The new tax year saw the introduction of the new dividend tax. The regime is squarely aimed at shareholder directors who have hitherto made dividend payments the standard way to take money out of a company without paying National Insurance contributions.
The savings were very considerable. Now, taking dividends rather than salary or bonuses out of companies is still worthwhile but the benefit is a good deal less than it was for most shareholder directors, especially if drawing large dividends.
In the centre of the legislators’ sights were the many thousands of personal services companies that have grown and employed the likes of IT consultants and other such freelancers who might otherwise have been self-employed or employed by their contractors and in either case paying their whack of NICs.
The new rules for dividend tax have also further complicated the tax system – if such a thing were possible. Dividends no longer come with a tax credit of 10 per cent. The tax credit essentially meant basic rate taxpayers did not pay tax on their dividends and other taxpayers paid special rates on their dividends plus tax credits.
Abolition of the tax credit also makes a difference to how much taxable income someone has. Until 6 April you calculated how much dividend income an investor received by grossing up the tax credit: so, £1,000 dividend received actually meant the individual had a taxable income of £1,111. Now the £1,000 you receive as a dividend is the amount on which you pay tax.
The abolition of the tax credit has its good side. People who receive dividends have had their taxable income cut by 10 per cent and that is an important factor when it comes to deciding how much income is subject to higher or additional rate tax or how much is nudged into one of those irritating high marginal rate bands (for example, where child benefit is taxed or the personal allowance is withdrawn).
However, there are complications too. The first £5,000 of dividends an individual receives is taxed at nil. The £5,000 is called an “allowance” but this is misleading. It is not an allowance; it is just a nil rate band. In particular, for example, the £5,000 still counts towards the higher rate threshold. The good news for wealthier clients is they get this £5,000 allowance or nil rate band in the same way as non-taxpayers and basic rate taxpayers. So this is a tax cut for them for modest amounts of dividend income.
Basic rate taxpayers and non-taxpayers are no better off at this level of dividend income. Basic rate taxpayers will then start to be worse off on dividend income above £5,000, at which point the new dividend tax rates start to bite.
- Basic rate taxpayers will have to pay 7.5 per cent dividend tax on all dividends they receive after 5 April 2016
- Higher rate taxpayers (that is, 40 per cent taxpayers on earnings, etc) have to pay 32.5 per cent
- Additional rate taxpayers (45 per cent taxpayers on earnings, etc) have to pay 38.1 per cent.
The rate applicable to trusts for dividends is 38.1 per cent and trusts do not get the £5,000 “allowance”.
Behind some tricky arithmetic, the rate of tax on dividends has effectively gone up by 7.5 per cent. And if you cannot follow the change easily, that is because the old tax rates on dividends were on “dividends plus tax credit” and now they are just on the dividends themselves.
So is it still worth drawing a dividend from a company rather than taking a salary or bonus? The answer continues to be yes but the payoff is now rather less than it was – at least for larger dividends.
One of the stock questions advisers will need to master will be: have you used your dividend “allowance”? For those without investments, the obvious course of action will be to try to pay at least £5,000 by way of dividends. Not all companies can pay dividends – it is necessary to have enough reserves, for instance – but most probably can.
So at this level dividends are likely to be much more tax-efficient than a salary or bonus, which are subject to tax and both employer and employee NICs. Below the individual’s £5,000 allowance, it would cost the company £1,000 for the shareholder to receive £1,000. Do not forget, dividend payments are not tax deductible for companies.
Above the £5,000 waterline the comparative advantages of dividends are lower. So, for a higher rate taxpayer who just pays 2 per cent employee NICs, it would cost the company a gross £1,962 in salary or bonus to pay such an employee £1,000 net. The company should then qualify for 20 per cent corporation tax relief on this amount, bringing the net cost down to £1,570.
In contrast, if the company paid the individual a dividend, the higher rate taxpayer would have to pay 32.5 per cent tax on the dividend, and the company would therefore have to pay a dividend of £1,481.48 for the shareholder director to have an after-tax income of £1,000. That is just 5.6 per cent less than the bonus, so it is still worthwhile. The NIC saving outweighs the extra dividend tax.
Danby Bloch is chairman at Helm Godfrey