Chapter 12 Example 4 Elliot

Charitable donations under the gift aid scheme attract tax relief at the taxpayer’s highest marginal rate of tax, i.e. the rate of tax that they would pay on an extra £1 of income (or, looking at it the other way round, the rate of tax they would save on £1 less of income).

A basic rate taxpayer’s marginal rate of INCOME tax is 20%, for a higher rate taxpayer it’s 40% and for an additional rate taxpayer it’s 45%.

The vast majority of taxpayers are basic rate taxpayers (BRT), so for them, paying the donation net of basic rate tax means that if they want a charity to receive £1,000, they actually pay £800 (80%) net to the charity. As charities don’t pay tax on donations, they claim the tax suffered at source back from HMRC, so HMRC gives the charity the other £200 (20%), so that the charity receives £1,000 (gross). The BRB can be extended by the the gross donation but for INCOME tax there is no point in doing so, as the taxable income falls within the existing BR band anyway, so extending it will not make any difference to the income tax liability; i.e. if your taxable income is £20,000, then it’s taxed at 20% regardless of whether your BRB is £37,700 or £38,700.

HMRC assumes that most taxpayers are basic rate taxpayers, but for a higher rate taxpayer (whose marginal rate of income tax is 40%), they deserve 40% tax relief, so 20% tax relief is given at source (as per a BRT) but they then get the extra 20% tax relief they deserve by extending the BR band by the gross donation, so that more income is taxed at 20% and less at 40%, giving an extra 20% of tax relief on the donation (i.e. reducing their income tax liability by 20% of the gross donation) so that they get 40% relief overall (20% at source and a further 20% through the calculation of income tax). The extra 20% is simply the difference between taxing an amount at 20% or taxing it at 40%.

For an additional rate taxpayer (whose marginal rate of income tax is 45%), they deserve 45% tax relief, so 20% tax relief is given at source (as per a BRT) but they then get the extra 25% tax relief they deserve by extending the BR and HR band by the gross donation, so that more income is taxed at 20% and less at 45%, giving an extra 25% of tax relief on the donation (i.e. reducing their income tax liability by 25% of the gross donation) so that they get 45% relief overall (20% at source and a further 25% through the calculation of income tax). The extra 25% is simply the difference between taxing an amount at 20% or taxing it at 45%.

Although for a BRT there is no point in extending the BR band by the gross donation for INCOME tax, if the taxpayer has taxable gains, then it is worth extending the band as that will result in them paying less CGT. So if taxable income is £(45,270 – 12,570) = £32,700 and the BRB is £(37,700 + (2,400 x 100/80) = £3,000) = £40,700, taxable income is still taxed at 20% BUT there is more BRB available for gains (£40,700 – £32,700) = £8,000 so we pay CGT at 18% on £8,000 of gains rather than on £5,000 of gains (the extra £3,000 which is the gross gift aid donation extension) giving a CGT saving of (24% – 18%) = 6% of £3,000 = £180, giving us total tax relief on the gross gift aid donation of 20% at source (IT) and 6% (CGT) = 26% (£600 IT at source (£3,000 gross – £2,400 paid net)) and £180 through the calculation of the CGT liability (£3,000 x 6% (24% – 18%)) = £600 + £180 = £780.

780/3,000 = 26%.

I hope this has clarified things for you.