In his Summer 2015 Budget the Chancellor announced significant changes to the way in which company dividends are to be taxed with effect from 6 April 2016.
The changes will affect both investors and the proprietors of owner managed businesses operated through limited companies.
The New Rules
The key features of the regime to take effect from next year are as follows:-
• The notional tax credit that effectively discharges the basic rate tax liability due on dividend income will be abolished.
• The first £5,000 of dividends received by a taxpayer will be chargeable to tax at a rate of 0%.
• The tax rates that will be applied to dividends received in excess of £5,000 will be as follows.
- Basic rate taxpayer 7.5% (currently 0%)
- Higher rate taxpayer – 32.5% (currently 25%)
- Additional rate taxpayer – 38.1% (currently 30.6%)
In short the rate at which dividends in excess of £5,000 will be taxed after 5 April 2016 will be approximately 7.5% more than is presently the case.
Winners and losers
There will be winners and losers from the proposed changes.
Investors who are higher and additional rate taxpayers with dividend income of £5,000 per year or less will inevitably be better off under the new rules. In fact, the interaction of the £5,000 nil rate band and the new tax rates means that taxpayers falling into these brackets will be better off unless their dividend income exceeds something of the order of £20,000 per year.
For many basic rate taxpayers the £5,000 nil rate band will leave them no better nor worse off under the new regime as long as their dividend income does not exceed that level. Basic rate taxpayers with dividend income in excess of £5,000 are likely to be worse off under the new regime to the tune of the new 7.5% charge although in some cases the impact of the abolition of the tax credit and its effect on the allocation of income to different rate bands may mitigate the effect of this.
Owner managed businesses
The position with respect to the proprietors of owner managed businesses operated through limited companies is more complex.
Many such businesses arrange thier affairs so that the proprietor is paid a salary broadly equivalent to the national insurance contributions threshold and the remainder of the income taken from the company is drawn in the form of dividends. This approach minimises the combined tax liabilities of the company and the owner.
It is likely, therefore, that significant dividends (in excess of £5,000 per year) will be drawn from the company. In most cases the 7.5% increase in the tax rate at which dividends will be payable at all levels of taxation will outweigh the benefit of the nil rate band applying to the first £5,000 of dividends.
Despite the changes it will remain most tax efficient for owner managers of the limited companies to continue to draw their remuneration from their companies in the form of a limited salary with the balance taken as dividends. Of course, if the rates applicable to dividend taxation are increased further in the future, this point will require further consideration.
This conclusion will be reinforced by the fall in corporation tax rates from 20% to 18% that was also announced in the Summer Budget.
What planning should the proprietors of owner managed businesses put in place in light of the forthcoming changes?
The key issue relates to the timing of dividend payments. On the assumption that dividends are being drawn from companies at levels comfortably in excess of £5,000 at first sight it makes sense to accelerate the payment of dividends so that additional payments are made before 6 April 2016.
Some care does need to be taken so as not to extend this principle too far and, in practice, a long-term view of dividend payments will be necessary. There is nothing to be gained from crystallising a tax liability in the current year that would not have been incurred subsequently in any event.
For example, if a company director/ shareholder currently draws dividends so as to use up all of his or her basic rate band, paying additional dividends before 6 April 2016 will avoid the 7.5% tax rate increase taking effect after that date. If, however, it remains the business owner’s long-term strategy to continue to pay dividends at a rate within the basic rate band, paying additional dividends before 6 April 2016 will avoid the 7.5% rate increase taking effect after that date but will crystallise a higher rate liability in the current tax year at the rate of 25%.
Dividend payment strategies also need to be considered in the context of other tax issues. In the new year we'll look at the impact of the forthcoming pension changes for the highest earners and action to capture tax relief in this area before it disappears may enable more dividends to be paid in the current tax year at the present favourable rate.
We will be contacting all of our owner managed business limited company clients as the end of the current tax year approaches in order to agree with them a bespoke strategy for dealing with these changes in order to ensure that the adverse effects are mitigated and tax planning opportunities are maximised.
By Michael Marsh, Partner and Head of Tax Services
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