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The new dividend tax – a brief guide

The new dividend tax – a brief guide

One of the biggest shocks to come in the 2015 summer budget was the changes to dividend taxation to be introduced from April 2016. As an accountancy practice acting for countless small limited companies it immediately became apparent that this was going to have a big impact on our clients.

Initially, information was vague on how the new regime would work but now HMRC have issued some guidance and things have become a little clearer.

To help our clients, this document will set out the basic changes and then provide some illustrative examples designed to broadly match the situations many clients will find themselves in.

Quick links:

How will the new system work?

What will the impact be?

Illustrative examples:
1) Director/shareholder with £8,000 salary and dividends taking taxable income to Basic Rate band
2) Director/shareholder with £8,000 salary and dividends taking taxable income to £50,000
3) Director/shareholder with £8,000 salary and dividends taking taxable income to £100,000
4) Director/shareholder with £8,000 salary and dividends taking taxable income to £150,000
5) Summary tables

How will the new system work?

New rates of tax will be introduced for dividends; 7.5% in the basic rate band, 32.5% in the higher rate band, and 38.1% in the additional rate band.

The dividend tax credit will be abolished with dividend income no longer being grossed up in the personal tax computation. Previously a dividend of £9 paid by the company to the taxpayer would have been grossed up to £10 on the tax return with a £1 notional tax credit. The total dividend income assessable would have been £10. This had an impact on the tax payable and the availability of allowances etc.

A dividend allowance of £5,000 has now been introduced. This is, effectively, a nil rate band for dividend income (the first £5,000 of dividend income is tax free). Any dividend income over and above the first £5,000 is taxed as if the £5,000 has used up either the basic rate or higher rate band.

What will the impact be?

For most small business owners it will mean an increase in their tax liability. It will still be advantageous from a tax perspective to operate through a limited company rather than as a sole trader or partnership but the tax saving has been diminished significantly.

For some the new system will actually lead to tax savings. Some of these scenarios are quite surprising. For instance, someone on a salary of, say, £90,000 with £5,000 of dividend income could see a tax saving of £1,625. There are also some interesting scenarios for people who currently have their child benefit clawed back, with an overall improvement in their tax position in some cases.

Ellis Lloyd Jones will be advising its clients individually on the impact the tax change will have on them.
Illustrative examples

Other analysis on this subject has tended to centre round showing the difference in tax cost between operating as a sole trader/partnership versus a limited company under the new rules. Rather than take this approach we have opted to provide clients with a number of scenarios that are designed to match the most common income extraction policies adopted by the small business owner.
All of the scenarios are based on the set level of income for the business owner.

However, as the new system removes the notional tax credit this makes it difficult to compare like with like. For this reason we have assumed that the business owner will continue to draw the same amount of cash from the business after the new system is introduced.

Scenario 1 – Director/shareholder with £8,000 salary and dividends taking taxable income to Basic Rate band

Jayne has a sweet shop which she runs through a Ltd company. She makes reasonable profits and takes an £8,000 salary from the company. The balance of her income is drawn as a dividend. In recent years this has been set at the level of the basic rate band, meaning she paid no tax outside of the company.

Under the old tax system she would have had to draw the following from the company to make her income equal the basic rate band:

Salary £8,000
Dividend £31,500 (net) £35,000 (gross)
£8,000 + £35,000 = £43,000 (BR band limit)
She would have paid no tax personally on these sums

Under the new system if she draws the same amount from the company:
Salary £8,000
Dividend £31,500 (no grossing up)
£8,000 + £31,500 = £39,500
She will pay tax of £1,763.

Scenario 2 – Director/shareholder with £8,000 salary and dividends taking taxable income to £50,000

Atticus runs an equality in the work place consultancy company. He makes profits of approximately £70,000 after corporation tax each year. He is married with two children and his wife earns £12,000 p/a from a part time job. To maintain their entitlement to Child Benefit, Atticus draws an annual taxable income of £50,000 from the company. This is made up:

Salary £8,000
Dividend £37,800 (net) £42,000 (gross)
£8,000 + £42,000 = £50,000 (Child Benefit taper threshold)
His tax liability would have been £1,275

Under the new system if he draws the same amount from the company:
Salary £8,000
Dividend £37,800 (no grossing up)
£8,000 + £37,800 = £45,800
He will pay tax of £2,935, an increase of £1,660.

Scenario 3 – Director/shareholder with £8,000 salary and dividends taking taxable income to £100,000

Kathleen runs a film special effects company. The company is very profitable but Kathleen doesn’t need to extract all of the profits. She makes substantial pension contributions from the company and extracts taxable income up to £100,000 per year from the company, thus avoiding having her Personal Allowance tapered away:

Salary £8,000
Dividend £82,800 (net) £92,000 (gross)
£8,000 + £92,000 = £100,000 (Personal Allowance taper threshold)
Her tax liability would have been £12,525

Under the new system if she draws the same amount from the company:
Salary £8,000
Dividend £82,800 (no grossing up)
£8,000 + £82,800 = £90,800
She will pay tax of £17,560, an increase of £5,035.

Scenario 4 – Director/shareholder with £8,000 salary and dividends taking taxable income to £150,000

Tony runs a company providing professional after dinner speakers. He extracts £150,000 of taxable income from the company, keeping himself below the additional rate tax band:

Salary £8,000
Dividend £127,800 (net) £142,000 (gross)
£8,000 + £142,000 = £150,000 (Additional rate threshold)
His tax liability would have been £28,150

Under the new system if he draws the same amount from the company:
Salary £8,000
Dividend £127,800 (no grossing up)
£8,000 + £127,800 = £135,800
He will pay tax of £36,760, an increase of £8,610.

Summary Table:

table 1

The above calculations assume that the business owners continue to draw the same amount of cash from their business as they did under the old system. If they chose to increase the cash they draw to push their income to the threshold they met previously they would see a corresponding tax increase over and above that detailed above. For example, Jayne in scenario 1, would have to increase her cash drawings by £3,500 to bring her income up to the basic rate band under the new system. This would lead to an additional tax liability of £262.50 (£3,500 x 7.5%).

The table below shows the new tax position in the above scenarios if each individual continues to set their income at the relevant threshold (i.e. increases the amount they draw from the company to compensate for the lack of grossing up):

table 2