Insights

Last month we highlighted the complexity that the new £5,000 dividend allowance will add to the personal tax regime from 6 April 2016. For almost all those who receive dividend income it will mean higher taxes in the future, which means you may want to reconsider how your personal income is structured.

Currently, dividend income is taxed at 0%, 25% or 30.55%, depending on whether your total income (including the dividend itself) puts you into the basic rate (20%), higher rate (40%) or top rate (45%) income tax bracket.

From 6 April, these rules will change. Although the first £5,000 of dividend income is tax-free, the tax rates charged on dividend income will increase by 7.5% for all tax brackets and become 7.5% (basic rate), 32.5% (higher rate) and 38.1% (top rate).

In addition, due to the way dividend income is treated, it will mean that some taxpayers will be paying a higher marginal rate of tax. This is because dividend income is added to all other income in order to calculate the top rate of tax and in arriving at this top rate of tax, no deduction is given for the £5,000 tax-free dividend amount. In practical terms, it means a taxpayer could in fact be taking less than £5,000 in dividends, and whilst they will not then pay any tax on the dividend income, their top rate of tax might increase, therefore increasing their overall tax bill on other income.

Example to explain how the dividend allowance increases tax rates

Peter earns an annual salary of £43,000 and he receives a dividend of £5,000.

After deducting the personal allowance of £11,000 his salary falls within the basic rate band of £32,000 and his employer will therefore deduct basic rate tax through PAYE. His dividend falls within the tax free allowance of £5,000, so no tax is due on that dividend.

Under the old rules, the £5,000 would have suffered higher rate tax at the effective rate of 25%. The result is that his net income will increase by £1,250 under the new rules at this income level.

We blogged about this issue last month in more detail - read more about the dividend allowance and tax.

How could the new dividend tax rates affect you?

Basic rate taxpayers receiving dividend income in excess of the £5,000 dividend allowance will inevitably pay more tax, because currently they pay no tax on dividend income;

Investors who pay tax at 40% or 45% will see a tax saving on dividend income of up to £21,000 (40% taxpayers) and £25,000 (45% taxpayers);

Those who take large dividends will see a range of increases in their tax liability, for example:

• A 25% taxpayer receiving net dividend income of £28,000 will see an increase of £1,725;
• A 40% taxpayer receiving net dividend income of £90,000 will see an increase of £5,125;
• A 40% taxpayer receiving net dividend income of £135,000 will see an increase of £8,500; and
• A 45% taxpayer receiving net dividend income of £200,000 will see an increase of £13,184.

The new regime will also have a significant negative effect on private company owners who employ their spouses. A couple working together in these circumstances, with each taking a dividend, could be at least £5,000 worse off.

Impact on owners of private companies

The new legislation has been developed to remove the tax advantages that previously existed where a company owner could take a small salary and receive the bulk of his or her remuneration as a dividend. This strategy means they are able to avoid paying national insurance contributions and until now, if they paid tax at only the basic rate band, their dividend income has been tax free. Now they will inevitably face higher tax charges on dividend income; even so, as the example below shows, shifting the salary/dividend split and taking a larger salary will not necessarily be the best solution.

Example: Sally is a consultant operating through her own limited company. Her income structure includes a £7,500 salary, which means she is below the threshold at which NICs become payable; and £80,000 of dividends of which a portion fall within her basic rate band. She currently pays £12,000 in personal tax through self- assessment. From 6 April, her tax bill will increase by £4,500.

Long term, although Sally will be facing a higher tax bill, her current remuneration structure is as tax efficient as possible. If she were to increase her salary to reduce the level of dividends she takes and avoid the higher rate of dividend tax (32.5%), this would incur NICs and mean an extra tax of £8,000.

More taxpayers will enter the self assessment system

The other effect of the new rules will be that more taxpayers will need to complete a self assessment return from 6 April 2016, as illustrated in the example of Peter above.

What action can be taken now?

Each situation is different and there is no one size fits all solution to the issue. If you are concerned about the amount of tax you will be paying from 6 April 2016, please arrange to speak with one of the tax team who can model the tax effects of different options. We can identify how much higher your tax bill will be and whether you should restructure your remuneration strategy.

However depending on your individual circumstances, one or more of the following may be appropriate:

• If your company has sufficient retained profits it may be advantageous to withdraw a larger dividend before 6 April 2016. This can be allocated to your director’s loan account and withdrawn as the company has cash available. Whilst this will accelerate your personal tax liability, it will also reduce it and if your loan account is in credit, the company may pay you interest on your credit amount;

• If you are already paying the top rate of tax and withdrawing a large dividend that incurs the highest rate of tax, you will benefit from taking an accelerated dividend payment to take advantage of the lower tax rates before 6 April. For example, a top rate taxpayer taking a £200,000 dividend will benefit from receiving an accelerated dividend payment now for the 2016-17 tax year and then reducing dividend payments in subsequent years – provided sufficient funds are available to do so;

• If you own the company premises – either an office or if you work from home – the company could be paying you rent at market rates. This is tax-deductible for the company and is not chargeable to national insurance contributions. However, there is a disadvantage to this strategy because it will affect the ability to claim entrepreneurs’ relief on disposal of business premises - expert advice is recommended;

• For smaller companies, where the owners are withdrawing the bulk of profits as dividends each year, the new dividend regime may make it more advantageous to disincorporate and operate as a sole trader or partnership from 6 April. This needs careful modeling because there are no tax reliefs available in relation to the disincorporation itself; the tax payable as a company or sole trader may be very similar; and operating as a company entity offers other benefits.

As these scenarios highlight, there is a lot for company owners and taxpayers with income from dividends to consider. Those affected can be considering a variety of options between now and the end of the current tax year. What’s important as a first step is to explore the future impact the new dividend tax allowance will have as each person’s circumstances are very different.

If you would like to discuss your remuneration strategy in detail please contact Lesley Stalker or another member of the tax team - las@rjp.co.uk.