Changes to dividends: what do they mean for you?
In the Summer Budget 2015, the Chancellor announced major changes surrounding dividends. From April 2016 a new tax-free Dividend Allowance will replace the Dividend Tax Credit. Headline rates of dividend tax are also changing. These changes will affect anyone who has dividend income.
This ebrief explores:
- what you need to know about dividends, starting with the basics of what dividends are, how and when these are paid and understanding the tax implications
- the impact of the Budget, what remains the same and the changes you need to be aware of.
Make the most of your dividends. As an Intouch client your dedicated personal accountant will guide you through the changes to dividends and help you understand opportunities relevant to your specific circumstances. All the help you need for a monthly fee.
Call 01202 901 385 or email email@example.com and get started with us today. The legislation to introduce these changes has been released and will be introduced in the Finance Act 2016. This ebrief has been prepared based on the best understanding of the information provided by HMRC at the time of publication.
What is a dividend?
Before we begin looking at the changes let’s recap on what a dividend is…
A dividend is a payment made by the company to its shareholders (the owners) as a distribution of the profits made. The directors make the decision when a dividend is declared, how much and when it is payable to the shareholders.
The directors are responsible for making sure the dividend is legal and for ensuring that the proper procedure and paperwork is in place before making payments to the shareholders
A dividend is legal provided that there are enough profits after tax that have not previously been paid out as dividends and that the company is left with enough money to pay its liabilities. Directors sometimes forget to make sure they leave enough money to pay Corporation Tax due on the profits that have been made in the current year.
Dividends must always be paid out in proportion to shares held; if a company has 100 ordinary shares and declares a dividend of £10,000, each shareholder will be entitled to receive £100 for each ordinary share that they own. For example, a shareholder with 25 shares will receive £2,500 whilst another shareholder holding 75 shares would receive £7,500.
Of course, if you are the only shareholder of your company, then 100% of the dividend will be paid to you. Be careful where shares are held by different people to make sure each receives their fair share of the dividend.
Some contractors create different classes of share to help them manage the amount each person receives as a dividend. This can be helpful to manage tax liabilities. Where several classes of share exists then a dividend is declared for each class separately. This is useful where you want to pay different dividends, at different times, to different people
It’s very easy to structure shares to enable you to manage the dividends and you should talk to an accountant, such as Intouch Accounting, to understand when it is appropriate and how to avoid the pitfalls that the tax rules can sometimes present.
The taxation of dividends has always been a little tricky to understand. From 6 April 2016 new rules are being introduced that changes the amount and how tax is calculated.
Before we look at those changes it’s worth just explaining the current rules.
The current rules
When a dividend is received it is regarded as having been received net of a tax credit. A bit like building society interest, dividends are received net of basic rate tax, but what often confuses some people is, unlike building society interest, which is paid net of the normal 20% basic rate of income tax, a dividend is received net of only a 10% tax deduction.
On the face of it you would expect additional basic rate tax to be paid, but this does not happen because the basic rate of income tax on dividends is 10%
Let’s explain this with an example:
A shareholder receives £9,000 as a dividend. This is the treated for tax purposes as if the shareholder has received income of £10,000 but has already suffered a notional £1,000 tax. Provided the shareholder is not subject to higher rates of income tax no further tax is payable because the rate of tax for dividends is only 10% within the basic rate tax band.
If the shareholder is subject to higher rates of income tax then further tax is payable. This higher rate is calculated by charging either 32.5% for a higher rate income taxpayer or 37.5% for an additional rate income taxpayer against the gross dividend received and then deducting the 10% already deducted.
Our shareholder receives the same dividend above, but instead is subject to higher rate tax on the total amount.
The £10,000 is the gross dividend and the first step is to calculate tax at 32.5%, giving £3,250. The second step is to take the £3,250 and then deduct the notional 10%. Our shareholder would have to pay £3,250 – £1,000 = £2,250.
But why does this make sense if the higher rate of tax is 40%? Well, let’s explain this further
The amount of tax paid is £2,250.
When the company made its profit it suffered 20% Corporation Tax. So in order to pay a dividend of £9,000 the company made profit of £11,250, paid Corporation Tax of £2,250 and a dividend of £9,000.
The shareholder then pays a further higher rate liability (they pay no basic rate tax) of £2,250.
Therefore, overall the company paid £2,250 and the shareholder paid £2,250 (totalling £4,500) on original profit of £11,250.
If you applied 40%, the normal rate of higher rate income tax to £11,250 the result is £4,500; the same as the total paid by the company and the shareholder together.
Most contractors get confused because of the 10% national tax, forgetting this is only a notional amount and not a real amount of tax.
Another error that contractors often make is working out when a dividend will be taxable at higher rates.
When you are considering tax bands you need to take account of all your income, including bank interest, salary, rental income and anything else. You must also consider your gross income, i.e. before any income tax liabilities are suffered, including those before you receive the income in the first place
If your salary is £12,000 and you have a normal tax code you pay a bit of income tax and National Insurance (NI) and receive something closer to £11,250. Your gross income is still £12,000.
If you receive interest from a bank or building society you receive that income net, and would need to add back the tax deducted before you received it.
And we have explained that dividends are received after a notional deduction of 10%.
There are a few key points to note with the current rules:
- The dividend is notionally grossed up by the 10% notional tax credit
- There is no additional basic rate tax paid on the dividend actually received
- There is a higher rate liability (and also an additional rate of income tax if you are lucky to earn more than £150,000) where your personal income is high enough
- All income has to be considered before working out if you have to pay higher rates of income tax.
So what’s changing?
The new rules from 6 April 2016
The Summer Budget 2015 announced a number of changes to the taxation of dividends. The changes are summarised as:
- the introduction of a £5,000 dividend allowance
- the notional 10% tax credit has been abolished
- dividends will be taxed at special rates:
- basic rate at 7.5%
- higher rate at 32.5%
- additional rate at 38.1% r
- pension schemes and ISAs are unaffected
From 6 April 2016 the amount you receive as a dividend will be the actual amount that is treated as your gross income.
What does this actually mean?
From 6 April 2016 the amount you receive as a dividend will be the actual amount that is treated as your gross income. There will be no need to add the 10% notional tax credit. So you will appear to receive less income from the start. The positive effect of this will mean you won’t reach the thresholds for higher or additional rates of income tax so quickly.
The other positive change is that the first £5,000 of any dividends will automatically be at a nil rate of tax, regardless of the level of income you receive. All seems very good news so far. But this is not an addition to the normal tax bands.
Sadly, however, as we always learn, HMRC are never that generous. The price to be paid by all shareholders will be that all dividends above the £5,000 nil rate will suffer tax even within the basic rate band. The new rates are:
- 5% within the basic rate band
- 5% within the higher rate band
- 1% within the additional rate
The rates are then charged on the dividends received depending on each person’s income levels.
Overall, and comparing tax paid before and after the rules change, all taxpayers will be paying an additional tax charge that evens out at 7.5% at any tax rate band on all dividends over £5,000.
So let’s make these comparisons:
Assumptions: For the purposes of comparison we’ll assume that the personal allowances are absorbed by salary.
- Therefore both are ignored for tax purposes.
- No other income.
- Basic tax rate band is £32,000.
- Note that Corporation Tax has been paid by the company
An unexpected consequence
The comparisons on the previous page show that at certain levels (£28,800 and £39,470) the tax paid can be lower at a marginal rate. This is because the removal of the tax credit has the effect of delaying when income falls within a higher tax band. This can mean that you pay the same tax for a greater level of dividends at these marginal points.
We’ll now apply this to some examples for what a typical contractor might take in salary and dividends and show the difference in tax liabilities under the old rules vs the new rules.
Why are these changes happening?
The Chancellor expects to collect £2.5bn in additional tax in the 12 months from April 2016 from his new dividend taxation plan. Clearly part of the motivation is to reduce the deficit by raising further taxes. But the Government is also aware that tax motivated incorporation is increasingly a burden on the Exchequer.
Many contractors take a small salary and high dividends. This simple measure has a substantial financial benefit by reducing, if not entirely removing, the NI cost. The new dividend tax is also partly intended to remove part, although not all, the incentive to incorporate purely for tax purposes.
So what should you do?
If you plan to take a dividend, and let’s face it most contractors will be doing just that, you should consider whether to take that dividend before or after 6 April 2016.
But don’t get carried away. If the result of taking a dividend before April means your total income will cross from one tax band to another stand back and think carefully.
Your accountant should offer you a calculation, if you wish, to work out what’s best for your circumstances.
There would be no point in suffering higher rate tax just to avoid paying 7.5% later on. Your accountant should offer you a calculation, if you wish, to work out what’s best for your circumstances. Here are some ideas they should discuss with you:
Make use of the nil rate band
Each person will be entitled to the £5,000 dividend nil rate band from 6 April 2016. Couples could consider their shareholdings and spreading dividends between them to make full use of the exemption.
Make the most of each spouse’s basic rate tax allowance and tax bands
Couples should make full use of both their personal allowances and the basic rate tax band and maintain the most dividends at the lowest tax rates
Make use of ISAs
All taxpayers will see a tax increase of 7.5% on dividend income received above £5,000 a year. ISAs are not affected by the new tax payable therefore if you have a portfolio of other investments that pay dividends, consider transferring those other shareholdings into an ISA so you can shelter those dividends and increase the available exemption for dividends from your own company.
Rebalance other income
The dividend tax is linked to the rate of income tax you pay. Therefore reducing other taxable income could also reduce the amount of dividend tax paid. Consider transferring assets and income if your spouse is a lower earner to ensure both make full use of their personal allowances, the dividend allowance and the basic rate tax band.
Consider dividends before 6 April 2016
Careful planning now to make use of the allowances and basic rate band will maximise the dividends that can be paid before 6 April. This might offer the opportunity to accelerate a dividend to before the new tax comes into effect.
What all contractors should be doing is looking at how their company is structured in the first place and whether or not there are missed opportunities to have different classes of shares or additional shareholders to minimise the tax you pay. Your accountant can discuss these matters with you; and always be cautious as measures to reduce tax don’t always work as intended if they are not carefully considered and properly introduced.
What will dividend documents look like in the future?
When you currently declare a dividend you should be holding a directors’ meeting and passing a resolution to declare your dividend. If you don’t then you run the risk HMRC will argue the payment is not a dividend. You should also be creating a dividend voucher to show the amount of dividend and the tax credit. This is the legal document that shows HMRC that the tax credit you claim exists.
After 6 April 2016, although both documents will still be required the format of the dividend voucher will change. You will no longer have to include reference to the tax credit.
If you are already a Limited Company contractor or are thinking about setting up your own Limited Company, these changes to dividends shouldn’t be considered in isolation. There are many other benefits to be had from working through this trading model.
Working with a reputable contractor accountant means you’ll get all the guidance you need to prepare for changes to dividends and make the most of the opportunities available to you before and after 6 April 2016, while remaining compliant.
At Intouch Accounting we work with contractors every day so know what you need, when you need it. Sign up for our service and for a monthly fee you’ll get unlimited advice from a specialist contractor accountant throughout the year. Access to our online portal makes it easier than ever to keep up to date about where you and your Limited Company stand.
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Contact us today to discuss how to get the best from your Limited Company. Or, if you’re still thinking about making the move, we can chat through your options so you can make the right decision for you.
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