A Scottish rate of property tax

What is happening to Scottish Income Tax?

Readers may be forgiven for not having trudged through all 564 pages of Finance Bill #2 quite yet. But those who do will notice an odd set of provisions about the Scottish rates of income tax.

Both Schedule 1 and Schedule 2 to the Bill purport to be amending the same section (s80C(2B)) of the Scotland Act 1998, but the amendments are contradictory.

Here are the two amendments (sch 1, para 55; sch 2 para 1) side by side:

Sch 1 effectively deems there to be a distinction between property and other forms of income for Scottish taxpayers, even though both types of income are taxed at the same rate. Sch 2 by contrast both: (i) acknowledges the sch 1 amendment; and then (ii) overwrites it to allow the Scottish government to set separate rates of income tax for property income (but not separate bands).

What’s happening?

We set out some important context at sections 2 and 3 of this blog; skip to section 4 for the explanation.

Background

At the 2025 Autumn (Winter?) Budget, Chancellor Reeves announced that rates of income tax on property income would be raised 2 percentage points above the ordinary income tax rates for the 2027/28 tax year onwards. So: basic, additional and higher rates of 22%, 42% and 47% respectively. In addition, the way that different types of income are “stacked” for tax purposes is amended so that property income is added last to taxable income (so more within the higher rates), and reliefs and losses are used up against non-property income first (likewise).

This has knock on implications for the Scottish Government’s finances and also, potentially, for Scottish taxpayers.

Tax (except local government tax) is reserved by law to Westminster. The only tax raising powers Holyrood has are the specific ones conferred to it by Westminster under Scotland Act 1998.

In 2016, the ability to set rates and bands of income tax on “non-savings, non-dividend” income of Scottish taxpayers was devolved to Holyrood via amendments to Scotland Act 1998. “Non-savings, non-dividend” income roughly covers salaries, earnings from self-employment, property income, pensions and some types of trust distributions. Crucially, Holyrood can only make one set of rates; it cannot cherry pick different types of income and apply different tax rules to each. Scottish taxpayers therefore pay income tax at three different sets of rates: (i) most income is taxed at the Scottish rates; (ii) savings (such as bank interest) are taxed at the normal UK income tax rates; and (iii) dividends are taxed at the UK dividend rates. This was one of the key outputs of the post-Indyref Smith Commission report which recommended devolving additional tax raising powers.

Smith’s Seesaw

As a quid quo pro for these additional powers, as well as the earlier introduction of the first two devolved taxes (the Land and Buildings Transaction Tax (LBTT) and Scottish Landfill Tax (SLfT) the way the block grant to the Scottish Government is calculated also changed. A full explanation is beyond the scope of this blog (view the latest fiscal framework, and the detailed calculation rules are in annexe C), but the basic idea is as follows:

• Since devolved taxes are paid directly to the Scottish Government, and Scottish income tax collected by HMRC is transferred to the Scottish Government, there needs to be a corresponding adjustment (a block grant adjustment) to the annual block grant to reflect the fact that more of SG’s funding comes from devolved taxes.

• There is a block grant adjustment for each UK tax (the original tax) which has a corresponding devolved tax or equivalent (the devolved tax) applicable to Scotland.

• The block grant adjustment for each devolved tax is calculated as follows:
  • A baseline of revenue that the original tax generates in Scotland is established. Where HMRC doesn’t have disaggregated figures to do this, the baseline has been established in practice by setting the rates for the first year of the devolved tax to the same rates as the original tax.
  • Each year that baseline is indexed and then adjusted on a per-capita basis. That adjusted baseline is calculated by pretending that the latest rules for the original tax continue to apply in Scotland, then using the indexed baseline figures to calculate the tax revenue that would be raised in Scotland by the original tax.
  • This adjusted baseline is the block grant adjustment for the devolved tax in question. It is deducted from the block grant and the deduction is made up for through the devolved tax itself.

While this mechanism gives the Scottish Government greater responsibility for funding its own expenditure and more fiscal flexibility, there are knock on implications.

First – UK tax policy still drives Scottish tax policy. If Westminster changes the provisions of an original tax, then this directly affects the funding available to the Scottish government unless a similar change is made in Scotland.

Second – it is (perhaps counterintuitively) an inverse relationship. If an original tax is raised, then the corresponding block grant adjustment is larger and the final block grant goes down. Likewise, a cut to an original tax leads to smaller adjustments and a larger block grant. There are several examples of this from the last few years. For example – the introduction of the SDLT higher residential rates (the HRAD) directly lead to the LBTT additional dwelling supplement (ADS) and last year’s increase of the HRAD triggered a corresponding increase in the rate of ADS. Conversely when Kwasi Kwarteng announced that he and Liz Truss would abolish the 45% additional rate of income tax, this was seen as a potential windfall for Scotland (and would have been since the SNP administration announced that it would not make a corresponding cut).

The effect of this inverse, see-sawing, relationship between roUK taxes and Scottish finances means that the intended raise in property income tax will lead to a real terms cut in Scottish Government funding unless a similar increase is made in Scotland.

What IS happening to Scottish Income Tax

To recap: in roUK the rates of income tax on property income are going up from the 2027/28 tax year, and the way in which tax is calculated will also change. All else remaining equal, this will lead to a reduction in Scotland’s bock grant. Holyrood does not have the power under existing law to create a corresponding change to offset this by increasing income tax on property income for Scottish taxpayers.

The question is whether Holyrood will get this power, and that is what the contradictory amendments are about.

The sch 1 is the default amendment. Under clause 6 of Finance Bill No 2 as drafted, this amendment will automatically have effect from 6 April 2027 when the new property income rules kick in. Presumably streaming Scottish Non Saving/Non Dividend income between property and everything else allows the new computational rules to still apply to Scottish taxpayers even if a separate Scottish rate for property income is not introduced.

By contract the amendment under Sch 2 will only have effect from (per clause 8 of the Bill) a date to be set by the treasury in regulations. From that date the Sch 2 amendment will supersede the sch 1 amendment, and it’s only from then on that Holyrood will have the power to set differential rates of tax for property income.

In other words, whether or not a separate Scottish rate of tax on property income is introduced which would allow Holyrood to offset the coming cut to its block grant through higher income taxes on property income (it can always deal by just raising other devolved taxes) will depend on discussions to be had between the UK and Scottish Governments. While it is hard to imagine that it won’t be introduced, it is still possible, and one expects that there may be practical issues to overcome such as in establishing the relevant baseline.

Thankfully this won’t impact the upcoming Scottish budget on 13 January 2026. At that budget the Scottish rates of income tax will be set for the 2026/27 tax year. We will still be a year out from the new property income tax rules biting. However, this quirk of drafting in the current Finance Bill does clearly demonstrate the limitations and consequences of the current policy around devolved taxation and the indirect policy constraints in which the Scottish tax system operates.