One of the challenges facing tax authorities around the world is how to tax individuals on dividends paid by companies, given that those companies generally pay tax on profits before any such distribution is made. The approach in the US, for example, where corporation tax rates are higher than those in the UK, is to charge an additional 15% withholding tax on dividends.
In the UK, however, investors have, at least since 1973, been afforded recognition of the fact that some tax has already been paid by the company. Until 1993, they were treated as though basic rate tax had already been paid and therefore came with a tax credit for that amount, which was reclaimable by non-taxpayers. In 1992/93, therefore, when the basic rate of tax was 25%, a £75 net dividend was accompanied by a £25 tax credit that could be reclaimed by tax-exempt investors such as non-taxpayers and pension funds. To ensure the tax was actually collected, the company had to pay advance corporation tax (ACT) equal to the tax credit, which could in reality exceed the company’s actual corporation tax liability.
The system was then amended by Norman Lamont in the 1993 Budget so that while the basic rate remained at 25% the tax credit and ACT were reduced to 20%, which was matched by a new 20% basic rate for dividends. For the Exchequer, this was doubly beneficial, as the lower credit meant more income tax from higher-rate taxpayers and a lower reclamation by non-taxpayers, while the actual corporation tax receipts did not change.
In 1997, Gordon Brown tweaked the system further with another reduction in the tax credit and basic rate for dividends to 10%, accompanied by the withdrawal of the ability for pension funds (immediately) and individuals and PEP/ISA investors (from 1999/2000) to reclaim the tax. Higher-rate taxpayers ended up paying more tax (an extra 22.5% after allowance for the 10% credit), and while ACT continued at 20% until April 1999, it was then scrapped, henceforth removing any link between the dividend tax credit and the corporation tax paid.
Move forward to 2015 and another chancellor, George Osborne, proceeded to scrap the 10% tax credit as well, thus moving the UK towards the US model of dividend taxation. While that could have been the end of it, with further adjustments to the rates for higher and additional rate taxpayers to maintain the same tax receipts, he opted to go further and introduced more far-reaching reforms.
The first was a new dividend allowance of £5,000 for all individual taxpayers from 2016/17 onwards, but this was accompanied by additional tax rates on dividends above this figure of 7.5% for basic-rate taxpayers, 32.5% for higher-rate taxpayers and 38.1% for additional-rate taxpayers – a rise, therefore, in all effective rates of around 7.5% (see Table 1).
Table 1
|
Basic-rate taxpayer (£) |
Higher-rate taxpayer (£) |
Additional-rate taxpayer (£) |
||||
| 2015/16 | 2016/17 | 2015/16 | 2016/17 | 2015/16 | 2016/17 | |
| Dividend | 90 | 90 | 90 | 90 | 90 | 90 |
| Tax credit | 10 | – | 10 | – | 10 | – |
| Taxable | 100 | 90 | 100 | 90 | 100 | 90 |
| Tax liability | 10 | 6.75 | 32.50 | 29.25 | 37.50 | 34.29 |
| Tax credit | 10 | – | 10 | – | 10 | – |
| Tax to pay | – | 6.75 | 22.50 | 29.25 | 27.50 | 34.29 |
While the chancellor claims that 85% of taxpayers will not be worse off and over a million will pay less tax, this is perhaps another fine example of the enthusiasm for all holders of that appointment to reform (i.e. increase) those taxes that are poorly understood by the majority of the public (i.e. voters).
It is indeed good news for taxpayers with income above the higher-rate threshold and who have dividends under £5,000, representing a saving of up to £1,250 for those paying 40% (who will only be worse off than currently when their dividend income exceeds £21,667) and up to £1,528 for those paying 45% (who are worse off only when their dividends exceed £25,250).
The losers will be those who pay only basic-rate tax but have dividends above £5,000; these individuals currently pay no tax at all on dividends until they reach the higher-rate threshold, but from 2016/17 they will pay 7.5% on all those in excess of the first £5,000. This group is likely to comprise not only some who own substantial investment portfolios (the relevant value depends on the yield after any fund charges) but also those who own substantial shareholdings in their own businesses and either remunerate themselves via dividends rather than salary or use a company structure to hold rental properties and would thus avoid the new rules restricting interest relief for individual buy-to-let investors.
An illustration of the size of portfolio affected is given in Table 2.
Table 2
| Yield | 1% | 2% | 3% | 4% | 5% |
| Portfolio to produce £5,000 | £500,000 | £250,000 | £166,667 | £125,000 | £100,000 |
The impact on two individuals (who are not caught by IR35) using dividends in lieu of salary is illustrated below.
Example 1 – A contractor
Thomas operates his contracting business via a limited company and takes just enough income to keep himself below the higher-rate threshold, drawing a salary (£8,000) just below the National Insurance contribution (NIC) threshold and net dividends of £30,946. Disregarding the 2016/17 changes to the personal allowance and thresholds, Thomas’s position is illustrated in Table 3.
Table 3
| Earnings | £8,000 | £8,000 |
| Dividend (net) | £30,946 | £30,946 |
| Tax credit on dividend | £3,438 | Nil |
| Total income | £42,384 | £38,946 |
| Personal allowance | £10,600 | £10,600 |
| Taxable income | £31,784 | £28,346 |
| Tax on earnings | Nil | Nil |
| Tax on dividends | Nil | £1,751* |
| Total tax | Nil | £1,751 |
*As Thomas’s salary leaves £2,600 of his personal allowance unused, he does not begin to pay tax on his dividends until they exceed £7,600.
Since the dividend is no longer grossed up and, again, disregarding the change in the higher-rate threshold (which will be £43,000 in 2016/17), he could draw a further £3,439 of net dividends before incurring higher-rate tax in 2016/17, which would entail paying another £258 (£3,439 x 7.5%) in tax, whereas if he had done so in 2015/16 his tax on that amount would have been £860 (£3,439/0.9 x 22.5%).
Once his income exceeds the higher-rate threshold, each £100 of dividend will be worth only £67.50 after 6th April 2016, compared with £75 before that date.
Example 2 – Bonus or dividend?
Annabel, a higher-rate taxpayer earns £50,000 and draws £7,500 of dividends from the company of which she is a director. The business has earned profits of £25,000 and she is considering how best to withdraw it (Table 4).
Table 4
| 2015/16 | 2016/17 | |||
| Bonus | Dividend | Bonus | Dividend | |
| Marginal gross profit | £25,000 | £25,000 | £25,000 | £25,000 |
| Corporation tax at 20% | N/A | £(5,000) | N/A | £(5,000) |
| Dividend | N/A | £20,000 | N/A | £20,000 |
| Employer’s NI contributions £21,968 at 13.8% | £(3,032) | N/A | £(3,032) | N/A |
| Gross bonus | £21,968 | N/A | £21,968 | N/A |
| Director’s NIC £21,968 at 2% | £(439) | N/A | £(439) | N/A |
| Income tax | £(8,787) | £(5,000) | £(8,787) | £(6,500) |
| Net benefit to director | £12,742 | £15,000 | £12,742 | £13,500 |
Although she would receive 60% of the gross benefit as a dividend under the 2015/16 regime, the new rules mean she will lose a further £1,500 in tax as the effective rate on gross profits increases to 46%, although the dividend route is still more tax-efficient than taking a bonus.
For business owners, a number of points are apparent:
- There is obvious merit to bringing forward dividend payments into 2015/16, which the Treasury anticipates bringing in additional revenue compared to its original expectations. Although this is offset to an extent by a fall the following year, by 2019/20 the forecast additional revenue is around £2bn annually.
- The Treasury expects reducing the tax advantages of incorporation will cause fewer businesses to opt for corporate status where the motivation is purely or largely for tax reasons.
- With the corporation tax rate due to be reduced to below the basic rate of income tax, incorporation for tax reasons would have looked increasingly attractive but is now less so.
- It is possible that reducing the motivation to incorporate is related to the Government’s declared intention not to increase NIC rates only for employers and employees; with the Class 2 rates paid by the self-employed due to be scrapped and Class 4 being revised, the rate of the latter may conceivably be increased from the current 9% to match the employee rate of 12%.
There are also changes for other recipients of dividends, notably the trustees of interest-in-possession trusts and the executors and personal representatives of an estate, for whom the 7.5% rate will now also apply.
However, the trustees/executors are then required to distribute income to the estate beneficiaries or life tenants, who may not be subject to the additional rate personally. Since the trustees/executors must pay the 7.5% rate on dividends received, a £1,000 receipt is passed on to a beneficiary as only £925 with an attached credit of £75. This is neutral if the recipient has already exceeded their own dividend allowance but, if not, they will need to make a tax reclamation. While it is possible that the situation will be avoided by the dividend being mandated direct to the beneficiary, HMRC has yet to confirm this.
For other trusts, trustees will not qualify for the new £5,000 dividend allowance and the dividend trust rate will continue to mirror that for additional-rate taxpayers, and so will be 38.1%.