Changes to dividend tax

Changes to the taxation of dividends will have a significant impact on owner-managers of small companies. The changes are expected to increase tax and change the way that business owners draw remuneration.

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The taxation of dividends will change from 6 April 2016 as announced by the Chancellor in July’s Budget.  We now have greater clarity on how this will work following publication of draft legislation in the Finance Bill 2016.

Many small companies are structured as limited companies which means that directors can opt to draw income through a combination of salary, bonus and dividends. Under current rules, drawing dividends allows directors to minimise their exposure to personal income tax and also reduces their employer and employee national insurance contributions.

The proposed dividend tax changes will reduce some of the incentives to draw dividends over salary, but a low salary and high dividend strategy will still remain tax-efficient after the changes.

Dividend tax rules

Under the current regime, when a shareholder draws dividends from his business, they are paid net and have a notional ten per cent tax credit. Non-tax payers and basic rate tax payers have no further tax to pay. Higher rate tax payers pay an additional 25 per cent and 30.56 per cent on the net dividend received.

From April 2016, the tax credit is to be abolished and dividends will be paid gross. Shareholders will have a tax-free dividend allowance of £5,000 and excess dividends will be taxed at 7.5 per cent (basic rate), 32.5 per cent (higher rate) and 38.1 per cent (additional rate).

Salary rules

Salary payments, over certain limits, are liable to both income tax and national insurance contributions paid through PAYE. Salary payments also give rise to an employer national insurance liability.

Salary or dividend?

Salary and employer national insurance payments are a direct cost to the business and tax deductible for corporation tax. Dividends are treated as an appropriation of profits and not deductible for corporation tax; they need to be paid from post-tax profits.

The following example compares the situation under current and new rules, for a basic rate taxpayer who has already drawn a salary of £11,000, using the tax-free personal allowance in full, and wishes to draw a further £20,000 from his/her company.

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The dividend route still remains more tax efficient than salary after April 2016, but the tax gap is closing.

What might this mean in practice?

For profitable businesses, it is worth looking at bringing forward dividends to the current tax year before the increases apply.

For shareholders who are approaching retirement, rather than take dividends, they may prefer to direct company contributions into their pension. The pension contribution would be tax deductible for the business providing it meets the “wholly and exclusively” test. Pension benefits can then be accessed using the new flexible regime, with 25 per cent payable tax free and the remainder subject to income tax.

The increase in tax will make the decision to incorporate from a sole trader to a limited business more finely balanced, especially when considering the additional administration and reporting burdens on companies. Unless profit is at least £30,000 to £40,000, then it may not be worth incorporating.

Small business owners who are additional rate tax payers may be incentivised to put their businesses up for sale. If they increase profits and pay themselves a dividend, they will pay a 38.1 per cent top rate dividend tax. The top rate of capital gains tax that would apply on a business sale is 28 per cent, but would reduce to just 10 per cent if they qualify for entrepreneur’s relief.

This article was first published in Business Advice on 18 August 2015.