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The seven steps required to calculate an individual’s income tax liability

14 min read 31 Mar 23

What are the seven steps required to calculate an individual’s income tax liability. Find everything you need to know in our knowledge library. 

  • Tax law states that seven steps are required to calculate an income tax liability

  • There are fixed ‘order of income’ rules that need to be followed

  • Savings income includes onshore and offshore bond gains
  • Under basis period reform, to calculate the income tax liability for a tax year where an amount of the “transition profits” has been treated as arising, the steps in section 23 ITA 2007 below are modified. This will apply for tax years 2023/24 to 2027/28.

Tax law instructs us how to calculate an income tax liability. In simple terms, you add up the different components of income, then deduct any reliefs and allowances. You then calculate the tax due on each component and total these up. In straightforward cases, that will be all that is required but in more complex cases you then need to deduct any tax reducers and add in any further amounts of tax due.

The full details are set out below.

Section 23 is titled “The calculation of income tax liability”, and it states the following.

“To find the liability of a person (“the taxpayer”) to income tax for a tax year, take the following steps.”

Steps one to seven are then listed. 

“Identify the amounts of income on which the taxpayer is charged to income tax for the tax year. The sum of those amounts is “total income”. Each of those amounts is a “component” of total income”. 

What is meant by a “component”?  These are all possible components of a client’s total income.

  • Employment income

  • Pension income

  • Social security income

  • Trading income

  • Property income

  • Savings income

  • Dividend income

  • Miscellaneous income

Section 16 ITA 2007 states that savings and dividend income are treated as the highest part of total income. S16 also confirms that if an individual has savings and dividend income then the dividend income is treated as the higher part. It’s more complicated however where there is a top slicing calculation being carried out for insurance bond gains. Also, onshore bond gains are taxed after dividend income.

Section 18 confirms that ‘savings  income’ includes onshore and offshore insurance policy gains. S465A ITTOIA 2005 states that onshore bond gains are treated as the highest part of an individual’s total income.

The order of income tax –


Earnings, pensions, taxable social security payments, trading profits, income from property


Savings income (includes offshore bond gains)


Dividend income


Onshore bond gains

With regard to insurance bond gains, how does top slicing relief fit into these rules?

When calculating the tax liability before top slicing relief then the above order of tax rules apply. Note how onshore and offshore bond gains are slotted in differently in the order of tax rules.

When you come to calculate top slicing relief itself, then bond gains and slices are treated as the ‘highest part’ and therefore both onshore and offshore gains and slices come after dividends in the top slicing relief calculation. In other words, the order in the top slicing calculation is as follows.


Earnings, pensions, taxable social security payments, trading profits, income from property


Savings income (excludes offshore bond gains)


Dividend income


Onshore and offshore bond gains and slices

Top slicing information is available here

“Deduct from the components the amount of any relief under a provision listed in relation to the taxpayer in section 24... See sections 24A and 25 for further provision about the deduction of those reliefs. The sum of the amounts of the components left after this step is “net income”.” 

Certain reliefs can be deducted from any component but others are restricted to a particular component. For example, if the client is a trader and sustains a trading loss in the tax year then the loss can be deducted against general income of the same or preceding tax year with any unrelieved loss then carried forward and set off only against future income from that same trade. Special loss provisions apply to both new and closing businesses.

Section 24 of ITA 2007 lists the various reliefs which are potentially deductible and Section 25 tells us that the reliefs can be deducted in the way which will result in the greatest reduction in the client’s income tax liability (though see below). That means deducting, as far as possible, from non-savings, non- dividend, income (earnings, pensions, taxable social security payments, trading profits and income from property). Any remaining relief is then deducted from savings income (being mindful not to waste 0% savings rates) and finally from dividend income. Clearly these reliefs need to be deducted from the individual components rather than from total income, to achieve this objective.

In the 11 March 2020 Budget, a measure was announced concerning  the treatment of allowances and reliefs within the top slicing relief calculation by confirming that they must be set as far as possible against other income in preference to the gain. Subsequently, Finance Bill 2020 was published on 19 March. This inserted a new subsection (8) in section 535 of ITTOIA 2005 to confirm that for the purposes of the top slicing relief calculations 

  • the rules of reliefs and allowances at section 25(2) of ITA 2007, that require reliefs and allowances to set off income in a way that results in the greatest reduction in an individual’s income tax liability, do not apply; and

  • an individual’s reliefs and allowances must be deducted from other income before being deducted from the gain. 

On 20 July 2020, HMRC confirmed to the Chartered Institute of Taxation (CIOT)  that the mode of calculation as set out in the March Budget (and which is now included in the Finance Act) will be applied, ‘by concession’, to any gains in both 2018/19 and 2019/20 tax years. This was subsequently confirmed in Agent Update 79. Originally, Agent Update 78, indicated that HMRC would only be applying the new provisions to 2019/20 gains.

Finance Bill 2020 gained Royal Assent on 22 July 2020.

Note that there is a limit on the amount of income tax relief deductible at Step 2 for certain reliefs. The cap is the higher of £50,000 or 25% of the individual’s adjusted total income.

Example of the cap on income tax relief -

In the current tax year, Roddy has total income of £170,000 and trading losses of £60,000. He makes a claim to set his trading losses off against his total income.  Roddy’s relief will be £50,000 as that is higher than £42,500 (25% of £170,000).

“Deduct from the amounts of the components left after Step two any allowances to which the taxpayer is entitled for the tax year... See section 25 for further provision about the deduction of those allowances.”  

Step three is where the personal allowance (and blind person’s allowance) is deducted.  Further information here.

Again Section 25 tells us that this should be done in the way which will result in the greatest reduction in the client’s income tax liability (though see above), and again the allowance(s) must be deducted from components rather than from the total net income figure to achieve this. See the worked example later in the article. 

“Calculate tax at each applicable rate on the amounts of the components left after Step three. See Chapter 2 of this Part for the rates at which income tax is charged and the income charged at particular rates.” 

The above is self- explanatory. Don’t forget to extend the basic rate band and higher rate limit for gross gift aid payments  and gross relief at source pension contributions

The different rates of tax are covered here.

The above link details the main rates, dividend rates and savings rates. If the individual has savings income comprising a UK bond gain and other gross interest, then the zero rate band is applied to interest in priority to the onshore bond gain. 

“Add together the amounts of tax calculated at Step four.” 

“Deduct from the amount of tax calculated at Step five any tax reductions to which the taxpayer is entitled for the tax year… See sections 27 to 29 for further provision about the deduction of those tax reductions.” 

Step six is therefore the step where any tax reducers are deducted. Essentially they reduce the tax liability calculated above.

These reducers are listed in Section 26 with the most common being EIS, VCT & SEIS tax reliefs, top slicing reliefdeficiency relief and community investment tax relief.  Also, marriage 'allowance' is deducted here. This arises when married couples and civil partners apply to transfer 10% of the unused income tax personal allowance from one to the other. To qualify, neither of the partners can be a higher rate taxpayer and they must not be claiming the married couple’s allowance. The word “allowance” is misleading as it delivers a tax reduction for the recipient rather than an additional allowance.

It is also here that additional ‘relief at source’ relief is available for Scottish (& Welsh when appropriate) taxpayers.  Scottish taxpayers subject to 21% intermediate, 42% higher or 47% additional rate are entitled to claim additional relief by completing a tax return. There is an example here.

Section 27 tells us that the general rule is to deduct the reductions in the order which will result in the greatest income tax reduction. There is a proviso however that, if a client is entitled to certain multiple reductions then a specific order applies. For example if  VCT, EIS and marriage ‘allowance’ reductions are all due then they need to be deducted in that order.  Section 28 is not relevant to individuals. Section 29 instructs that a tax reduction applies only so far as there is sufficient tax calculated at Step five.

Example of restricted tax reducer -

If Jonny subscribed £20,000 for VCT shares, his maximum income tax relief at 30% would be £6,000. If his actual liability in that year before any VCT tax relief was £5,000, then that is the relief he would receive. The difference of £1,000 can’t be set off against the income tax liability of any other year.

“Add to the amount of tax left after Step 6 any amounts of tax for which the taxpayer is liable for the tax year under any provision listed in relation to the taxpayer in section 30. The result is the taxpayer’s liability to income tax for the tax year.” 

This is the final step in the process of calculating a client’s income tax liability. It is necessary to add any further amounts of tax due. Common examples include

  • Gift aid donations where the donor has not paid sufficient tax to cover the income tax deducted from the donation meaning that the individual is liable to pay the difference.

  • High income child benefit charge. See here to understand how reducing adjusted net income can reduce the impact.

  • The lifetime allowance charge.

  • The annual allowance charge.

Remember that a client’s income tax liability is not necessarily the same as tax payable because there may be tax already paid (e.g. PAYE) or tax deducted at source. 

Tax law for taxing insurance bond gains is contained in Part 4, Chapter 9 of the Income Tax (Trading and Other Income) Act (ITTOIA) 2005. Although, where the policyholder is a company, then the loan relationship rules apply instead as discussed here.

Chapter 9 comprises Sections 461 to 546 and from outset, S461 (1) makes it clear that gains are charged to income tax. Only in certain specific circumstances will a charge to capital gains tax arise.

Chargeable event gains on UK bonds are not liable to basic rate tax. The individual (or trustee) who is liable for tax under the chargeable event regime is treated as having paid tax at the basic rate on the amount of the gain. This reflects the fact that the funds underlying a UK policy are subject to UK life fund taxation.

It is a longstanding principle that the notional tax is not repayable (S530 (2) ITTOIA 2005

Insurance Policyholder Tax Manual 3810

The general rule is that an individual or trustee who is liable for tax under the chargeable event regime is treated as having paid tax at the basic rate on the amount of the gain. Where this rule applies, the notional tax is not treated as repayable in any circumstances but basic rate tax is still treated as paid if some or all of the gain is liable to income tax at the starting rate for savings and the personal savings allowance nil rate.

As far as we are aware, it has not been definitively settled whether or not the notional tax credit is repayable. S530(2) states that the notional credit cannot be repaid. That suggests  it is not available to set against other income resulting in income tax to be repaid,  but instead it should be possible to reduce that tax down to zero.  Nevertheless, we are aware that HMRC have previously taken the view that the notional tax credit can be set against other income, creating a refund of other income tax if appropriate. This is valid but at odds with the intention of the legislation.

Finance Act 2008 created a new 10% starting rate for savings. A consequence of this was that S530(6) was repealed. That particular subsection had been in place to ensure that gains taxed under the previous 10% starting rate band would be taxed at 20% rather than 10%. With S530(6) being omitted, this consequence was that gains with a notional 20% credit became chargeable at 10% (now 0%) leaving a balance of tax credit.

Example of bond gain partially taxable at 0% savings rate -

In 2023/24, Alex, who lives in Leeds, has earned income of £16,570 and an onshore bond gain of £30,000 with a 20% notional tax credit of £6,000.

After setting off the Personal Allowance of £12,570, his taxable earned income is £4,000. He will pay 20% tax on that = £800.

His £5,000 0% Starting Rate for Savings is reduced to just £1,000. 

  • His Personal Savings ‘Allowance’ will be £1,000.

  • Tax due on his bond gain will be 20% of £28,000 = £5,600.

His notional tax credit of £6,000 ensures there is no tax liability on his bond gain but what is the position with the £400 which has not been required?

That can be set against the £800 tax due on his earnings reducing his overall tax bill to £400.

The Seven Steps outlined above help form the calculation of an individual’s ‘adjusted net income’. S58 ITA 2007 sets out the calculation as follows.


Start with the individual’s ‘net income’ as calculated at Step 2.


Deduct gross gift aid payments


Deduct gross relief at source pension contributions


Add back payments to trade unions and police organisations which were deducted in arriving at net income above

The term ‘adjusted net income’ is important for several reasons

  • The basic personal allowance is restricted for those where adjusted net income exceeds £100,000

  • The high income child benefit tax charge impacts those with an adjusted net income over £50,000

  • The amount of Personal Savings ‘Allowance’ (PSA) depends on adjusted net income (up to £50,000, the PSA is £1,000 then £500 up to £150,000 then zero

  • The income limit for Married Couples ‘Allowance’ where either party born before 6 April 1935 is based on adjusted net income

In 2023/24, Sarah has pension income of £8,570, savings income of £7,000 and dividends of £8,000


Pension £

Savings £

Dividends £

Total £






Personal Allowance










£5,000 taxable at 0%





£1,000 taxable at 0%





£1,000 taxable at 0%




£4,000 taxable at 8.75% = £350









The Personal Allowance is firstly set against the pension income.  That means the taxable savings income and taxable dividend income is maximised which is sensible as those components enjoy an element of 0% tax which we do not want to waste.

Note that the general rule of thumb is to deduct the maximum personal allowance from non-savings, non-dividend income as this component suffers tax at the highest rates and enjoys no 0% bands which may apply to savings and dividend income; also remember that dividends are taxed at a maximum rate of just 39.35%.

Sarah’s non savings income is lower than the personal allowance meaning that she is entitled to a £5,000 0% band for her savings income.

Sarah’s adjusted net income is lower than £50,270 meaning that she is entitled to a Personal Savings ‘Allowance’ of £1,000.

To maximise use of the £5,000 0% rate and the £1,000 PSA, only £1,000 of personal allowance is set off against the savings income of £7,000. That leaves £3,000 of personal allowance to be deducted from dividends.

Regarding dividends, the £1,000 nil rate is available to anyone who has dividend income. Sarah is comfortably a basic rate taxpayer meaning that she will pay 8.75% on dividends in excess of £1,000.

The longstanding rule for businesses such as self-employed and partnerships has been that trading profits of a tax year are generally based on the profits for the 12 month accounting period ending in the tax year. For example, if the accounting period ends on 31 December each year the 2021/22 taxable profits would be based on the accounts for the year ended 31 December 2021. This is the “current year basis” and the period being taxed is the “basis period”.

Specific rules determine the basis period in certain cases, including during the early years of trading. These rules can create overlapping basis periods, which charge tax on profits twice and generate corresponding ‘overlap relief’ which is usually given on cessation of the business.

Basis period reform changes the above to a ‘tax year basis’ with effect from the tax year 2024/25 so that a business’s profit or loss for a tax year is the profit or loss arising in the tax year itself, regardless of its accounting date. This removes the basis period rules and prevents the creation of further overlap relief. On transition to the tax year basis in the tax year 2023/24, all businesses’ basis periods will be aligned to the tax year and all outstanding overlap relief given. Under the current year basis, two businesses that are identical except for their accounting date may have very different taxable profits for a tax year. Basis period reform takes effect for 2024/25 with 2023/24 being a transition year. Note that overlap profits do not occur if the accounting periods are aligned to the tax year and therefore many businesses prepare accounts to 31 March or 5 April. For the avoidance of doubt, dates from 31 March to 5 April inclusive are treated as aligned to the tax year.

From 2024/25, taxable profits will be based on time-apportioned profits of the accounting periods that fall within the tax year. So, if accounts are prepared to 31 December, the 2024/25 taxable profits would be based on 9/12 (or more accurately270/366ths) of the 2024 calendar year profits and 3/12 (more accurately) 95/365ths of the 2025 calendar year profits.

For those with accounting periods not aligned to the tax year, (and who do not cease trading in the year), then profits in 2023/24 are based on the period from the end of the 2022/23 basis period to 5 April 2024 with a deduction for any unrelieved overlap profits. Assume accounts are prepared to 31 December every year, the 2023/24 profits would be based on the whole of the 2023 calendar year accounts together with 3/12 (more accurately 96/366ths) of the 2024 calendar year accounts, with a deduction for any unused overlap profits that arose in the opening years of trading. Where this profit figure exceeds the profits for the first 12 months of the extended basis period, then spreading provisions apply. These are called “transition profits” which are spread equally over five tax years, including 2023/24, but the person involved  can elect to be taxed sooner. Any untaxed transition profits are taxed automatically on cessation of the trade. Where there are transition profits for the 2023/24 tax year, then for each of the first four tax years, 20% of the amount of the profits will be treated as arising in each year starting with the 2023/24 tax year. The balance of profits will be treated as arising in the fifth tax year (2027/28). This increases the chargeable profits of those years.

The acceleration of profits for five years does however create anomalies for various allowances and tax charges that depend on the individual’s level of income (e.g. the £100,000 limit for the personal allowance taper or the £50,000 limit for the High Income Child Benefit Charge). With that in mind, the law includes provisions to mitigate the impact of this by firstly removing the transitional profits from the main tax computation and secondly creating a stand-alone income tax charge. The provisions do prevent some anomalies, such as the High Income Child Benefit Charge, but not all. In particular, the personal allowance taper anomaly remains.

Also, losses can arise in the transitional year if the unrelieved overlap profits exceed the profits for the extended basis period. Where the loss has been generated by the overlap relief, extended loss reliefs may be available. The loss can be treated as a “terminal loss”, which can be carried back and set against profits of the same trade in the previous three tax years. Other loss reliefs may also be available.

For continuing trades, the basis period for 2023/24 starts immediately after the end of the basis period for 2022/23 and end on 5 April 2024. The 2023/24 basis period comprises two parts:

1)    Standard part, and

2)    Transition part.

For example assume accounts are prepared annually up to 31 October. The basis period for 2023/24 will be 1 November 2022 to 5 April 2024 comprising 1 November 2022 to 31 October 2023 plus the transition part comprising 1 November 2023 to 5 April 2024.

If there is a transition part of the basis period for 2023/24, then Sch 1 (“Abolition of basis periods”) of Finance Act 2022 amends Part 2 of ITTOIA 2005. Specifically, paragraph 70(2) of Sch 1 sets out six steps to arrive at the taxable profits for the year.

Subsequently, paragraph 75 is titled “Calculation of income tax liability on amount of transition profits” and it applies when determining the trader’s liability to income tax for a tax year in which an amount of the 2023/24 transition profits are  chargeable to income. This paragraph then refers to S23 ITA 2007. Paragraph 75(2) states that to find the trader’s income tax liability for the tax year then S23 of ITA 2007 must be amended as outlined below.

     I.  At Step 1 of the S23 calculation, transition profits are to be identified and treated as a separate component of total income, “the transition component”.

     II.  Apply Step 2 as normal by deducting from the components, including the transition component, the amount of any relief under a provision listed in section 24 to which the individual is entitled for the tax year. However, you should then exclude the transition component from the sum of the amounts of the components left after this step. This total is the “net income”. Follow Steps 3 – 5 of the S23 calculation as normal to give amount A (see below example).

   III. Prepare a notional calculation with the same amounts of income at Step 1, and the same deductions made at Step 2. For this notional calculation only, include the amount of transition profits in “net income”. Follow Steps 3 – 5 of the s23 calculation as normal to give amount B. Note that the amounts of allowances given at Step 3 may be different, as these will be based on this notional value of “net income”.

  IV.  Calculate the difference between amounts A and B, amount C. Treat amount C as an amount of tax calculated at Step 4 of the s23 calculation.

Therefore, S23 sets out the income tax liability calculation. But when calculating the income tax liability for a tax year including transition profits then the steps in section 23 set out earlier in the article are modified. For the avoidance of doubt, this applies for tax years 2023/24 to 2027/28. The transition profits are excluded from the net income amount to reduce the impact on benefits and allowances. However, the tax that would have been charged on them had they been included in the net income amount is added to the tax calculation instead.

An example best explains.

This page in HMRC manuals sets out how the S23 steps are amended, and includes a worked example of a trader with standard profits of £20,000 and transition profits of £8,000 for 2023/24. There is a further example of a trader with standard profits of £98,000 and transition profits of £20,000 for 2023/24 – this shows that when carrying out the standard profit calculation (calculation A) the £12,570 personal allowance is not reduced because net income is below £100,000. Why? Because you do not include the transition profits of £4,000 in net income. In calculation B, you include the transition profits in net income which means that total net income of £12,000 results in a reduced personal allowance of £11,570.  In the example, the calculation A total tax liability is £26,632 and the total tax liability under B is £28,632. The difference of £2,000 gives rise to C – the amount of tax due on the transition profits which you then treat as an amount of tax calculated at step 4 of the S23 calculation.