Goodbye Dividend Tax Credit, Hello Dividend Allowance!

In July the Government announced a complete change to how dividend income will be taxed with the new rules set to come into effect from April 2016. The current system of dividend tax credits will be replaced by new rates of dividend tax with everybody entitled to a £5,000 dividend allowance. The Government estimates that these changes will generate £6.8bn during the course of this parliament

In this post we outline the current rules and then explain the upcoming changes and provide several examples of how this may affect you depending on your overall level of income.

The current system for taxing dividends

Currently shareholders receive their dividend income with the benefit of a notional 10% tax credit. The idea behind the 10% credit is to compensate for the fact the company will have paid corporation tax on its profits.

The rate of tax you pay on dividend income depends on your other income with dividends treated as the “top slice.” There are currently three rates of tax for dividends, 10%, 32.5% and 37.5%. After taking the notional 10% credit into account the effective tax rates are 0%, 25% and 30.56%. Basic rate tax payers pay 10% and so the notional 10% credit offsets this and so they effectively receive their dividend income tax free up to around £38,000 per year.

It is common practice for shareholder directors to take their remuneration as a mix of a small salary and dividends in order to reduce tax and National Insurance payments and it seems to be these individuals and family run business directors who stand to be most affected by these changes.

Changes set for April 2016

On April 6th 2016, the dividend tax credit is to be replaced with the new £5,000 dividend allowance. Any dividend income over £5,000 will be subject to the new dividend tax rates:

• Basic rate tax payers; 7.5%
• Higher rate tax payers; 32.5%
• Additional rate tax payers; 38.1%

If dividend income takes you from one tax band to another you will pay the higher dividend rate on that portion of income.

HM Revenue & Customs have confirmed that the Dividend Allowance will not reduce your total income for tax purposes and that dividends within the Allowance will still count towards your tax banding. This could push some tax payers up into a higher band than previously.

Summary of the changes in dividend tax rates

  2015/16 2016/17 Basic rate band (20%) 0%             7.5%* Higher rate band (40%) 25% 32.5% Additional rate band (45%) 30.6% 38.1% *first £5,000 at 0%    

Remaining advantages of receiving dividends

Shareholder directors reading this may assume it's no longer viable to pay a small salary topped up with dividends. However, you will still receive the first £5,000 of dividends tax free and unlike salary, dividend income does not attract National Insurance contributions. The overall taxes paid by a company and shareholder directors on dividends will still be less than if they were taxed under the PAYE scheme but will be more than under the current regulations if dividends exceed £5,000.

If your total annual income is less than £11,000 then this will be covered by your personal allowance for 2016/17 meaning you won’t have to use the dividend allowance.

Dividends received by pension funds and on shares held in Individual Savings Accounts (ISA) are unaffected by the change, so as now, they will be tax-free.

Higher rate tax payers with dividend income of £5,000 or less per year will not pay any tax on that income as it will be covered by the dividend allowance. The new regime will save tax for individuals with income and dividends amounting to just above the £100,000 limit, at which point they start to lose their personal allowance.

Examples

HM Revenue & Customs has recently published a Dividend Allowance Factsheet which includes several examples using the 2016/17 rates and allowances:

• Personal Allowance £11,000
• Basic Rate Limit £32,000
• Higher Rate Threshold £43,000

Below are some more examples of small companies (sole director/shareholder) paying a small salary (currently £8,060) which secures National Insurance benefits and dividends:

Example 1: Total income £25,000; £8,000 salary and £17,000 dividends

  Current Rules New Rules Tax on salary nil nil Tax on dividends nil £675

Under the new rules the dividends are taxed as follows:

£3,000 @ 0% covered by the remaining balance of the personal allowance

£5,000 @ 0% using the dividend allowance

£9,000 @ 7.5%

Example 2: Total income £43,000; £8,000 salary and £35,000 dividends

  Current Rules New Rules Tax on salary nil nil Tax on dividends nil £2,025

Under the new rules the dividends are taxed as follows:

£3,000 @ 0% covered by the remaining balance of the personal allowance

£5,000 @ 0% using the dividend allowance

£27,000 @ 7.5%

Example 3: Total income £60,000; £8,000 salary and £52,000 dividends

  Current Rules New Rules Tax on salary nil nil Tax on dividends £5,125 £7,550

Under the new rules the dividends are taxed as follows:

£3,000 @ 0% covered by the remaining balance of the personal allowance

£5,000 @ 0% using the dividend allowance

£27,000 @ 7.5%

£7,000 @ 32.5%

Under the current rules the dividends are taxed as follows:

Gross dividend £52,000 x 100/90 = £57,778

£35,000 @ 10% (plus salary = basic rate limit)

£22,778 @ 32.5%

Less 10% tax credit £5,778

If you would like to discuss how these changes might affect you please contact your local office.