Tim is correct. The legislation does not prescribe the order in which the personal allowance (PA) is offset, therefore the taxpayer may allocate it in the most beneficial manner.
The introduction of the personal savings allowance and dividend nil rate band mean we must consider the interaction with the PA and starting rate band. Before the introduction of the new allowances, the PA would be offset left to right in the income tax computation. However, as the legislation states that the taxpayer may deduct the reliefs and allowances in the way which will result in the greatest reduction in the taxpayer's income tax liability, it is now beneficial to ensure the PA is not wasted on income that would otherwise be taxed at 0% under the new allowances.
In the example above the net income is £21,000. The PA should first be used to reduce NSI to nil. This is because there are no other allowances available to offset against NSI.
We are now left with £2,500 of PA. In the past we would have offset this against SI, working left to right in the computation. However there is a £5,000 0% starting rate band available for interest AND a personal savings allowance available of £1,000 (as the individual is a BRTP). Therefore only £500 of SI needs to be sheltered by the PA. The SI is now reduced to nil and there is no tax liability on the interest of £6,500.
£2,000 of PA now remains and this can offset against the dividends to reduce them to £4,000. The new dividend nil rate band allows the first £5,000 of taxable dividends to be taxed at 0%, hence the £4,000 of taxable dividends gives rise to no liability.
Please note this example and many more will be covered in the interest and dividend allowance webinar on 30 June 2016. For more information please visit https://events.icaew.com/ShoppingCart.aspx?com=detailview&iid=3917&st_t=46&st_ti=418&rid=232&returncom=productlist&source=search
In response to Duncan’s questions, we have raised these software issues with HMRC as the answers are not known at present. We will communicate HMRC’s response once available.