The 2016/17 tax year has seen some major changes as to how dividends are taxed.  This has had a significant impact on the tax planning position for companies where directors are also shareholders.  We have covered these changes in another article but we'll also go through some of the major changes here.

The old rules for dividend taxation pre 2016/17

Prior to the 2016/17 tax year, dividends had an associated 'tax credit'.  This meant that a dividend was posted through a company's accounts 'net' but shown in a personal tax return 'gross' with an associated tax credit of 10%.

So let's look at how that worked in practice:

• Company declared a dividend of £9,000 - this is what was shown in the company's accounts
• This was grossed up by 10% ie £9,000/0.9 = £1,000 - giving a gross dividend for personal tax purposes of £10,000
• You were taxed on dividend income of £10,000 with a 'tax credit' allowed against any tax due of £1,000
• So if your total taxable income (including the gross dividend income) was below the higher rate threshold (£42,385 for 2015/16) you had no additional tax to pay
• If your total taxable income was above the higher rate band, then any dividend which fell into that higher rate band was taxed at an effective rate of 22.5% of the gross dividend (or 25% of the net dividend) - remembering that the higher rate of tax on dividends was 32.5% (not 40% as for other income).
  

The new rules for dividend taxation post 2016/17

The dividend tax credit has now been replaced by an annual tax free dividend allowance of £5,000 - this means that the first £5,000 of any dividend income is tax free.

Any dividend income above £5,000 will be taxed as follows:

• If you have any un-used personal allowance (£11,000 for 16-17) then that element is tax free
• Any dividends in the basic tax band (up to £43,000 for 16-17) attract a tax charge of 7.5%
• Dividends above the basic tax band are charged at 32.5%
• Additional rates of tax will apply at the upper tax band (£150,000 for 16-17)
  

Optimum levels of salary and dividends for 2016/17

So now that the way dividends are taxed has changed, what does that mean to the most tax efficient levels of salary and dividends.

A low salary combined with dividends has long been the most tax efficient salary for limited company contractors, freelancers and owner managed businesses.  The rationale is as follows:

• Take a salary at a level which is below the personal allowance (so there is no PAYE payable) and high enough to trigger a national insurance record (usually at the lowest level so that there is no national insurance payable) which maintains your contribution record for state pension - in other words, this will count as contributions towards your state pension entitlement
  
• The company gets a deduction for the salary in the accounts - so corporation tax is saved at 20% of the gross salary
• Dividends are then declared up to the amount of post tax profit available in the company - remember, dividends are declared after tax and so there is no corporation tax saving on dividends
  
• Dividends do not attract National Insurance charges
• As not all profit after tax has to be paid out as a dividend in any one year, dividend payments can be managed to help keep any personal tax liability to a minimum
  

The introduction of the Employment Allowance in April 2014 meant it was slightly more tax efficient to take a salary up to the personal allowance - although this was offset by the administrative problem of paying any employee's National Insurance due.

From 2016-17 HMRC have announced that the Employment Allowance will no longer be available for single director companies.  This is to ensure that the Employment Allowance is used for its original purpose ie to encourage employment.

However HMRC have confirmed in their guidance that husband and wife directors can claim the allowance if they are earning above the secondary NI threshold.

You'll find below two dividend and salary combination options which aim to keep any income below the higher rate threshold (£43,000 for 2016-17).

Please note that in both examples it’s important you have sufficient post-tax profits in the company to declare the dividends mentioned. It is illegal to declare a dividend where there isn’t sufficient profit.

So it’s very important you keep on top of your finances in order to ensure you have adequate profits – we recommend FreeAgent for contractors and Xero for other businesses.

In general, we think it's simplest and safest to keep the salary level for husband and wife businesses below the NI threshold (2016-17 £8,060) - and for a single director business this is also generally the simplest route.

Strategy 1: Take a salary below the NI Primary Threshold

So if you want to keep things simple, or are worried about claiming the Employment Allowance, then we think this is the best strategy - and it's the one we recommend to most of our clients.

There are two main National Insurance thresholds you should be aware of:

• Lower Earnings Limit – as long as you earn above this you are protecting your entitlement to future state pension and benefits, without necessarily paying any National Insurance
• Primary Threshold – if you earn above this you have to start paying National Insurance (£8,060 for 2016-17)
  

So we recommend paying a salary up to the Primary Threshold.

You can then take dividends up to £34,940 without having to pay any higher rate tax (basic rate band of £43,000 less salary of £8,060). 

However there will be basic rate tax of £2,025 to pay - calculated as follows:

• Personal allowance - £11,000 (£8,060 for salary and £2,940 against dividends)
• £5,000 tax free allowance for dividends - meaning £27,000 dividend income is taxable (£43,000 total dividends less £2,940 from personal allowance less £5,000 tax free allowance)
• Tax to pay of £2,025 (£27,000 at 7.5% tax rate)
  

This means you will have a 'take home' amount of £40,975 (£8060 salary + £34,940 dividends less £2,025 tax payable).

In addition you will save corporation tax of £1612 (£8060 * 20%).

Strategy 2: Claim the Employment Allowance

This option isn't available to you if the only person on the payroll is a single director - although the strategy is allowable if you are a husband/wife business as mentioned above.

This option is also not effective if the employment allowance will be used against the employer's NI on other employees in the business.

So for the purposes of this example we will assume that this is a sole director with other employees and there will be excess employment allowance to use against the director's income.

The recommended salary would be up to your personal allowance (£11,000 for 2016-17 - although your own personal code may be different).

Assuming you have a full personal allowance then you would take a £11,000 salary and a dividend of £32,000 without paying any higher rate ​tax - as this salary/dividend combination would take you up to the higher rate threshold.

However there will be basic rate tax and employee's national insurance of £2,377.80 to pay - calculated as follows:

• ​Employer's National Insurance - £405.72 (being £11,000 less Primary Threshold (£8,060) = £2940 *13.8%) - assume all covered by employment allowance therefore nothing to pay
  
• Personal allowance - £11,000 (all used against salary)
• £5,000 tax free allowance for dividends - meaning £27,000 dividend income is taxable (£32,000 total dividends less £5,000 tax free allowance)
• Tax to pay of £2,025 (£27,000 at 7.5% tax rate)
• Employee's national insurance payable on salary - £352.80 (£11,000 less £8,060 = £2,940 * 12% (assuming NI letter = A))
  

This means you will have a 'take home' amount of £40,622.20 (£11,000 salary + £32,000 dividends less £2,377.80 tax payable).

In addition you will save corporation tax of £2,200 (£11,000 * 20%).

So overall, strategy 2 will save you £235.20 - however you would need to remember to pay the employee's national insurance to HMRC.  This can be a bit of a headache if you don't have any other payroll payments to make to HMRC.  The cashflow benefit is also realised more quickly with the first strategy and this is the only strategy available to single director companies.

And if you have any questions, or would like any help on any other topics, feel free to email me at [email protected].