The importance of dividends (particularly reinvested dividends) as a contributor to investment returns is undeniable. So their taxation is of considerable interest.
The introduction of the £5,000 dividend allowance from 6 April 2016, with an increase of 7.5 per cent to the rate of tax applying to dividends above the allowance, represented a significant change to investment taxation.
But it was announced in the Budget earlier this month that from 2018/19 the allowance will reduce to £2,000. The stated driver for this change was the desire to reduce the attraction (and resulting tax loss generated) of incorporation and the taking of income by way of dividends as opposed to salary by owner managers. I will be talking about that a bit more in a later article.
As well as looking to reduce the existing differentials in the taxation of earnings, the Chancellor also made it clear he was seeking to reduce the benefit to investors attached to tax-free dividends.
He said: “The dividend allowance has increased the tax advantage of incorporation. It allows each director/shareholder to take £5,000 of dividends out of their company tax free, over and above the personal allowance. It is also an extremely generous tax break for investors with substantial share portfolios.
“I have decided, therefore, to address the unfairness around director/shareholders’ tax advantage, and at the same time raise some much needed revenue to fund the measures I shall announce today, by reducing the tax-free dividend allowance from £5,000 to £2,000 with effect from April 2018.
“About half the people affected by this measure are director/shareholders of private companies. The rest are investors in shares with holdings worth, typically, over £50,000 outside Isas. And, of course, everyone will benefit from the generous £4,760 increase in the annual Isa allowance to £20,000, and the further increase in the personal allowance to £11,500 from April.”
The Chancellor seemed eager to point out most “ordinary people” would not suffer as a result of the change. “A Government for the many; not the few,” remember.
But the £5,000 allowance has only been available since the beginning of the 2016/17 tax year and now only has one year left to run. It also came with the increases to the tax rates on dividends that exceeded the allowances. Those increased rates will continue. So less benefit, same potential detriment.
What does this all mean for investors, then? Simply put, from 6 April 2018 the new dividend allowance will reduce the size of portfolios that can deliver tax-free income.
It will also reduce the threshold above which investment bonds could be considered for their tax-deferring qualities.
The size of portfolio that will deliver a tax-free income with the reduced dividend allowance will, of course, depend on the yield, as the table below illustrates.
|Portfolio size||Yield||Tax free dividend|
It is also worth remembering as long as a fund does not have more than 60 per cent of its investments in fixed interest stock, the emerging income payment (even though it may be contributed to by interest) for the investor will be taxed as a dividend.
Crunching the numbers on collectives
Despite the drop in the allowance, there is still a positive message to convey to investors in collectives. Assuming capital gains can be managed on a yearly basis to use the annual exemption (increasing to £11,300 in 2017/8), reasonably sizeable portfolios can produce entirely tax-free returns. And that is on top of the no brainers of pensions and Isas.
Even at the higher end of the yield curve, you could look at a couple investing £100,000 between them and expect tax-free returns.
However, as mentioned, with the reduction of the tax-free dividend allowance to £2,000 comes the reduction of the portfolio threshold above which it may be worth considering an investment bond for its tax deferment qualities.
Of course, the choice of a bond or collective is not a binary one but tax is the most important factor. And although the taxation of capital gains cannot be ignored it is hard to make a tax case for considering investment bonds until the value of the fund that produces a dividend that is tax-free is exceeded.
Wrapper allocation to maximise relief and flexibility – especially given future tax uncertainty – remains a strategy well worth considering.
Tony Wickenden is joint managing director of Technical Connection. You can find him Tweeting @tecconn