We have reviewed the detail of the measures, which are due to take effect from 6 April 2016. Consequently we would advise that that all shareholders of companies which yield dividends should take stock of their affairs now, before this change takes place.
The current regime
Dividend income is currently taxable at various rates:
• Basic rate taxpayers – 10%, giving an effective rate of 0% after deducting the tax credit;
• Higher rate taxpayers – 32.5% (an effective rate of 25% on the net dividend);
• Top rate taxpayers – 37.5% (an effective rate of 30.6% on the net dividend).
However, the taxation of dividends has never been particularly straightforward. Net dividends, being the amount of cash actually received, must be ‘grossed up’ in order to ascertain the amount to be assessed to tax for individual shareholders. Although this does lead to a tax credit which can later reduce the amount of tax payable on the total dividends received, the calculation required to reach this point has traditionally seemed onerous. Despite this complexity, for owners of limited companies there are advantages to the availability of the tax credit.
Under current rules it is possible for a company to pay a low salary to shareholder/directors which can then be topped up by further payments by way of dividends, up to the basic rate band limit. The company pays corporation tax on profits made at the relevant rate, but the application of the tax credit means that it is possible that no further income tax is payable by the shareholders on extraction.
By way of example, during the current 2015/16 tax year, £39,206 can be paid to shareholders and provided that they have no other sources of income, no further tax will be payable.
Savings are also possible for shareholders who receive dividend payments in excess of the basic rate band. Their effective rates of tax on this form of income are 25% for higher rate tax payers, or 30.6% for top rate taxpayers. This is opposed to 40% or 45% income tax, plus National Insurance Contributions on higher salaries.
What is changing?
With effect from 6 April 2016, dividends received up to the basic rate band limit will carry a 7.5% tax charge. Higher rate dividends will remain taxable at 32.5% but a new 38.1% rate will apply to top rate taxpayers.
Tax will be payable on the amount of dividends received, with no ‘grossing up’ calculation required. Conversely there will be no tax credit to deduct from the overall tax payable. The tax credit will be replaced with a new allowance, which will apply to the first £5,000 of dividends received, per shareholder. This allowance will be available in addition to the
personal allowance, meaning that from 6 April 2016 it will be possible to receive up to £16,000 in salary and dividends from a company before any income tax will become payable.
However, beyond this amount, the new rate of 7.5% will become applicable. Using a typical scenario of extraction by way of low salary combined with dividends received up to the basic rate band limit, (£43,000 for 2016/17), income tax of £2,025 will become payable where historically this would be nil.
The new regime will also affect the amount of tax payable for higher and top rate taxpayers, however a combination of a small salary plus dividends still remains the most tax effective extraction method.
What are the next steps?
Any shareholder/director of a company will need to review their remuneration and extraction policies.
In addition, it may be worthwhile, where possible to bring forward the declaration of dividends during the current tax year (2015/16) whilst the lower rates are still applicable. Even if the physical cash is not taken by the end of the current tax year, once declared the dividend will provide the director/shareholder with a credit in the company accounts. The cash can then be drawn later with no further tax becoming payable.
Reduction in rate of corporation tax
Finally, it is worth noting that over the coming tax years, the effect of this change will be mitigated somewhat. It is proposed that the corporation tax rate will drop again to 19% from 1 April 2017 with a further reduction to 18% scheduled to take effect from 1 April 2020.