How do the changes to the taxation of dividends from April, 2016 affect owner-managed and family companies?
At present, owners of owner-managed and family limited companies would would pay themselves a minimum salary to cover the personal allowance and avoid payment of tax and National Insurance on it but enough to qualify for state pension purposes.
The balance of their remuneration would be in the form of dividends (provided there is enough retained profit in the company).
The Present Situation
At the moment, dividends have a 10% tax credit so that for every £100 dividend actually paid by the company (the net dividend) is divided by 9 and then multiplied by 10 to get to the gross dividend of £111.11.
How much additional tax would you be liable to pay at present?
- Provided you are a basic rate tax payer (20% band), you have no further tax to pay;
- If you are a higher rate tax payer (40% band), you will have a further 25% of the £100 net dividend to pay in tax;
- If you are an additional rate tax payer (45% band), you will have a further 30.6% of the £100 net dividend to pay in tax
The reason that basic 20% rate tax payers have no further tax to pay is that the company has already been taxed 20% on the profit before it is paid out as dividend.
What is the Benefit of Business Owners Paying Themselves with Dividends?
Although the company does not get tax relief on dividends paid (unlike wages and salaries), dividends are attractive as you do not have to pay National Insurance contributions on them and no additional tax is payable until your income goes into the higher 40% after income reaches the limit of the basic rate band of £31,785 plus your personal allowance (2015/16).
What will Change from April 2016?
The 10% dividend tax credit will be abolished on 6 April, 2016. In its place, all taxpayers will receive a tax free dividend allowance of £5,000 which is offset against the first £5,000 of taxable income. This means that someone who only has dividend income will be able to receive £16,000 in dividends with no further tax to pay (£11,000 personal allowance in 2016/17 plus the £5,000 dividend allowance).
Where dividends are received above the dividend allowance, from 6 April, 2016 the balance will be taxed at 7.5% for basic rate tax payers, 32.5% for higher rate tax payers and at 38.1% for additional rate tax payers.
In effect, from 6 April, 2016, all tax payers receiving dividends above the £5,000 dividend allowance, will be paying 7.5% more tax than prior to 6 April, 2016.
This additional tax is tackling owners of owner-managed companies who pay themselves a small salary and take the balance in dividend to avoid National Insurance.
However, like a blunderbuss, it hits the pensioners who do not pay National Insurance anyway and the higher earning employees who pay the maximum National Insurance (at normal rate) that have dividend income from investments.
Dividends in ISA’s and pension funds will not pay the tax.
The way the allowance will work in different situations is demonstrated in the examples below.
Where appropriate to the calculations, the examples use the limits that will apply from April 2016:
- Personal Allowance: £11,000
- Basic Rate Limit: £32,000
- Higher Rate Threshold: £43,000
“I receive less than £5,000 per year in dividends”
From April 2016 you won’t have to pay tax on your dividend income as it is within your new Dividend Allowance.
“I receive dividends of £600 from shares invested in an ISA”
As is the case now, no tax is due on dividend income within an ISA, whatever rate of tax you pay.
“I have a non-dividend income of £6,500, and a dividend income of £12,000 from shares outside of an ISA”
With a Personal Allowance of £11,000, £4,500 of the dividends are under the threshold for tax. A further £5,000 comes within the Dividend Allowance, leaving tax to pay at Basic Rate (7.5%) on £2,500.
“I have a non-dividend income of £20,000, and receive dividends of £6,000 outside of an ISA”
You won’t need to pay tax on the first £5,000 of dividends due to the Dividend Allowance, but will pay tax on £1,000 of dividends at 7.5%.
“I have a non-dividend income of £18,000, and receive dividends of £22,000 outside of an ISA”
Of the £18,000 non-dividend income:
- £11,000 is covered by the Personal Allowance
- the remaining £7,000 to be taxed at Basic Rate
Of the £22,000 dividend income:
- the Dividend Allowance covers the first £5,000
- the remaining £17,000 of dividends to be taxed at the Basic Rate (7.5%)
“I have a non-dividend income of £40,000, and receive dividends of £9,000 outside of an ISA”
Of the £40,000 non-dividend income, £11,000 is covered by the Personal Allowance, leaving £29,000 to be taxed at basic rate.
This leaves £3,000 of income that can be earned within the basic rate limit before the higher rate threshold is crossed. The Dividend Allowance covers this £3,000 first, leaving £2,000 of Allowance to use in the higher rate band. All of this £5,000 dividend income is therefore covered by the Allowance and is not subject to tax.
The remaining £4,000 of dividends are all taxed at higher rate (32.5%).