Under the present rules, dividends tend to be the preferred method of paying yourself for the owners of small companies and investors because they are:
- Paid net of a notional 10% tax credit. This tax credit can wipe out basic rate tax arising on dividends and goes towards covering the tax bill on dividends in the higher and additional rate bands
- Not subject to National Insurance
- Subject to lower income tax rates
But in the Summer Budget, it was announced that from April 2016 the tax credit will be replaced by a Dividend Tax Allowance of £5,000. Dividend income over the Allowance will be liable for tax at the basic rate of 7.5%, 32.5% for the higher rate and 38.1% for the additional rate.
Effective tax rates
Taking into account the tax credit mentioned above, the effective personal tax rates under both regimes look like this:
|Rules until 31 March 2016||Rules from April 2016|
One of the key points the table is highlighting is that basic rate taxpayers have not been physically paying tax on dividend income because any liability arising is normally covered by the tax credit.
Should I still incorporate?
For most people, the point at which incorporation becomes worthwhile has moved and it won’t lead to quite the same tax savings as the current regime.
But overall, in certain circumstances operating as a limited company can still be more tax efficient than trading as a sole trader or partnership.
Many small businesses operate as limited companies and by virtue of their shares in their companies, are unfortunately caught by the changes.
Basic rate owner-managers
Director-shareholders will tend to draw dividends right up to where higher rate tax applies - thus they pay little-to-no income tax or National Insurance on any of their income (the company would be paying Corporation Tax though).
Under the proposals, a similar set-up might cost each director-shareholder in the region of £1,700 in tax.
Higher rate and additional rate taxpayers
Due to the unusual application of the Allowance, some higher and additional rate taxpayers actually stand to benefit from the Dividend Tax Allowance.
Dividends are always considered to be the very top slice of your income. If your dividends straddle two tax rates, the Allowance will first be used by the lower of the tax rates.
If you’ve got large amounts of other income and your dividends therefore fall entirely within the higher or additional rate bands, the Allowance could be worth up to £1,625 for higher rate taxpayers (£5,000 x 32.5%) or £1,905 for additional rate taxpayers (£5,000 x 38.1%).
Can you tell me exactly how I’ll be affected?
At the time of publishing, the only information we have consists of the few paragraphs in the Budget document and a HM Revenue & Customs' factsheet, which gives a few examples of how the £5,000 voucher will interact with tax bands, rates and allowances.
Unfortunately, we don’t yet know the National Insurance bands for next year and the rates have not been confirmed. Furthermore, while the aforementioned factsheet has answered some of the questions surrounding the Allowance’s application for tax purposes, we do not have any draft legislation to substantiate what is set out in the factsheet.
As a result, no one is in a position to commit themselves to 100% accurate calculations at this time.
Why has this been introduced?
The motivations behind the Dividend Allowance have not been outlined. But we do know that the government is estimating to generate £6.8bn from this measure during this parliament.
Furthermore, the Government has been trying to tackle ‘employees’ who disguise their employment as a trade using personal service companies. There is also a sense that the Government are looking to reduce incorporations that are predominantly tax-motivated; rather than being for commercial reasons.
By reducing the tax incentive to incorporate, they’ll indirectly reduce the numbers of people opting for these set-ups.
How we can help
As we mentioned, we don’t have all of the details yet however, if you have any questions, do feel free to talk to us. By late 2015 or early 2016, we should have draft legislation so at that point should be able to give you a more accurate idea of how your circumstances will be affected. You should then be able to factor in any changes to your cashflow forecasts or budgets.
By Jo Nockels
Last updated August 2015
Disclaimer: The information provided is based on current guidance (at date of publication) from HMRC and may be subject to change. Any advice shared here is intended to inform rather than advise. Taxpayer's circumstances do vary and if you feel that the information provided is beneficial it is important that you contact us before implementation. If you take, or do not take action as a result of reading this information, before receiving our written endorsement, we will accept no responsibility for any financial loss incurred.