Dividend tax is changing
We have circulated a newsletter for clients to outline the changes in dividend tax which will occur in April 2016, and you can download a copy of the newsletter by clicking here.
This is an attempt to provide some more detailed information which cannot really be covered in the newsletter, and to provide some more guidance and advice. As always, individual circumstances may mean that this advice may not be entirely appropriate for your specific circumstances, and you should always seek professional advice about your own circumstances.
The basics of the dividend tax changes
The new dividend tax system introduces some welcome simplifications to the taxation system but these come at a cost to the taxpayer, with higher rates of tax due by most taxpayers.
From 2016/17 the first £5,000 of dividend income will be tax free thanks to a new dividend allowance, but receive above that in dividends and you will generally have a higher tax liability to pay.
Dividend income will be taxed as if it were the top slice of your income, attracting an increased rate of tax, and subject to a minimum tax charge of 7.5% for basic rate taxpayers, a tax rate of 32.5% for higher rate taxpayers and 38.1% for the additional rate.
Business owners will want to consider the timing and the value of the dividends you may want to pay before 5/4/16, to reduce your overall tax liability. Although you will end up paying the tax 12 months sooner, you will pay 7.5% less before the changes and common sense advises that unless you can earn that rate of return elsewhere it make business sense to suffer the tax in 2015/16 before the changes kick in. This advice only applies to basic rate taxpayers, as higher rate taxpayers face the loss of the lower rate band which will outweigh the tax saving.
A bit of history…
Before we go onto the detail of the computations, most taxpayers are confused by just how and why the dividend is taxed the way it is. This is not surprising.
Abacus is a family owned company with two shareholders which makes profits of £100,000 and pays £20,000 in Corporation Tax (20% is the standard rate) and distributes the balance of £80,000 as dividends.
Brian owns 25% of the company and receives dividends of £20,000 and Charlie who owns 75% of the company receives £60,000 in dividends.
Dividends are paid to the shareholders out of the after tax income. This dividend carries a tax credit of 10% of the gross amount, which requires the dividend to be grossed up by 10/9. [This used to be a tax credit of 20% and a grossing up factor of 5/4 until 1999.]
The ‘political’ and ‘economic’ reason for this was to reward investment by taxing that income at a lower rate, but the 1999 budget moved the tax rates for earned and unearned income closer together.
The tax effects
Taxpayers paid tax on dividends at differing rates, depending upon the band of tax into which their income fell.
Up to 2015/16 these rates will be 10% for basic rate taxpayers, 32.5% for higher rate taxpayers and 37.5% based on the gross income, including the tax credit, but with a 10% credit for the tax deemed to have been suffered.
This means that (for instance) basic rate taxpayers would have no additional tax liability.
These rates are increasing by 6 April 2016 to 7.5%, 32.5% and 38.1% with no tax credit but with a £5,000 dividend allowance available.
So far, so confusing, but let’s look at the impact on the two shareholders of our example company Abacus, and compare the year on year effect. We will assume that neither has any other income, for simplicity.
[table]
Brian, 2015/16,2016/17
Dividend income,”20,000″,”20,000″
Deemed tax credit (1/9),”2,222″,nil
Total income,”22,222″,”20,000″
Dividend allowance,nil,”(5,000)”
Personal allowance,”(10,600)”,”(11,000)”
Taxable income,”11,622″,”4,000″
,,
Tax due at 10%/7.5%,”£1,162.20″,£300.00
Dividend tax credit,”(£1,162.20)”,nil
Tax payable,nil,£300.00
[/table]
So in the above example, Brian is £300 per year worse off, as the dividends received exceed the tax allowance.
For higher rate taxpayers, the impact is more marked.
[table]
Charlie, 2015/16,2016/17
Dividend income,”60,000″,”60,000″
Deemed tax credit (1/9),”6,666″,nil
Total income,”66,666″,”60,000″
Dividend allowance,nil,”(5,000)”
Personal allowance,”(10,600)”,”(11,000)”
Taxable income,”56,066″,”44,000″
,,
“Tax due on first 31,785/31,900 at 10%/7.5%”,”£3,178.50″,”£3,190.00″
Balance at 32.5%,”£7,891.32″,”£3,932.50″
Dividend tax credit,”(£5,606.60)”,nil
Tax payable,”£5,463.22″,”£7,122.50″
[/table]
Charlie is £1,659.28 worse off as a result of these changes.
Tax planning for dividends
If you control your own company, then you – like Brian and Charlie – may want to bring forward the payment of dividends into 2015/16 to avoid the increased tax charge. You can do this and lend the cash back to the company until such time as it is flush enough to pay the dividend, but remember you have to pay the tax early, and you are likely to have an increased tax charge; so this would only make sense if you are paying an extra dividend.
Extending the above examples, if Brian and Charlie took two dividends in the same tax year, then their tax bills would significantly increase, as shown below.
[table]
2015/16 double dividends,Brian,Charlie
Dividend income,”40,000″,”120,000″
Deemed tax credit (1/9),”4,444″,”13,333″
Total income,”44,444″,”133,333″
Personal allowance,”(10,600)”,”nil”
Taxable income,”33,844″,”133,333″
,,
“Tax due at on first 31,785 at 10%”,”£3,178.50″,”£3,178.50″
Balance at 32.5%,£669.18,”£33,003.10″
Dividend tax credit,”(£3,384.44)”,”(£13,333.33)”
Tax payable,£463.24,”£22,848.30″
[/table]
In this instance, Brian has to pay £463.24 in January 2017 rather than £300 in January 2018 as he is pushed into the higher rate tax band. Charlie has to pay £22,848.30 in January 2017 rather than £5,463.22 in 2017 and £7,122.50 in 2018 because he loses the benefit of the basic rate band at 7.5%.
However, it could still be worth doing this if both Brian and Charlie expect to receive income of at least £31,900 in 2016/17. The problem would be where Charlie remained a higher rate taxpayer in 2016/17 but Brian did not; in this case the tax advice to each shareholder would differ significantly.
Summary
There is no great advantage in taking dividends early, as the tax charge can be much higher. However, it makes sense to fully utilise the basic rate band, so basic rate taxpayers should maximise the dividends they pay.
Taking dividends is still better than paying an increased salary, and if you are going to pay a special dividend it is best to take it earlier rather than later, but otherwise there is not a lot you can do to reduce the overall tax cost.
