Administration of Scottish income tax 2021-22

HM Revenue & Customs

SESSION 2022-23
12 JANUARY 2023
HC 1022

SG/2023/15

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Administration of Scottish income tax 2021-22

HM Revenue & Customs

Report by the Comptroller and Auditor General

Ordered by the House of Commons
to be printed on 11 January 2023

Presented to the House of Commons pursuant
to Section 9 of the National Audit Act 1983

Presented to the Scottish Parliament pursuant to
Section 80HA of the Scotland Act 1998 as amended
by the Finance Act 2014

Gareth Davies
Comptroller and Auditor General
National Audit Office

5 January 2023

SG/2023/15

© National Audit Office 2023

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010401 01/23 NAO

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Rosie Diamanti, Andy Serlin and Poppy Sparham, under the direction of Darren Stewart.

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Key facts

Summary

Introduction

1 The Scotland Act 2016 gave the Scottish Parliament power to determine the rates and thresholds (excluding the personal allowance) paid by Scottish taxpayers on all non-savings, non-dividend income from 6 April 2017. The Scottish Government receives all income tax revenue generated from non-savings, non-dividend income under Scottish income tax policy.

2 The Scottish Parliament sets income tax rates in Scotland using the five-band system first introduced in 2018-19. There are three tax bands in the rest of the UK. For 2021-22, the top rate tax band in Scotland stayed at £150,000. All other tax bands increased by between approximately 0.5% and 0.6%, similar to the increases for the rest of the UK (see Figure 1). The personal allowance, set by the UK government, increased from £12,500 in 2020-21 to £12,570 in 2021-22.

3 HM Revenue & Customs (HMRC) administers and collects Scottish income tax as part of the UK tax system. HMRC identifies taxpayers living in Scotland by applying a ‘flag’ in its systems that indicates they are subject to Scottish income tax rates and thresholds. HMRC has calculated that there were 2.5 million Scottish taxpayers in 2020-21. HM Treasury is responsible for paying Scottish income tax to the Scottish Government.

4 Following the end of each tax year, HMRC produces a provisional estimate of Scottish income tax revenue for that year. The final outturn is calculated the following year once HMRC receives further information from taxpayers and employers. This report covers the final outturn for 2020-21 and the provisional estimate for 2021-22. HMRC expects to publish the outturn for 2021-22 in its 2022-23 Annual Report and Accounts.

5 Section 80HA of the Scotland Act 1998, as amended by the Finance Act 2014 and the Scotland Act 2016, requires the Comptroller and Auditor General (C&AG) to prepare a report for each financial year on:

the adequacy of HMRC’s rules and procedures, in consequence of the Scottish rate provisions, to ensure the proper assessment and collection of income tax charged at rates determined by those provisions;

whether these rules and procedures are being complied with;

the correctness of sums brought to account by HMRC which relate to income tax attributable to a Scottish rate resolution; and

the accuracy and fairness of amounts reimbursed to HMRC as administrative expenses.

6 This report assesses:

HMRC’s calculation of the 2020-21 income tax revenue for Scotland, the ‘outturn’, and assurance on the correctness of amounts brought to account (Part One);

HMRC’s estimate of the 2021-22 income tax revenue for Scotland and our view on the estimate methodology (Part One);

key controls operated by HMRC to assess and collect income tax (Part Two);

HMRC’s approach to assessing and mitigating the risk of non-compliance with Scottish tax requirements (Part Two); and

the cost of administering Scottish income tax. We provide assurance on the accuracy and fairness of these amounts in the context of costs incurred by HMRC (Part Three).

7 In December 2022, the Scottish Government announced that the top rate of income tax will increase from 46% to 47% and that the higher rate of income tax will increase from 41% to 42%. This will come into effect on 6 April 2023 to cover the 2023-24 tax year. The level at which taxpayers will pay the top rate of income tax will reduce from £150,000 to £125,140 for taxpayers in both Scotland and the rest of the UK. We will consider the impact of these changes in future reports.

8 Appendix One sets out our audit evidence base.

Key findings

Scottish income tax 2020-21 final outturn and 2021-22 estimate

9 HMRC calculated the final outturn for 2020-21 as £11,948 million, representing amounts collected under Scottish income tax policy. HMRC’s estimate of 2020-21 Scottish income tax revenue, published in November 2021, was £12,035 million, meaning the actual outturn was £87 million (0.7%) lower than HMRC had originally estimated. We examined the methodology for the calculation of the actual outturn, which necessarily includes some remaining areas of estimation, for instance where returns from taxpayers had not yet been received. In these areas, we have evaluated the basis of HMRC’s estimate, including the relevant assumptions and available data. Based on that audit work, we have concluded that the Scottish income tax revenue outturn for 2020-21 is fairly stated (paragraphs 1.2 to 1.16).

10 HMRC has estimated Scottish income tax revenue for 2021-22 as £13,295 million. This represents an increase of £1,347 million (11.3%) compared with the 2020-21 outturn. Income tax for the whole of the UK increased by 13.2% in 2021-22. The increases in UK and estimated Scottish income tax revenues reflect the recovery of the economy after the acute phase of the COVID-19 pandemic had ended. HMRC expects to calculate the finalised 2021-22 income tax outturn attributable to Scotland in 2023. The estimate HMRC produces is solely for financial reporting purposes in its annual accounts and does not affect the amount of revenue ultimately received by the Scottish Government (paragraphs 1.17 to 1.22).

11 External factors have increased the level of uncertainty in HMRC’s estimate of Scottish income tax revenue for 2021-22. HMRC identified the key source of uncertainty as the accuracy with which it can estimate Scotland’s share of UK income tax liabilities, particularly since this estimate relies on survey data from 2019-20. External factors outside its direct control, such as the wave of the Omicron variant of COVID-19 that developed during the year and the impact of the Ukraine conflict on taxpayers’ ability to meet their tax liabilities, have introduced further uncertainty to the estimate. We consider the approach adopted by HMRC to estimating the impact of these areas of uncertainty on Scottish income tax revenue in 2021-22 to be reasonable (paragraph 1.23).

Administration of Scottish income tax

12 HMRC has adequate rules and procedures in place to ensure the proper assessment and collection of Scottish income tax and those rules are being complied with. Our work on Scottish income tax matters builds on our wider assessment of HMRC’s rules and procedures, completed as part of our annual audit of HMRC. As part of that audit, we concluded that HMRC had framed adequate regulations and procedures to secure an effective check on the assessment, collection and proper allocation of revenue, and that these regulations and procedures are being duly carried out (paragraphs 2.2 to 2.14).

13 Maintaining an accurate and complete record of the addresses of Scottish taxpayers remains the key challenge in administering the system. HMRC relies on taxpayers notifying it of a change of address, although there is no legal requirement for them to do so. We found that there had been a reduction in the number of Scottish postcodes identified by HMRC’s address-cleansing work as either missing or invalid, with 1% (25,488) of the overall taxpayer population identified as either missing or invalid in June 2021 compared with 2% (61,213) in September 2020. HMRC has investigated and updated those cases where individuals were either employed or receiving a pension (paragraphs 2.16 to 2.25 and Figure 8).

14 The divergence between the tax regimes in Scotland and the rest of the UK in 2021-22 remained broadly the same as in 2020-21. As in previous years, the amount of income tax paid in Scotland diverges the most in percentage terms from the rest of the UK for those earning around £50,000, although the percentage difference paid by taxpayers at that level did reduce slightly in 2021-22. HMRC continues to assess the risk of a Scottish taxpayer manipulating their address to minimise their tax liability. HMRC has not identified any significant or widespread instances of taxpayers changing their address to obtain a tax advantage (paragraphs 2.29, 2.38 to 2.41 and Figure 9).

15 HMRC continues to assess as ‘low’ the risk of non-compliance as a result of divergence between Scottish income tax and rest of the UK. In 2021-22, HMRC produced a Scottish Strategic Picture of Risk (SPR). It considers the main areas of risk to Scottish income tax to be the same as those compliance risks which are assessed at the whole-of-UK level. There are no risks identified in the Scottish SPR which are specific to Scotland as HMRC assesses that compliance risk in Scotland is consistent with the rest of the UK. There is a risk that this current position may not be sustainable in the longer term, particularly if further divergence of tax policy occurs. The Scottish Government did not ask HMRC to undertake any specific compliance activity in 2021-22, in addition to the work undertaken as part of its UK-wide compliance approach (paragraphs 2.28 to 2.30 and 2.38).

16 HMRC calculated a compliance yield of £280 million relating to Scotland for 2020-21, the most recent data available. HMRC measures the effectiveness of its enforcement and compliance activities through compliance yield: its estimate of the additional revenues it has generated through its compliance work, and the revenue losses it has prevented. HMRC also estimated that Scotland’s share of net losses was £970 million. HMRC calculates these figures as a proportion of the equivalent UK figure, rather than using Scotland-specific data to quantify the risks. HMRC does not consider or report on geographical variations in the level of compliance risk, or the relative success of compliance activity in Scotland compared with the rest of the UK (paragraph 2.31).

17 HMRC has limited performance data available about its compliance activities in Scotland. Unlike its income tax system which flags residents as Scottish, HMRC’s compliance system cannot readily identify people living in Scotland. HMRC therefore cannot easily track and monitor compliance activity in Scotland and this affects its ability to collect performance data about the extent of Scottish non-compliance (paragraph 2.33).

18 COVID-19 continued to have an impact on HMRC’s compliance activities during 2021-22. Across the UK, the number of compliance cases opened and closed in 2021-22 was higher than in 2020-21 but 27% lower than in 2019-20 before the pandemic. The ability to conduct face-to-face enquiries and the need to re-deploy compliance staff to support other COVID-19 measures also affected its compliance activity during the year. HMRC’s yield from its tax compliance activities for the whole of the UK was £30.8 billion in 2021-22, up 1.1% compared with 2020-21 but lower than the £36.9 billion reported in 2019-20. It will take some time to understand fully the impact of the pandemic on tax compliance and yield (paragraphs 2.34 and 2.35).

19 Tax debt has reduced since 2021 but remains higher than pre-pandemic levels. HMRC’s debt balance is affected by external factors that have an impact on taxpayers’ ability to pay their tax liabilities, including current inflationary pressures and increases in the cost of living. At 31 March 2022, total tax debt for the UK was £41.6 billion, 86% (£19.2 billion) higher than the level of debt reported at 31 March 2020, before the impact of the COVID-19 pandemic. HMRC expects the level of tax debt to fall more slowly than it initially anticipated. HMRC estimated Scottish taxpayers’ total tax debt to be £2.0 billion as at 31 December 2021, 5.7% of UK tax debt at that time.1 Some £0.9 billion of this was attributed to debts from Pay As You Earn (PAYE) and Self Assessment income tax. HMRC calculated this estimate in response to a question from the Scottish Public Audit Committee, with no equivalent figure being available at 31 March 2022 (paragraphs 2.36 and 2.37).

Costs

20 In 2021-22 HMRC incurred and recharged £0.6 million to the Scottish Government for the cost of administering Scottish income tax. We examined HMRC’s method for estimating the costs of collecting and administering Scottish income tax for the year ended 31 March 2022. Based on our audit work, we have concluded that the amount paid by the Scottish Government was accurate and fair in the context of the agreement between HMRC and the Scottish Government (paragraphs 3.4 and 3.5 and Figure 10).

1 Figures provided by HMRC to the Convener of the Scottish Public Audit Committee in June 2022. Figures do not sum to the total debt balance of £39.5 billion at that time because they exclude non-UK debts where the country cannot be identified. We have not audited these figures.

Part One

Income tax collected from Scottish taxpayers

1.1 Part One of this report covers HM Revenue & Customs’ (HMRC’s) calculation of the final revenue outturn for Scottish income tax in 2020-21 and its provisional estimate of Scottish income tax revenue for 2021-22. This includes:

our assessment of HMRC’s Scottish income tax outturn calculation for 2020-21, including data limitations and HMRC’s judgements in areas of uncertainty; and

our views on HMRC’s estimate of Scottish income tax revenue for 2021-22 and the features and limitations of HMRC’s methodology.

The Scottish income tax 2020-21 final outturn

1.2 HMRC’s calculation of the outturn for Scottish income tax revenue for 2020-21 is £11,948 million (Figure 2). HMRC calculates the final outturn figure from several components, which are aggregated to produce the total Scottish income tax liability for 2020-21. Each component is calculated using one or more sources of data to extract the total Scottish income tax liability.

1.3 Figure 2 shows how the outturn for Scottish income tax has changed over time. The calculated outturn for 2020-21 represents an increase of 1.0% compared with 2019-20. The outturn for non-savings, non-dividend income tax for the whole of the UK increased by 2.0% in 2020-21.2 HMRC’s estimate of 2020-21 Scottish income tax revenue, published in November 2021, was £12,035 million, meaning the actual outturn was £87 million (0.7%) lower than HMRC had originally estimated.

1.4 The outturn calculation is largely based on established tax liabilities, some £12,067 million, where HMRC has finalised the tax owed and fully reconciled the taxpayer records. HMRC calculates the established liabilities from the final tax liability data extracted from the Pay As You Earn (PAYE) and Self Assessment income tax systems.

1.5 HMRC makes adjustments or estimates where tax due has not yet been finalised, or where HMRC must estimate the Scottish share of uncollectable amounts or tax reliefs. The reduction in Scottish income tax outturn arising from these adjustments was £119 million (net) (Figure 3). In some areas of the calculation, HMRC does not have data available in sufficient detail to identify income tax liabilities, reliefs or other adjustments relating to individual taxpayers. HMRC estimated the Scottish share of these balances by using other available data, such as population and income data, to apportion the balance between Scotland and the rest of the UK.

1.6 HMRC and the Scottish Government discussed and agreed the methodology used to calculate the 2020-21 outturn for Scottish income tax at the Scottish Income Tax Board in April 2022. The methodology used to calculate the outturn has remained broadly the same since the prior year.

1.7 We examined the methodology for the outturn calculation, which necessarily includes some remaining areas of estimation, for instance where returns from taxpayers had not yet been received. In these areas, we evaluated the basis for HMRC’s estimate including relevant assumptions and available data. We concluded that the Scottish income tax revenue outturn for 2020-21 is fairly stated. We describe the key components of the outturn calculation in more detail below.

Self Assessment established liability

1.8 The Self Assessment established liability of £5,116 million represents the calculation of all income tax attributable to Scotland from Scottish Self Assessment taxpayers in 2020-21. The calculation of Self Assessment liabilities is mainly based on the extraction of Scottish taxpayer data from HMRC’s systems but with some apportionment of other balances.

1.9 HMRC identifies Scottish taxpayers using its record of Scottish residency status in its Computerised Environment for Self Assessment (CESA) system. It can identify total Scottish income tax liabilities by extracting Scottish taxpayer records from CESA. HMRC has also made minor adjustments to apportion Scotland’s share of other relevant Self Assessment balances where specific data are not available.3

PAYE established liability

1.10 The PAYE established liability of £6,884 million represents the sum of all income tax attributable to Scotland from Scottish PAYE taxpayers in 2020-21. While most PAYE liabilities are based on extracting Scottish taxpayer data from HMRC’s systems, some apportionment of other smaller elements is required.

1.11 Under PAYE, employers submit data monthly to HMRC on the earnings and tax deductions made for their employees and this information is recorded in HMRC’s National Insurance and PAYE Service (NPS) system. HMRC identifies Scottish taxpayers in the NPS using a residency indicator based on taxpayer postcode information. By extracting Scottish taxpayer records from the NPS, HMRC can identify the total Scottish income tax liabilities. HMRC deducts from this the Scottish share of tax reliefs given against PAYE liabilities.

1.12 An adjustment is made to apportion the tax collected from employers under PAYE settlement agreements.4 The Scottish share calculated for 2020-21 was £19 million. As tax liabilities are settled through one payment for the employer, the identity of individual taxpayers is not recorded and therefore HMRC undertakes an analysis of employer submissions to determine the Scottish proportion of UK-wide settlement agreement revenue. HMRC was able to base this on a complete set of PAYE settlement agreement returns from employers for 2020-21, compared with the previous year when it did not receive all returns in line with the expected timetable due to the COVID-19 pandemic.

Estimated further liabilities

1.13 Most Self Assessment liabilities for 2020-21 are established prior to calculating the outturn. Nevertheless, HMRC knows from past years that Self Assessment tax liabilities will continue to be established and collected for up to six years afterwards. This is because HMRC continues to receive additional information from taxpayers and through its compliance activity. HMRC calculates the estimated additional liability for these elements based on past performance and valued it at £305 million in the 2020-21 outturn. HMRC made an estimated adjustment of £10 million in relation to further PAYE liabilities that had not yet been determined, such as where year-end totals or information about benefits-in-kind received by the taxpayer were still outstanding.

Deductions from revenue

1.14 HMRC makes a series of deductions from the outturn revenue, recognising that not all taxpayer liabilities will be collected in practice. It uses historical information to calculate these deductions and apportions an amount for Scottish taxpayers.

1.15 Some PAYE and Self Assessment income tax liabilities are never settled because either employers or taxpayers fail to pay the full amounts due. HMRC has analysed historical data for the UK as a whole to determine patterns of uncollected liabilities and then apportioned an amount relating to Scottish taxpayers. HMRC calculated this to be £97 million for 2020-21.

1.16 HMRC makes further deductions for pension contributions and Gift Aid, both of which attract income tax relief at the taxpayer’s marginal rate of income tax. Pension scheme administrators claim tax relief at the basic rate from HMRC on behalf of their scheme members, while charities claim tax relief at the basic rate from HMRC on behalf of their donors. HMRC calculated both deductions by estimating the Scottish share of each tax relief claimed across the UK using historical data. HMRC calculated the Gift Aid deduction to be £114 million for 2020-21 and pension contributions to be £155 million.

The Scottish income tax estimate for 2021-22

1.17 HMRC estimates it will collect £13,295 million of Scottish income tax revenue relating to the 2021-22 year.5 This represents an increase of £1,347 million (11.3%) against the 2020-21 outturn. There was a 13.2% increase for the UK overall against the 2020-21 outturn. Income tax revenues increased in both Scotland and the rest of the UK in 2021-22, reflecting the recovery of the economy after the acute phase of the COVID-19 pandemic had ended. The final outturn for the 2021-22 year is expected to be published in HMRC’s 2022-23 Annual Report and Accounts by July 2023. The estimate produced by HMRC is solely for financial reporting purposes in its annual accounts and does not affect the amount of revenue ultimately received by the Scottish Government.

1.18 HMRC’s methodology to estimate Scottish income tax revenue for 2021-22 is based on taxpayer data from 2019-20, extracted from its Survey of Personal Incomes. Scotland’s percentage share of the overall UK income tax liability is determined by analysing data in a model replicating the UK income tax system, known as the Personal Tax Model. The data are adjusted to reflect demographic and policy changes that are expected or known to have taken place between 2019-20 and 2021-22. The share is then applied to the total UK tax liability to produce an estimate of revenue for Scottish income tax (Figure 4).

1.19 HMRC’s current methodology for estimating Scottish income tax revenue is consistent with the Office for Budget Responsibility’s methodology to forecast income tax receipts for both Scotland and the whole of the UK. The methodology is also largely consistent with that used to calculate the 2020-21 estimate.

1.20 HMRC made a ‘calibration’ adjustment to the revenue estimate because its methodology has historically resulted in actual outturn being lower than estimated outturn. HMRC made this adjustment by comparing the 2020-21 outturn with a revised estimate of 2020-21 revenue using the same methodology but with the most recent assumptions and data. The impact of the calibration adjustment reduced the 2021-22 provisional estimate by £0.6 billion (4.4%) (see Figure 4).

1.21 The calibration adjustment is subject to the following limitations:

It assumes the 2021-22 over-estimation is consistent with the over-estimation observed in 2020-21 in percentage terms.

The causes of the over-estimate in 2020-21 are not fully understood and any socioeconomic factors contributing to it may be different in 2021-22.

1.22 Our review concluded that HMRC’s approach is reasonable. However, the limitations we described in previous reports relating to HMRC’s methodology for estimating Scottish income tax revenue remain relevant for 2021-22:

The use of sample data introduces sampling uncertainty into the revenue estimate from which the Scottish portion is calculated as a percentage.

The methodology combines the calculation of PAYE and Self Assessment liabilities for the UK such that the amount apportioned to Scotland does not reflect the differing proportions of each type of taxpayer between Scotland and the rest of the UK.

The data used for PAYE include all income types and do not exclude tax from savings and dividend income.

An assumption must be made around the volume and value of under- and over-payments relating to PAYE liabilities.

1.23 HMRC identified the key source of uncertainty in the 2021-22 estimate as the accuracy with which it can estimate Scotland’s share of UK income tax liabilities. The estimated share is based on 2019-20 survey data so there is an inherent risk that this could change for Scotland by 2021-22. HMRC estimates that Scottish income tax liabilities will grow at a slower rate than the UK overall. External factors outside HMRC’s direct control, such as the wave of the Omicron variant of COVID-19 that developed during the year and the impact of the Ukraine conflict on taxpayers’ ability to meet their tax liabilities, increases the level of uncertainty around estimating Scotland’s share. We consider that HMRC has taken a reasonable approach to estimating the impact of these areas of uncertainty on Scottish income tax revenue in 2021-22.

2 HM Revenue & Customs, Scottish Income Tax Outturn Statistics: 2020 to 2021, July 2022.

3 This includes an estimate of £29 million from manually entered liabilities and assessments, which do not provide a split of the liability between taxes. It also includes sensitive records, which are not accessed by HMRC to calculate Scottish income tax. A sum of £102 million was deducted for the Scottish share of tax reliefs claimed through Self Assessment.

4 A PAYE settlement agreement allows employers to make one annual payment to cover all tax due on minor, irregular or impracticable expenses or benefits for employees in the scheme.

5 HM Revenue & Customs, Annual Report and Accounts 2021-22, HC 494, July 2022.

Part Two

Administering Scottish income tax

2.1 This part of the report covers:

HM Revenue & Customs’ (HMRC’s) key processes to administer the income tax system and our approach to obtaining assurance on them (paragraphs 2.5 to 2.14);

HMRC’s procedures to identify and maintain a complete and accurate record of the Scottish taxpayer population (paragraphs 2.15 to 2.26); and

HMRC’s activity to identify and respond to compliance risks (paragraphs 2.27 to 2.45).

2.2 HMRC uses the same systems to administer income tax whether it is received from a taxpayer in Scotland or the rest of the UK. However, HMRC also operates additional rules and procedures for Scotland, and we assess these below. This reflects HMRC’s responsibility to administer income tax for Scottish taxpayers in the same way as the service provided elsewhere in the UK.

2.3 Under Section 2 of the Exchequer and Audit Departments Act 1921, the Comptroller and Auditor General (C&AG) must consider the adequacy of HMRC’s systems to assess and collect tax in the UK, including income tax. Each year we publish a report (the Standard Report) alongside HMRC’s Annual Report and Accounts setting out the C&AG’s conclusions in this respect. Our 2021-22 Standard Report concluded that HMRC had framed adequate regulations and procedures to secure an effective check on the assessment, collection and proper allocation of revenue, and that they are duly carried out.

2.4 To support the conclusions of this report, we extended our UK-wide testing to address risks and approaches arising from divergences in income tax policy. We also undertook specific procedures looking at HMRC’s address-cleansing and wider tax compliance activities. These informed our assessment of the completeness and accuracy of HMRC’s Scottish income tax estimates. To reach our conclusions, we examined several elements of devolved tax administration, such as the ongoing maintenance of Scottish taxpayer records, and how devolved tax compliance risks were identified and responded to.

The income tax system

2.5 HMRC’s system to collect income tax is consistent across the UK. Depending on the type of income an individual receives, income tax is assessed and collected by employers deducting earnings through Pay As You Earn (PAYE), by the taxpayer submitting a Self Assessment return, or both.

2.6 The PAYE and Self Assessment processes share common principles, despite using different IT systems and data sources to assess and collect tax. Figure 5 identifies these principles and describes the main processes for each income tax stream.

Assurance of income tax processing

2.7 Our annual audit work programme on HMRC includes procedures providing assurance over key tax processing controls. These controls are broadly divided into two categories:

automated system controls around data-handling, storage and processing; and

complex key business controls that have a high level of automation.

2.8 Following annual updates to business rules to reflect changing tax rates, thresholds and allowances for the UK and devolved administrations, HMRC completes several phases of assurance testing on key business controls to confirm system functionality. We evaluate the scope of this testing and re-perform elements to confirm HMRC’s conclusions as part of our audit. The key processes for PAYE include annual:

reconciling employer information with personal tax records to confirm tax due on earnings and calculate any over- or under-payments of tax based on country of residence; and

issuing tax codes to PAYE taxpayers which incorporate residency information to ensure employers deduct tax under the tax rules of the correct country.

2.9 Similar processes are applied to each individual Self Assessment return that HMRC receives. Self Assessment taxpayers make payments on account and at the year-end calculate their own tax liability using HMRC’s calculator in the tax return submission.

Devolved income tax

2.10 The main differences in administering Scottish income tax, when compared with UK processes, are the business rules that the HMRC system applies when completing tax liability and tax code calculations. There have been no significant changes to system rules since our last report covering 2020-21. The rules applied for Scottish taxpayers are as follows:

The system checks the individual’s residency status and applies the ‘S’ tax code prefix where they are identified as a Scottish resident. This instructs employers to collect tax under Scottish tax rates. Where an individual is no longer resident in Scotland, the ‘S’ prefix is removed.

Where an individual is identified as a Scottish resident, Scottish tax rates and bands are applied to the reported income when calculating the liability for the current tax year.

If an individual has been identified as a Scottish resident and is enrolled on a PAYE scheme, the system uses Scottish income tax rates and thresholds to calculate a new tax code for the following year.

2.11 Self Assessment returns include a check box for the taxpayer to state whether they resided in Scotland during the tax year. If this contradicts HMRC’s records, HMRC uses the address it holds to calculate the taxpayer’s tax liability. HMRC notifies taxpayers of the discrepancy and asks them to update their address if required. Figure 6 shows where these divergences occur within the income tax system.

Tax relief on pension contributions

2.12 Pension scheme administrators must identify Scottish taxpayers so that tax relief is correctly allocated. Pension administrators claim tax relief at source on behalf of their members and add this to their members’ contributions. HMRC’s Relief at Source (RAS) system automatically confirms the residency status of pension scheme members to ensure the correct relief is applied at source. It applies tax relief on pension contributions at the basic rate of 20% for all taxpayers. Scottish taxpayers paying a tax rate above 20% can claim the remaining tax relief through a Self Assessment return or by contacting HMRC.

2.13 To administer relief at source, HMRC requires all pension administrators to submit an annual report listing their members’ contributions during the previous tax year. HMRC’s systems automatically trace scheme members and match them against addresses held to identify Scottish taxpayers. An Annual Notification of Residency Report is then issued to all pension administrators. HMRC confirmed the residency status for 93% of Scottish and Welsh pension scheme members following the 2020-21 tax year. Following the 2020-21 tax year, HMRC issued Annual Notification of Residency Reports to pension scheme administrators in January 2022.

Tax relief on Gift Aid contributions

2.14 Tax relief on Gift Aid contributions in Scotland is provided at the UK basic rate of 20%. This is because HMRC does not have systems in place to establish the residency of taxpayers donating to charity. All taxpayers paying tax above the basic rate can claim the difference between their tax rate and the basic rate on their donation. Where donations are made by Scottish taxpayers, the correct rate of relief is applied when HMRC is notified of the donated amount either through a request to amend a tax code or via a Self Assessment return.

Scottish taxpayer population

2.15 HMRC has calculated that there were 2.5 million Scottish taxpayers in 2020-21.6 A Scottish taxpayer is someone with a tax liability whose main place of residence during the tax year is Scotland.7 Higher-rate and top rate taxpayers accounted for around 15% of the Scottish income tax population in 2020-21 and contributed around 60% of tax paid. Starter-rate and basic rate taxpayers accounted for more than half of the population (51%) and provided around 11% of tax paid (Figure 7).

2.16 Maintaining accurate and complete records of the Scottish taxpayer population continues to be the main challenge for HMRC in administering Scottish income tax. HMRC has many information sources for changes of address but relies primarily on taxpayers informing it of such changes on a timely basis, although taxpayers are not legally required to do this. HMRC also obtains address information from other sources such as employers, although it is not mandatory for employers to provide updates when their employees’ addresses change.

2.17 Address information must be correct to ensure the right amount of tax is collected from individuals and allocated to the appropriate government. HMRC has several assurance processes in place to maintain the completeness and accuracy of the address data it uses to identify Scottish taxpayers (Figure 8).

Postcode scans

2.18 HMRC scans taxpayer records to identify missing or invalid postcodes which would result in an incorrect residency status being applied. It investigates and updates identified cases where individuals were either employed or receiving a pension. The most recent scan performed in June 2021 identified 25,488 postcodes either missing or invalid, of which 3,031 were updated. This compares with 61,213 postcodes either missing or invalid in HMRC’s previous scan in September 2020, of which 9,429 were subsequently updated. Those cases not updated are identified as dormant because they have no current taxable income. Numbers of postcodes either missing or invalid represent 1% of the 2.5 million Scottish income taxpayer population, compared with 2% in September 2020.

The administration of Scottish tax codes

2.19 Where an employer does not apply the ‘S’ prefix to an employee’s tax code, they will deduct tax at the UK rate. HMRC reconciles what each taxpayer has paid in tax against what it thinks they should have paid at the end of the tax year. HMRC then uses this finalised information and the residency status held on its systems to calculate the tax liability each taxpayer should pay. The outturn for Scotland is, therefore, unaffected where the ‘S’ prefix in an individual’s tax code is not correctly applied by an employer.

2.20 Using a tax code without the ‘S’ prefix could result in Scottish taxpayers either under- or over-paying tax during the tax year. In this situation, taxpayers may have to pay additional amounts in future years to offset an underpayment or await a refund from HMRC for any overpayments. HMRC does not collate the number of reconciliations for Scottish taxpayers where the amount of tax collected was different from the amount HMRC calculated should have been paid.

2.21 Each month, HMRC compares tax codes in PAYE submissions with its own taxpayer record to identify cases where employers are using a different tax code. The number of cases where the correct ‘S’ prefix was not being operated varies across the year. In March 2021, HMRC identified 39,364 Scottish taxpayer records (1.2% of cases at that time) where employers were not operating a tax code with an ‘S’ prefix. In March 2022, there were 41,182 cases (1.1% of cases). We noted in previous reports that HMRC has not set a target for how low the number of missing ‘S’ prefixes would be before it considers that its compliance activity has been successful.

2.22 When HMRC identifies an employer is not using the correct tax code, it issues a P6 notification to the employer asking them to update the employee’s tax code. HMRC identifies employers making persistent errors and works with them to implement the correct tax code. HMRC told us that the number of employers that repeatedly use the incorrect tax code is very low and so it does not routinely track this information.

Third party-data exercise

2.23 HMRC periodically compares the Scottish taxpayer address records it holds with third-party data to identify differences. This comparison is HMRC’s main source of assurance over its address information and it previously agreed with the Scottish Government to run the exercise every two years.

2.24 In April 2021, 5.1 million Scottish address records held by HMRC were compared with third-party data, showing that:

3.7 million records (72.2% of records analysed) held by HMRC were successfully matched to third-party data with a Scottish address. This is a decrease from 78.7% in the previous third-party data exercise in 2019;

8,347 records (0.2% of records analysed) were identified where the residency determined from the address held by HMRC did not match the residency suggested by third-party data; and

the residency status of taxpayers for 1.4 million records (27.7% of records analysed) could not be corroborated by comparison with the third-party data. HMRC reviewed these records against other internal data sources to gain assurance over the accuracy of the addresses held.8

2.25 HMRC wrote to most of the taxpayers where the details of residence held by HMRC did not match that suggested by third-party address data. Letters asked taxpayers to check that the address held by HMRC was up to date. There are limits to how effective this exercise can be. Due to data protection legislation, HMRC can only write to each taxpayer at the address it holds on its system, and not any alternative address indicated by the third party-data exercise. HMRC followed up a sample of 100 Scottish taxpayers who received a letter in 2021. It found 33 had subsequently updated their address details with HMRC. It also found 30% of all Scottish taxpayers receiving a letter had also received a letter during the previous third party-data exercise in 2019.

Scottish parliamentarians

2.26 Scottish parliamentarians are automatically deemed as Scottish taxpayers in any tax year they are in office. This applies to the 129 elected members of the Scottish Parliament (MSPs) and the 59 members of Parliament in Westminster representing a constituency in Scotland. Records for Scottish parliamentarians are not processed using normal business rules. HMRC previously used a manual process to identify these records and ensure they were recorded as Scottish taxpayers regardless of residency. HMRC required employers or parliamentarians themselves to provide the required information to HMRC annually. HMRC introduced system changes designed to remove the need to annually update parliamentarians’ records in August 2020. HMRC told us that it did not identify any issues in relation to Scottish parliamentarians being recorded as Scottish taxpayers during 2021-22.

Compliance risk assessment and planning

2.27 HMRC applies the same risk-based compliance approach to collect income tax in Scotland as it does in the rest of the UK. This approach involves:

promoting compliance by designing processes to encourage and help customers get things right first time;

preventing non-compliance through process design and customer insight and providing an opportunity to correct mistakes; and

responding, investigating and correcting compliance risks using tailored activity when intervention is needed.

2.28 As part of its Service Level Agreement with the Scottish Government, HMRC produces an annual Scottish Strategic Picture of Risk (SPR) to assess and plan for compliance risks applicable to Scotland. For the Scottish SPR, HMRC considers key compliance risks at the overall UK level and applies a value to represent the Scottish proportion of these risks. HMRC does not vary the size of this proportion for each risk; instead it is calculated in line with Scotland’s share of UK income tax in the Scottish Income Tax Outturn Statistics. As with previous years, HMRC has not identified any significant risks specific to Scotland and considers the main risks to Scottish income tax are the same as for the whole of the UK. These risks include:

evasion, where individuals or businesses deliberately omit, conceal or misrepresent information to reduce their tax liabilities;

the hidden economy, where taxable income is not declared or where declared income is deliberately understated; and

tax avoidance, where tax rules are exploited to gain a tax advantage that Parliament never intended.

2.29 There is a risk that HMRC’s current assessment that compliance risk in Scotland is consistent with the rest of the UK may not be sustainable in the longer term, particularly if further divergence occurs in tax policy between Scotland and the rest of the UK. HMRC told us that it monitors risks specific to Scottish income tax and would include these in future SPRs if it deemed appropriate. It gains assurance that its assessment of Scottish-specific risk is low through its bi-annual address assurance exercises and tracking the number of compliance cases it has identified as relating to the residency status as a Scottish taxpayer. It told us that a factor in its assessment was the level of divergence between Scottish income tax and the rest of the UK. HMRC does not test its assumption that non-compliance in Scotland is the same as the rest of the UK because of the methodological challenges and costs involved.

2.30 Under the Memorandum of Understanding between HMRC and the Scottish Government the Scottish Government can propose further compliance activity which HMRC will carry out if it agrees it is feasible, would reduce revenue risk and improve compliance. HMRC would charge the costs of this further activity to the Scottish Government. The Scottish income tax compliance plan for 2021-22 was agreed by HMRC and the Scottish Government in July 2021. The Scottish Government did not request any specific compliance activity to be undertaken in 2021-22, in addition to the work undertaken as part of HMRC’s UK-wide compliance approach. The Scottish Government told us it obtained data from HMRC on Scottish incorporated companies and cross-border home ownership to give it further assurance on HMRC’s compliance activity.

2.31 HMRC measures the effectiveness of its enforcement and compliance activities through compliance yield, its estimate of the additional revenues it considers it has generated and the losses it has prevented. HMRC estimates a compliance yield of £280 million in 2020-21 for Scotland’s share of the risks in the SPR. It also estimates that Scotland’s share of net losses from these risks was £970 million.9 HMRC calculates these figures as a proportion of the equivalent UK figure, rather than using Scotland-specific data to quantify the risks. HMRC does not consider or report on geographical variation between Scotland and the rest of the UK when assessing compliance risk or the relative success of compliance activity.

2.32 The tax gap is the difference between the amount of tax that should be paid and what is actually paid. HMRC does not currently produce a Scotland-specific tax gap. HMRC’s view remains that calculating a Scotland-specific tax gap would be difficult for methodological reasons, including the increased burden on taxpayers who would be selected for further enquiry, the additional HMRC resource which would need to be deployed, and the loss of Exchequer revenue associated with redeployment of compliance staff away from yield-bearing work.10

2.33 HMRC has limited information on total compliance activity undertaken in Scotland. Its compliance system allows HMRC to raise a flag where potential manipulation of residency status has been identified. We understand there are currently no such flags on the compliance system. It told us that information about numbers of active compliance cases relating to Scottish taxpayers for reasons not related to their status as a Scottish taxpayer requires interrogation of separate information systems. Unlike the income tax system, which can flag Scottish residents, HMRC’s compliance management information system cannot readily identify people living in Scotland and information must be compared with other data to provide numbers on the extent of Scottish non-compliance in total.

Impact of COVID-19 on HMRC’s compliance activity and debt management

2.34 The impact of the COVID-19 pandemic, and HMRC’s response to it, affected its compliance activity in 2021-22 and reduced the level of tax receipts collected through it. The pandemic limited HMRC’s ability to visit taxpayers to carry out its compliance investigations. In addition, some staff were reallocated from compliance work to support other COVID-19 measures during the year. Across the UK, the number of compliance cases opened and closed in 2021-22 was higher than in 2020-21 but 27% lower than in 2019-20 before the pandemic.

2.35 HMRC’s yield from its tax compliance activities was £30.8 billion in 2021-22, up 1.1% compared with 2020-21 but lower than the £36.9 billion reported in 2019-20. Our recent report Managing tax compliance following the pandemic found that HMRC’s compliance work had raised around £9 billion less revenue since the pandemic began, compared with historical levels. We concluded that it would take some time to understand fully whether the pandemic has affected tax compliance, with swift action likely to be needed to prioritise efforts and stem potential losses.11

2.36 HMRC’s management of tax debt affects how much income tax that is initially unpaid is subsequently collected across the UK, including in Scotland. HMRC’s debt balance is affected by external factors that have an impact on taxpayers’ ability to pay their tax liabilities, including current inflationary pressures and increases in the cost of living. At 31 March 2022, total tax debt for the UK was £41.6 billion, 28% (£15.9 billion) less than the debt reported at 31 March 2021 but 86% (£19.2 billion) higher than the level of debt reported at 31 March 2020, before the impact of the pandemic. HMRC expects the level of tax debt will fall more slowly than it initially anticipated. Our report Managing tax debt through the pandemic provides further detail on how HMRC changed its debt management work in response to the pandemic.12

2.37 HMRC estimated total tax debt in respect of Scottish taxpayers to be £2.0 billion as at 31 December 2021, 5.7% of UK tax debt at that time.13 Some £0.9 billion of this was attributed to debts from PAYE and Self Assessment income tax. The estimate was calculated to answer a question from the Scottish Public Audit Committee, with no equivalent figure being available at 31 March 2022.

Divergence between Scottish and rest-of-UK income tax rates

2.38 The amount of income tax paid in Scotland diverges the most in percentage terms from the rest of the UK for those earning around £50,000, with a Scottish taxpayer earning around that amount paying 20% more than a taxpayer elsewhere in the UK (Figure 9). This divergence means there is a potential risk that taxpayers subject to higher Scottish rates may seek to manipulate their residency status to reduce their tax liability. This could include failing to notify HMRC of address changes or deliberately manipulating address information. HMRC considers that the risk of these behaviours is very low compared with the overall risk of non-compliance across the UK, such as efforts to avoid or reduce liabilities altogether.

2.39 In 2021-22, the divergence between the tax regimes in Scotland and the rest of the UK remained broadly the same as in 2020-21, although it reduced slightly for those earning around £50,000.

2.40 In December 2022, the Scottish Government announced that the top rate of income tax will increase from 46% to 47% and that the higher rate of income tax will increase from 41% to 42%. This will come into effect on 6 April 2023 to cover the 2023-24 tax year. The level at which taxpayers will pay the top rate of income tax will reduce from £150,000 to £125,140 for taxpayers in both Scotland and the rest of the UK. We will consider the impact of these changes in future reports.

2.41 HMRC has not identified any significant or widespread instances of taxpayers changing their address to obtain a tax advantage. HMRC has several ways to identify compliance risk:

HMRC periodically compares its address records with those of third-party data sources. If the number of discrepancies increase, this may indicate taxpayers are not updating HMRC with address changes, either through error or deliberately.

Each month, HMRC compares PAYE submissions with its own records to identify cases where employers are not correctly applying ‘S’ prefixes to tax codes for Scottish residents. If the number of incorrect ‘S’ codes varies from HMRC’s expectations, this could suggest wider compliance issues.

HMRC monitors cross-border migration trends. HMRC has reviewed taxpayers who have moved from Scotland to England since 2017-18 and found 1.6% of cross-border movements could not be fully reconciled to Land Registry data and therefore merited further scrutiny.

2.42 HMRC began work in 2020 looking into Scottish taxpayer liabilities and behaviour in response to Scottish income tax changes introduced in 2018-19. The analysis from this work was published in December 2021 and showed some limited evidence of Scottish taxpayers lowering their taxable income in response to increasing tax rates. HMRC’s analysis covered actions taken by taxpayers to lower their taxable income such as tax avoidance activities, changing the number of hours worked, or deciding whether to invest time in a personal business. It only looked at taxpayers who paid Scottish income tax in all three years it reviewed and so does not cover actions which removed the taxpayer from the workforce entirely such as retirement or migration.

2.43 HMRC found that generally taxpayers on higher incomes decreased their declared income by more than those on lower incomes. For taxpayers earning more than £150,000, HMRC estimated that a 1% reduction in the proportion of income they retain after tax leads to a reduction between 0.52% and 0.77% in the level of income they declare to HMRC.14 HMRC has not undertaken any specific actions in response to this research given its overall assessment of risk in Scottish income tax. It told us that while the research found that increasing tax rates indicated increased risk of behavioural change it did not show that the behaviour change would be non-compliant.

2.44 In 2022 HMRC began work with the Scottish and Welsh governments to analyse cross-border migration and taxpayer characteristics over time. HMRC told us that the dataset from this work will enable it to analyse cross-border migration in response to any income tax changes between devolved administrations and the rest of the UK. HMRC has established a working group to oversee the design of the dataset and agree what analysis it will complete, which includes representatives from the devolved administrations. The work is being funded by the UK government, Scottish Government and Welsh Government. It expects to produce its first dataset by the time it publishes the Scottish Income Tax Outturn Statistics for 2021-22.

2.45 Having completed our additional work on devolved tax issues, we are satisfied HMRC has adequate rules and procedures in place to assess and collect Scottish income tax and that these are being complied with.

6 HM Revenue & Customs, Scottish Income Tax Outturn Statistics: 2020 to 2021, July 2022.

7 Scottish parliamentarians are also deemed Scottish taxpayers. See paragraph 2.26 for more details.

8 Approximately 142,000 records were discounted from any analysis as the individuals concerned were under the age of 18, deceased, indicated as living abroad or were duplicate records.

9 This relates to the latest data available for net losses, covering 2019-20. This means the impact of the COVID-19 pandemic on net losses will only begin to show in next year’s SPR.

10 Letter from HMRC to the Public Audit and Post-legislative Scrutiny Committee of the Scottish Parliament, on 12 March 2021, available at: https://archive2021.parliament.scot/S5_Public_Audit/General%20Documents/2103112_Ruth_Stanier_to_PAPLS_Committee.pdf.

11 Comptroller and Auditor General, Managing tax compliance following the pandemic, Session 2022-23, HC 957, National Audit Office, December 2022.

12 Comptroller and Auditor General, Managing tax debt through the pandemic, Session 2021-22, HC 799, National Audit Office, November 2021.

13 Figures provided by HMRC to the Convener of the Scottish Public Audit Committee in June 2022. Figures do not sum to the total debt balance of £39.5 billion at that time because they exclude non-UK debts where the country cannot be identified. We have not audited these figures.

14 HM Revenue & Customs, Estimating Scottish taxpayer behaviour in response to Scottish Income Tax changes introduced in 2018 to 2019, December 2021, available at: www.gov.uk/government/publications/estimating-scottish-taxpayer-behaviour-in-response-to-scottish-income-tax-changes-introduced-in-2018-to-2019.

Part Three

Costs

3.1 This part considers the administrative costs of Scottish income tax and whether they are reasonable.

3.2 Under the Service Level Agreement between HM Revenue & Customs (HMRC) and the Scottish Government, the Scottish Government must reimburse HMRC for net additional costs incurred through administering Scottish income tax powers.

3.3 A supporting framework sets out the principles for identifying net additional costs. HMRC recharges the Scottish Government only for costs that specifically relate to administering devolved Scottish income tax powers, not for the costs of administering the overall income tax system in Scotland.

Costs incurred in 2021-22

3.4 HMRC invoiced the Scottish Government for £0.6 million of costs relating to the administration of Scottish income tax in 2021-22. This was a £0.2 million underspend against the budget of £0.8 million, and £0.1 million lower than the £0.7 million HMRC recharged in 2020-21. Reasons for the underspend against the budget included less time spent on Scottish income tax by HMRC staff than planned, delays in recruitment and savings in relation to Scottish income tax processes becoming business-as-usual. There have been no significant changes to the recharging process in 2021-22. HMRC completed the implementation of the Scottish Income Tax Project in 2019-20 and so 2021-22 is the second year in which expenditure relates entirely to operating costs (Figure 10).

3.5 We examined HMRC’s method for estimating the costs to collect and administer Scottish income tax for the year ended 31 March 2022. Based on our audit work, we concluded that the amount paid by the Scottish Government was accurate and fair in the context of the agreement between HMRC and the Scottish Government.

Appendix One

Our evidence base

1 Section 80HA of the Scotland Act 1998, as amended by the Finance Act 2014, requires the Comptroller and Auditor General (C&AG) to prepare a report for each financial year on:

the adequacy of any of HM Revenue & Customs’ (HMRC’s) rules and procedures put in place, in consequence of the Scottish rate provisions, for the purpose of ensuring the proper assessment and collection of income tax charged at rates determined under those provisions;

whether these rules and procedures are being complied with;

the correctness of the sums brought to account by HMRC which relate to income tax which is attributable to a Scottish rate resolution; and

the accuracy and fairness of the amounts which are reimbursed to HMRC as administrative expenses.

2 To reach the conclusions of this report relating to the rules and procedures operated by HMRC, we drew directly from our statutory audit work on HMRC’s Annual Report and Accounts, including the C&AG’s report on HMRC’s controls for the proper assessment, collection and allocation of tax under Section 2 of the Exchequer and Audit Departments Act 1921. We also completed specific audit procedures over controls relevant to administering devolved taxes.

Financial audit

3 We audited the data, methodologies, assumptions and mechanics of the calculation for the revenue outturn for 2020-21 and the revenue estimate for 2021-22, which are described in this report. For the estimate, and where appropriate for the outturn, this work was planned and completed by applying principles set out in International Standards on Auditing (UK) 540 Auditing Accounting Estimates and Related Disclosures, to design audit procedures relevant to the nature of the estimates and to a sufficient level of precision.

4 In relation to administration costs, our conclusion on the accuracy and fairness of the costs HMRC charged to the Scottish Government is based upon evaluating costs against the details of the Service Level Agreement and supporting framework for costs agreed between both parties. HMRC estimated some of the incurred costs from available data on customer contacts and staff time. During the audit, we saw evidence that both parties regularly discuss and review cost budgets and forecasts as well as agreeing any amounts to be invoiced and paid.

5 All of these audit procedures were planned, performed and reviewed in accordance with our internal quality control procedures for financial audit.

6 We completed our financial audit fieldwork between April 2022 and July 2022.

Document review

7 To evaluate HMRC’s approach to compliance risk, we reviewed published and unpublished HMRC documents about Scottish income tax including project documentation, risk and compliance documentation, and details of key assurance work performed by HMRC.

8 Our review was carried out between October 2022 and December 2022.

Interviews with departmental officials

9 We carried out four interviews with officials from HMRC, selected to participate because of their job role and their relevance to the audit. This included staff responsible for (or involved in) devolved tax policy and compliance.

10 We also spoke to the Scottish Government and Audit Scotland to inform our risk assessment and planning for this report.

11 Fieldwork took place between October 2022 and November 2022. Interviews were carried out online, typically lasted one hour and notes were taken.

Third-party data exercise teach-in

12 To inform our understanding of HMRC’s processes to gain assurance over the Scottish taxpayer population we attended a teach-in run by HMRC in November 2022 covering the third-party data exercise which it performs using a third-party supplier.

Quantitative analysis

13 We analysed financial data from HMRC on Scottish income tax revenue, HMRC’s estimate of Scottish income tax revenue and the administrative costs of Scottish income tax.

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