One of the major changes from the Summer Budget is that the taxation of dividends will be reformed from 6 April 2016.
The 10% dividend tax credit is abolished and, in its place, individuals will have a £5,000 dividend tax allowance. An individual will pay no income tax on dividend income received up to that amount. However, dividend receipts in excess of £5,000 will be taxed at:
- 7.5% for basic rate taxpayers (previously 0%)
- 32.5% for higher rate taxpayers (previously 25%)
- 38.1% for additional rate taxpayers (previous 30.56%)
The new dividend allowance will represent a significant tax increase for owners of small companies who have been able to extract profits from their business with a tax-efficient mixture of salary and dividends.
In 2015/16, Alan takes a dividend of £27,000 net (£30,000 gross) from his personal company. His only other income is salary equivalent to his personal allowance. He pays no income tax on this combination of salary and dividend because it’s all covered by his personal allowance and basic rate band.
In 2016/17, Alan takes a dividend of £27,000 (gross, no tax credit) from his company and a salary equal to his personal allowance. He pays tax at 7.5% on £22,000 of that dividend after deducting the dividend tax allowance of £5,000. In 2016/17 he will pay income tax of £1,650 on the dividend.
The ‘tax lock’ prevents the Chancellor from raising the rate of income tax. The tax rise illustrated above is achieved by reducing the rate of tax on dividends from 10% to 7.5% while simultaneously removing the tax credit that balanced the 10% tax charge.
Some initial reactions from commentators were that people would switch back to paying salary instead of taking dividends. However, we ran calculations for different levels of Income Tax and NIC and it is still beneficial to take a dividend rather than salary, although the saving has been reduced. The saving is still particularly pronounced for a dividend if employee’s NIC would be payable on any salary at 12%, rather than at the 2% rate.
We are also exploring other options for profit extraction such as charging interest on credit balances on directors’ loan accounts and employer pension contributions. There can be a requirement to deduct 20% tax at source on interest payments by the company. Tax relief on pension contributions in respect of higher income individuals is to be restricted, but with the new pension freedom rules, pension contributions are more popular than they have been for some time.
When we prepare tax returns for clients for the year ended 5 April 2015, we will discuss the additional tax that they would have had to pay if the level of any dividends received had been taxed at the rates applicable from 6 April 2016. This will give them a good guide based on their own income profile in regards to how the increase in income tax payable on dividends is likely to affect our clients from 2016-17, if they decide to keep the same income profile going forward.
The effect of this tax hike is likely to be felt at 31 January 2018 when the self-assessment balancing payment for 2016/17 will be due for payment.
Depending on individual circumstances and future income needs, some clients may decide to stockpile a certain level of dividend income before the end of this current tax year ending 5 April 2016, in advance of the increase in the effective rate of tax payable on dividends. This will typically only be beneficial if a certain level of dividend income is already taxed at the current effective higher and additional rates of 25% and 30.56% respectively.
In summary, taking a higher salary is still not likely to be beneficial in tax terms under the proposed tax regime. The low salary with the balance of income requires being taken by dividend is still the cheapest option, however the overall Income Tax and National Insurance contributions savings will not be as great as they have been once the new rules are introduced.
Please feel free to discuss the effect of these changes with your usual contact at Tait Walker.