Beware the new dividend tax…

We referred to George’s dividend tax previously in our Summer Budget blog (here) and given the widespread impact this is likely to have on small and family run businesses we think this topic is worth re-visiting in further detail.

By way of a recap the key facts are as follows:-

• From April 2016, notional 10% tax credit on dividends will be abolished.
• A £5,000 tax free dividend allowance will be introduced.
• Dividends above this level will be taxed at 7.5% (basic rate), 32.5% (higher rate), and 38.1% (additional rate)
• Dividends received by pensions and ISAs will be unaffected

Whilst no further detail is available presently, it is likely that dividends will continue to remain non-deductible (unlike, say, a director’s salary) for corporation tax purposes.

These changes are clearly aimed at small companies who pay a modest salary (designed to trigger entitlement to the State Pension without actually resulting in a PAYE liability), and a larger dividend payment in order to reduce their National Insurance costs. This is a tax planning strategy which has been used by owner managed limited companies for some time now.

This new measure will have a very harsh effect on those who work with spouses in family companies. The ‘hard working families’ that George Osborne refers to frequently in his political soundbites, could be in excess of £5,000 a year worse off.

Although the changes will not come into effect until April 2016 there appears to be widespread confusion over how exactly the proposed changes to the taxation of dividends will actually work in practice.

There appears to be two differing opinions.

Some think that either:

​1) The new £5,000 dividend allowance will, like the savings allowance, be included in the basic rate band, or
2) The dividend allowance will be in addition to the basic rate band.

Whichever change applies there’s no denying that either method will be highly detrimental not only for small business owners and family companies but also for many investors.

However we would stress that HMRC have yet to publish the detail.

So let's run through some examples as to how the new rules might work.

Proposed rules

Example 1 - Assumes the dividend allowance is within the basic rate band

If you are basic rate taxpayer, and you receive all your income in dividends you will be up to £2,025 worse off!

The basic rate tax threshold for 2016/17 is £43,000 (personal allowance of £11,000, plus basic rate tax band of £32,000)

If a dividend of £43,000 is received we assume (at this stage) that it is taxable as follows, breaking it down into the different "slices":

The first £11,000 - covered by your personal allowance
The next £5,000 - covered by your dividend allowance
The next £27,000 - taxed at the new 7.5% = £2,025 tax due.

Example 2 – Assumes the dividend allowance extends your basic rate band

If you are basic rate taxpayer, and you receive all your income in dividends you will be up to £1,650 worse off!

The basic rate tax threshold for 2016/17 is £43,000 (personal allowance of £11,000, plus basic rate tax band of £32,000), plus you have a £5,000 dividend allowance.

If a dividend of £43,000 is received it is taxable as follows, breaking it down into the different "slices":

The first £11,000 - covered by your personal allowance
The next £5,000 - covered by your dividend allowance
The next £22,000 - taxed at the new 7.5% = £1,650 tax due.

If we assume that George’s dividend tax is just a bad dream (or nightmare), what would the position be under the old rules if you received all your income in dividends?

Example – old rules

The basic rate tax threshold for 2016/17 is £43,000 (personal allowance of £11,000, plus basic rate tax band of £32,000).

If a dividend of £43,000 is received, it is grossed up to £47,777.77 (£43,000 x 100/90) taxable as follows, breaking it down into the different "slices":

The first £11,000 - covered by your personal allowance
The next £32,000 - taxed at 10% = £3,200
The next £4,777.77 is taxed at 32.5% = £1,552.77
You receive a tax credit = £ (4,777.77)
Tax is paid of £nil (the tax credit is non-repayable under the old rules).

We assume the new rules will be published in detail ahead of the Chancellor’s autumn statement, which could be as late as November/December 2015. This is hardly sufficient time for small businesses owners to makes adjustments for the negative impact these changes will have on their businesses from April 2016.

Whilst this is only our personal opinion, we cannot help but wonder whether the current Government is actually on the side of small business and enterprise. Especially given the fact that many large multi-national companies will have seen their effective rate of tax cut from 28% to 18% before the end of this Government’s current term.

One thing is for sure - small business owners need to start reviewing the way they extract profits from their company sooner rather than later.

If you’d like more advice on how these changes might affect you, or would like to discover how we can help your business, simply email our friendly tax adviser, [email protected] or give us a call on 01202 048696.