Tax Credits: Understanding self-employment

Tax credits, in particular working tax credit (WTC), can be of great benefit to self-employed claimants. This guide covers some aspects of the tax credits system that are of particular importance for the self-employed.

Self employment and tax credits

To be entitled to tax credits you must be in ‘qualifying remunerative work’. There is no restriction on claiming WTC if you are self-employed. You can find out more about the qualifying remunerative work requirement on the LITRG website.

Calculating working hours

Under the Working Tax Credit (Entitlement and Maximum Rates) Regulations 2002, the number of hours which a self-employed person is in qualifying remunerative work is defined as ‘the number of hours he normally performs for payment or in expectation of payment’.

The HMRC compliance manual states that any hours which will be costed to the client/customer as spent in producing/providing the individual order or service count when working out hours for self-employment. In addition, the following activities also count:

It goes on to say that:

'The amount of time being spent on these activities may also depend upon how established the business is. If a business is in its early days, it is more likely that the claimant will have to invest large amounts of time and effort in building up business contacts for little or no outcome. However, over time the amount of unproductive time spent in this way reduce considerably. If it does not, it may be an indication that the work is not genuinely remunerative.'

The compliance manual also acknowledges that particular trades may present claimants with more difficulty in calculating their working hours and guidance is given for bed and breakfast owners, artists, writers, property renovators and door to door sales people.

Self employment and income

Tax credits generally follow the tax system when it comes to calculating income from self-employment.

HMRC have produced some online guidance which explains how to calculate income from self-employment. This basically involves taking the claimant’s taxable profit and deducting various allowed items such as gift aid and pension contributions. The remaining figure is to be entered into the self-employment income box on the form. If the figure is a loss, 0 should be entered on the form.

Working sheet TC825, provided by HMRC, can be used to calculate income where trading losses, gift aid and pension contributions are involved.

Losses from self-employment

While the computation of trading profits and losses are the same for income tax and tax credits, there are the following important differences in the way the relief is calculated as between tax and tax credits.

A trading loss in a year must be set off against the claimant’s other income for that year. Where the trader is part of a couple and a joint claim is in force, a trading loss in a year must be set off, for tax credits, not only against the trader's current year income but against the joint income of the trader and his or her partner.

Any surplus may be set off against profits of the same trade in future years for tax credits (ie the same as ICTA 1988, s 385 for income tax losses).

There is no carry-back of losses for tax credits.

Unrelieved losses of 2001-02 could be carried forward to 2003-04 and beyond for tax credits; but losses incurred in years prior to 2001-02, or in 2002-03, could not. These were effectively 'non-years' for tax credits, because the income of those years was not used for any tax credit purpose.

Trading losses cannot be carried forward for tax credits unless the trade in which they were incurred is being carried on upon a commercial basis and with a view to realising profits.

For example:

Walid’s trading results and Leila’s employment income for the years 2007/08 to 2010/11 are shown below, alongside their income for tax credits after taking account of Walid’s loss relief.

Year

Walid

Leila

Loss relief

TC income

2010/2011

£3,000

£13,000

(£500)

£15,500

2009/2010

(£12,000)

£11,500

(£11,500)

NIL

2008/2009

(£10,000)

£11,000

(£10,000)

£1,000

2007/2008

£15,000

£10,500

NIL

£25,500

 

Renewals and the self-employed

Tax credits claims last for a maximum of one year. After the end of each tax year, HMRC send renewal packs to claimants. The purpose of these packs is two fold. They finalise the claim for the year just ended and act as a claim for the new tax year.

In order to finalise the claim for the year just ended and ensure any new claim is as accurate as possible, HMRC ask claimants to provide their actual income for the year just ended.

These packs are generally sent out in the summer time. Many self-employed claimants will not have completed their tax returns nor had their final figures from their accountants. For this reason, HMRC allow claimants to complete their declaration forms using an estimated income.

It is important that claimants give an estimated income to HMRC by the deadline (in most cases 31 July) even if they cannot provide an actual income. If they don’t, their payments may stop. The self-employed should give an estimate even if they receive an auto-renewal and their estimated income is within the limits quoted on the renewal form. This will ensure the system knows they have used an estimated income. See the information on missing the deadline in our renewals section.

The claimant then has until the following 31 January to report their actual income. That is also the filing date for income tax self-assessment purposes.

Thus, in order to renew a claim for 2013/14, a self-employed claimant should file income figures for 2012/13 by 31 July 2013, but that may be an estimate. If so, the claimant must file final 2013/13 figures by 31 January 2013.

It is important that they give HMRC their actual income otherwise HMRC will finalise the claim for the previous tax year using the estimated figure which may not be correct. This could potentially lead to penalties and overpayments.

Protective claims

Self-employment has many benefits, but one of the downsides is that income is not necessarily consistent and regular. It may be that a business is doing well and the claimant’s income is too high to qualify for tax credits, but there is a chance that this could change at any time in the future.

Because tax credit entitlement accrues at a daily rate throughout the year, income is worked out by being spread evenly, day by day, over the whole year. This can mean that tax credits already received may have to be recalculated.

This can work to a claimant’s advantage if they start the year on a high income and finish it on a low income, especially if they have made a claim at the start of the year and been given a Nil Award. This is because their award is recomputed for the whole year to give them the tax credit entitlement which is now due. If they had not made a claim, but had delayed claiming until their income fell, they would only have been allowed three months' backdating.

A claim made in these circumstances and followed by a Nil Award is loosely termed a 'protective' claim.

For example:

Edward and Lisa have two children. Edward, on £50,000 a year, is the sole earner. On 1 October 2013 Edward is made redundant and expects to spend the rest of the tax year on contribution based jobseeker’s allowance (JSA).

If Edward and Lisa have made a ‘protective’ claim for the whole of the tax year, their initial award will have been nil. But when Edward is made redundant, and he reports his fall in income to HMRC, he receives a revised award for the whole tax year backdated to April based on an estimate of £25,000 income (£50,000 a year paid for six months) plus his contribution based JSA of £1,846.

Tax credits entitlement £1874.

If they have not made a claim, Edward and Lisa can backdate their claim by only one months from the date of the redundancy. Tax credits entitlement approx £973.

In March 2012, HMRC wrote to claimants who had made protective claims and who were receiving Nil (as well as claimants who they thought would be Nil from April following various system changes). The aim of these letters was to remove people from the system by not renewing their claims for 2012/2013 unless the claimants responded to those letters by 31 March 2012. This exercise will not be repeated for 2013/14 claims. More information can be found in our renewals section.

HMRC Self-employed Helpcard

In response to requests for more information, HMRC have produced a Self-employed Helpcard for tax credit claimants. The Helpcard gives additional information to that contained in the claim form notes and also provides an insight into the way HMRC look at whether an activity can be classed as self-employment, what types of activity can be included as remunerative work and what kinds of records they expect claimants to keep in case they ask to see them.

LITRG have raised concerns about the way HMRC handle claims from self-employed tax credit claimants and we have sought clarification on several points published in the Helpcard. Namely, clarification around the expression ‘expectation of payment’ vs ‘hope of payment’, the requirement for the self-employed claimant to have a ‘client base’ and their activity be ‘regular, organised and developed’ and clearer definition in reference to a claimant who ‘reasonably’ expects payment and who ‘genuinely’ expects payment. Whilst these expressions do not appear as such in the rules set out in the legislation, they are points which add definition to the rules and we will provide additional guidance around their application once we have HMRC’s response.

 

Updated 5 April 2013