The tax credit allowed on dividends remains unchanged at 10% which means that the effective top rate of tax on net dividends received will be 30.56%. That is a more awkward number to work with than the present effective top rate on net dividends of 25%.

How the new rate will affect trusts depends on whether they pass their income on directly to beneficiaries or accumulate it. For income that is passed to a beneficiary the amount distributed will be reduced as the trustees have to retain 45% of any gross distribution; the beneficiary will be able to claim credit for, or repayment of the tax paid by the trustees.

However, where trustees do not immediately distribute their income they will have less cash available for reinvestment for the benefit of the beneficiaries. This will reduce the income earning potential of trusts used to save up for future costs such as higher education of grandchildren.