As part of my latest series looking at the best ways to extract funds from a private company so as to make minimum payments to the authorities, I began last week to consider the topic of dividends.
Taking the example of a company paying corporation tax at the rate of 19 per cent which wishes to utilise £10,000 for the benefit of its shareholding director, who is a 40 per cent taxpayer and earning above the employee's upper earnings limit, I showed that the position in respect of dividends for 2003/04 is as in Table A. This can be compared with the position for bonuses (Table B).
In these circumstances, purely on tax grounds (and there are other factors to consider), the dividend will look most attractive. However, the position will change depending on the rate of corporation tax paid by the company and the director's marginal rate of income tax.
It is important to note that the subject of dividend payments from small private companies did not pass without comment in the Chancellor's pre-Budget report. There was no specific press release, consultation document or draft legislation but it has been made clear that the Treasury is concerned with the tax leakage (in its eyes) taking place as a result of the introduction of the £10,000 nil-rate corporation tax band.
Apparently (surprise, surprise), unincorporated small businesses with profits below the £10,000 threshold are incorporating and are then paying dividends out of profits which have not suffered corporation tax but which nevertheless carry a 10 per cent tax credit. This means that no tax is paid by basic-rate taxpaying shareholders and a reduced rate is paid by higher-rate taxpayers. Oh, and no National Insurance is payable either.
Well, what did it expect? We look forward to reading its proposals for dealing with this situation.
Pre-tax profit £10,000
Corporation tax @ 19 per cent £1,900
Net to distribute £8,100 (1)
(1) Because the dividend is not deductible, the corporate tax liability for the company remains at 19 per cent, that is, £1,900, so £8,100 is available for distribution.
Shareholder receives £8,100
Grossed up by 10 per cent £900
Taxable £9,000 (1)
Less tax @ 32.5 per cent £2,925 (2)
Less tax credit £900
Net to pay £2,025 (3)
Net dividend £6,075 (4)
Effective rate of tax 39.25 per cent
(1) The dividend is £8,100 grossed up by 10 per cent tax credit to £9,000.
(2) The tax rate payable on the gross dividend by a higher-rate taxpayer is 32.5 per cent.
(3) Tax of £900 is already deemed to have been paid via the tax credit and so the balance liability is £2,025.
(4) The director is left with a net dividend of £6,075. The dividend has therefore suffered an effective rate of tax of 39.25 per cent.
Bonus £8,865 (1)
Employer's NIC £1,135
Total £10,000 (all deductible)
Higher-rate tax £3,546 (2)
Net received £5,230 (3)
Effective rate of tax 47.7 per cent
(1) Where the £10,000 is paid by way of Schedule E bonus, the whole amount is deductible. However, out of the £10,000, employer's National Insurance of 12.8 per cent is payable, again deductible. So taking account of £1,135 employer's National Insurance, £8,865 is available as a bonus.
(2) The director will suffer 40 per cent higher-rate tax and the 1per cent NIC charge via the PAYE system on the bonus. This liability equals £3,635.
(3) He is left with £5,230 net in his hands. The £10,000 available in the company has effectively suffered tax at 47.7 per cent.