Back in July with the release of the Summer Budget, one of the most important announcements affecting business owners was with regards to the taxation of dividends. It was announced that from April 2016 the existing Dividend Tax Credit was to be replaced by a new tax free Dividend Allowance. At the time there was very little additional information released, however HMRC have now published a fact sheet clarifying how exactly these changes will operate.
What has changed?
From next year dividends will be taxed based on the amount of dividend income received, removing the need to gross up the dividend by the associated 10% tax credit. The first £5,000 of dividend income, regardless of any other income received, will be covered by the new dividend allowance and any dividends exceeding this amount will be taxed at the following new rates;
Dividend Income within the Basic Rate Band 7.5 %
Dividend Income within the Higher Rate Band 32.5 %
Dividend Income within the Additional Rate Band 38.1 %
Dividend income is taxed as the ‘top slice’ of taxable income, after all other income, and is therefore subject to an individual’s highest rate of tax.
What does this mean for me?
An individual who receives dividends of less than £5,000, will pay no tax on their dividend income regardless of their tax rate band – it will be covered by the dividend allowance. Under these circumstances, the changes will be beneficial to anyone paying tax in either the higher or additional rate band, who under the old regime, would have been taxed on these dividends at an effective rate of 25% or 36.1%.
Basic rate tax payers receiving dividends in excess of £5,000 however, could see an increase of up to £2,025 to their tax bill. Under the current regime, no tax is paid on dividend income within the basic rate band.
Higher rate tax payers could see an increased tax liability of up to £6,300 and an additional rate tax payer taking £200,000 of dividends could expect an increase of up to £13,800.
Due to the removal of the tax credit regime which resulted in the dividend received being grossed up by 10% when calculating total taxable income, the dividend amount received will now be aligned with the actual amount upon which you are taxed. This will be particularly beneficial to tax payers who are close to the limits of £50,000 and £100,000 respectively, at which child tax credits and the tax free personal allowance begin to be removed.
For example, a dividend received of £100,000 would have previously been assessed as total taxable income of £111,111 inclusive of the 10% tax credit. As this amount would have exceeded the threshold at which a tax payer begins to lose their personal allowance, the amount in excess of the £100,000 limit would have reduced the personal allowance available to £5,444 from £11,000. Under the new regime a £100,000 dividend would result in the personal allowance remaining available in its entirety.
Should I still consider incorporating?
The changes made to the taxation of dividends generally increases the tax cost of extracting profits from a company by an individual, and seeks to align the taxation of small owner managed businesses with that of an unincorporated entity (like a sole trader business or partnership). The financial advantages of incorporation, particularly for family owned businesses have therefore been reduced. Whilst it is still beneficial for existing companies to extract profits primarily by way of dividends rather than salary, the decision as to whether to incorporate will likely become increasingly commercially driven, rather than tax driven, although there may still be savings to be achieved.
What can I do to mitigate the effect of the changes?
The exact impact of the changes will vary depending not only on the level of dividends taken, but the amount and sources of any other income you may have. The changes discussed do not come into effect until 1 April 2016, meaning we have ample time to plan ahead and reconsider timings of dividends, and the split of salary vs dividend taken, in order to achieve the best solution on a case by case basis.
If you feel the change to the taxation of dividends is going to adversely effect you and wish to discuss further please get in touch with me via my team page