Dividend Tax Rises
As you may have seen in our Summer Budget initial reaction commentary, from 6 April 2016 a new income tax regime will apply to the receipt of dividends by individual taxpayers (subject to any changes as part of the Finance Bill going through the legislative process).
Currently a basic rate taxpayer pays no income tax on dividends received due to the operation of the dividend tax credit system. Only higher rate or additional rate taxpayers pay income tax on dividends received.
From April next year, basic rate taxpayers who receive dividends in excess of £5,000 (an exemption that will also be introduced from that date) will pay income tax at the rate of 7.5% on that part exceeding the £5,000 exemption. This represents a real tax rise to the majority of SME shareholder/directors who have historically adopted a small salary/large dividends remuneration policy.
In the current tax year an individual remunerating themselves this way could extract a salary of just over £8,000 in addition to dividends of just under £30,900 and pay no income tax. Applying the same extraction policy next year would result in income tax charges of £1,722.
Where the taxpayer’s income is taxable at the higher rate (over £43,000 for 16/17) the effective rate on dividends jumps to 32.5% from 25%, and for additional rate taxpayers (broadly those with taxable income in excess of £150,000) the effective rate goes to 38.1% from 30.6%.
The following example highlights how these changes will take effect in a common scenario.
A trading company with three equal shareholders makes profits of £120,000. Each individual takes a salary of £8,000, with the retained profits after corporation tax being distributed to the shareholders equally as dividends.
The following table shows that the taxation that would have applied under the old rules and the tax that will apply under the new rules:
From April 2017 the effect of this new dividend tax regime will reduce slightly when the rate of corporation tax is reduced to 19%, however this will not offset the increased tax on dividends.
Dividends v Salary
The introduction of these new dividend tax rates will cause many shareholder/directors to consider whether or not they wish to continue with a dividend based remuneration policy.
There is no “one answer fits all” and each specific circumstance needs to be examined to ascertain whether or not paying dividends (as opposed to salary) remains the best course of action. In the main we expect dividends to still be more tax efficient than salary, however, in some circumstances salary may become more attractive, especially for higher rate and additional rate taxpayers, or taxpayers with aggressive dividend policies where it has become of only marginal difference.
Using the same example as given above, however comparing the new regime with the position if all of the profits were extracted by salary. In this example a dividend based remuneration policy remains more tax efficient:
The following example assumes that the shareholder/directors are higher rate taxpayers as result of income already received.
In this scenario the position starts to become more marginal. If the individuals had utilised their £5,000 dividend allowance elsewhere, the £50,325 total tax would increase to £55,200. This would make dividends better per individual by only £643 per shareholder per annum.
Summary & Action Points
The changes to the income tax regime for dividends will result in many small investors being removed from the charge to income tax on their dividends (i.e. where their dividend income is less than £5,000). However, for many, and especially owners of SME’s, this represents a real tax increase.
We recommend that any individual who thinks they may be affected by these changes has their position reviewed before April 2016.
This is especially important for owner managed businesses and SMEs who have historically adopted a dividend based remuneration policy. Amongst the options that they may wish to consider are:
- Where cash flow/reserves permit, the declaration of dividends before April 2016, i.e. bringing some dividends forwards
- Increasing the use of other forms of remuneration, for example salary, pension contributions and interest
- Reviewing the shareholding structure to ensure that it provides the most tax efficient outcome whilst also representing the commercial direction of the business.
If you would like remuneration planning services before April 2016 please contact the tax team.