Tax Credits: Understanding self-employment

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’. For claims prior to April 2015, there was no restriction on claiming WTC for people who were self-employed, providing the work was done for payment, or in expectation of payment, and they met the remunerative work conditions. You can find out more about the qualifying remunerative work requirement in our entitlement section.

For claims from 6 April 2015 onwards, claimants must be either employed or self-employed. For tax credit purposes, HMRC define self-employed as meaning the self-employed activity is done on a commercial basis with a view to realising a profit and it must be organised and regular.

HMRC will apply this test to new claims from 6 April 2015 and gradually check existing claims to see if those claimants also meet the new test. HMRC will write out to existing claimants about the new test from July/August 2015 before they start to apply these rules to existing claims later in the year.

HMRC have clarified that new claims will be checked against the test if the claimant's previous year income from self-employment is less than the number of working hours (declared by the claimant) x standard rate of national minimum wage.

Notably, this means for example that where a claimant says they normally work say 25 hours a week even if they are only required to work 16 hours a week to qualify for working tax credits, they may be selected for a check if their earnings fall below the threshold based on the hours they declare. (You can find the national minimum wage rates in our national minimum wage section). If they are not earning that amount, then HMRC may ask the claimant to provide evidence that they meet the requirements of the new test. The evidence asked for may include things such as business plans and other business records, including any relevant insurance documents (see HMRC’s Helpcard). It is expected that not everyone whose earnings fall below the threshold will necessarily be asked to prove their self-employment is commercial with a view to realising a profit and is organised and regular. HMRC are developing their guidance on this subject and we will provide more information as it becomes available.

It is not yet clear how this test will be applied in joint claims, where there is a joint hours requirement nor whether there are tax implications where HMRC determine that the self-employment is not commercial for tax credit purposes.

HMRC issued a briefing in March 2015 about how they will apply the new rules.

We will add further information as it becomes available. HMRC’s Tax Credits Technical Manual contains some information about the new test (what is meant by ‘a commercial basis’ and ‘view to the realisation of profits’ for tax credit purposes. It should be noted that even where HMRC determine that a self-employed activity is not undertaken on a commercial basis with a view to realising a profit and is organised and regular, any taxable income from that activity will still be taken into account when assessing the tax credit award amount. This may be relevant where ctc is awarded but wtc refused or claims where the basic remunerative work conditions are met other than by the self-employment activity in question.

HMRC say that the requirement to be either employed or self-employed will not be applied so as to remove entitlement from those whose status is unclear, such as some company directors and some agency workers.

'Company directors who are not otherwise employees are covered as regulation 2(4) extends references to being 'employed' to include being the holder of an office and thus covers company directors as mentioned in your e-mail.

We can also confirm that agency workers are covered in the amended regulations. Although the definition of ‘employed’ in regulation 2 refers to being employed under a contract of service or apprenticeship, the policy intention is that the definition should be read as including agency workers engaged under a contract for services whose earnings are chargeable to income tax as employment income under Chapter 7 of Part 2 Income Tax (Earnings and Pensions) Act 2003 (ITEPA.) This reading of the ‘employed’ definition is supported by the qualification in relation to engagements falling within Chapter 8 of Part 2 (arrangements made by Personal Service Companies) where similarly individuals may not necessarily be engaged under a contract of service. Agency workers, as described in your e-mail, will therefore be considered to meet the entitlement conditions as an employed person for the qualifying remunerative work test for working tax credit.

HMRC will look to clarify this position and if necessary, put it beyond doubt in regulations at the earliest opportunity.'

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. Note that this helpcard has not been updated since it was first produced.

LITRG have raised concerns about the way HMRC handle claims from self-employed tax credit claimants and we have sought clarification on several points about the new definition of self-employment and other points published in the Helpcard. We will provide additional guidance around their application once we have HMRC’s response.

 

Updated 10 August 2015