Taxation of Dividends ~ New Rules from 6 April 2016

In the Summer July 2015 Budget the Chancellor outlined significant changes to the way that dividends will be taxed from the 2016-17 tax year. The changes are unlikely to have any effect on taxpayers receiving a modest level of dividends from their quoted share portfolios.

However owner-managers of family limited companies are likely to see a significant rise in the amount of income tax payable on any dividends extracted. This is because traditionally shareholders of family businesses have tended to take a modest salary, currently around £8,000 pa to avoid exposure to National Insurance Contributions and then extract some or all of the company’s post-tax profits via dividends.

According to the Chancellor the main reason for making the changes was a desire to ‘close the tax gap’ between the self-employed and those who operate their business through a limited company. The rate of corporation tax is due to fall from 20% to 19% from 1 April 2017 and 18% from 1 April 2020.

Summary of the changes which come into effect from April 2016:

• The current rule of grossing-up of dividends by a 10% tax credit is to be abolished.
• New dividend rates will apply to the actual amount of dividends received
• Any income tax due on dividends will be paid through self-assessment.
• A Dividend Allowance will effectively tax the first £5,000 of dividends at 0%
• Dividends will continue to be treated as the top slice of income

Comparison of effective current and new dividend tax rates:

Dividend Allowance

HM Revenue & Customs have recently clarified the treatment of the £5,000 Dividend Allowance via a factsheet and have confirmed that it will NOT reduce total income for tax purposes. However, the Dividend Allowance will count towards the basic or higher rate bands. 

The HMRC factsheet, which includes several useful examples, can be accessed by clicking on the following link: 

www.gov.uk/government/publications/dividend-allowance-factsheet

Illustrations of new rules:

1. David is the sole director/shareholder of DJR Limited. Each year he takes a salary of £8,000 plus £40,000 in cash dividends. For 2016-17 the personal allowance will be £11,000 and the basic rate band £32,000.

   For 2015-16 his income tax liability will be £2,263.

   Under the new rules his income tax liability for 2016-17 will be £3,650 computed as follows, an increase of £1,387.

   Dividends covered by PA	£3,000 exempt	0
   Dividends within dividend allowance	£5,000 @ 0%	0
   Dividends within basic rate band	£27,000* @ 7.5%	2,025
   Dividends at higher rate	£5,000 @ 32.5%	1,625
   	TOTAL TAX	£3,650

    
   *£32,000 basic rate band less £5,000 Dividend Allowance.

2. Ruth is the sole director/shareholder of RPC Limited. Each year she takes a salary of £8,000 plus £80,000 in cash dividends. For 2016-17 the personal allowance will be £11,000 and the basic rate band £32,000.

   For 2015-16 her income tax liability will be £12,263.

   Under the new rules her income tax liability for 2016/17 will be £16,650 computed as follows, an increase of £4,387.

   Dividends covered by PA	£3,000 exempt	0
   Dividends within dividend allowance	£5,000 @ 0%	0
   Dividends within basic rate band	£27,000 @ 7.5%	2,025
   Dividends at higher rate	£45,000 @ 32.5%	14,625
   	TOTAL TAX	£16,650

Impact on the personal allowance and child benefit claw-backs

For taxpayers with income greater than £100,000 the non-grossing up of dividends from 2016-17 will mean that the taxpayer could be entitled to a higher personal allowance given that their total income for tax purposes will be lower.

Similarly, taxpayers with a total income of over £50,000 could see a reduction in the amount of child benefit claw-back that they will suffer from 2016-17.

Although the above changes will adversely affect most shareholders of family businesses they certainly do not negate the overall tax and other benefits of incorporation compared to a sole trader or partnership business.

The dividend policy of companies will need to be tailored to the disposable income needs and tax position of individual shareholders so that the effect of the new dividend rates can be minimised. 

This could include a review of current salary and dividend levels and the possible introduction of a spouse as a shareholder. It may also be worth considering maximising the payment of dividends prior to 5 April 2016 to take advantage of lower 2015/16 dividend tax rates.

If you would like to discuss the content of this article and how the proposed changes to the treatment of dividends would impact on your individual circumstances then please do not hesitate to email us at contact@marshvision.com or ring us on 01633 215 544