With all the (quite understandable) concentration on pension reform it is not surprising to see the massive change to dividend taxation, taking effect from 6 April, has gone a little under the radar. Here is what we know about it:
- The abolition of the dividend tax credit and the consequent end to the need to gross up the net dividend received to work out the tax on it, then to deduct the tax credit to work out the actual tax payable on the dividend
- The first £5,000 of dividends being tax-free for all
- The 7.5 per cent increase in the effective rate once you have exceeded the £5,000 allowance. By “effective rate” I mean the rate of tax found by expressing the tax actually payable by the investor as a proportion of the net dividend received, for example, 25 per cent for higher rate taxpayers currently
- Basic rate taxpayers being no worse off under the new rules (though there will be no basic rate “winners” from the change either).
But facts are one thing. What does it all mean? Well, it depends on the circumstances but HM Revenue & Customs believes 85 per cent of dividend-receiving taxpayers will be better off under the new rules. Given the “unconditional” £5,000 tax-free dividend allowance, that seems a reasonable statement. But the change is estimated to generate £2bn of extra tax.
So where is it coming from? A good guess would be owners of small and medium-sized enterprises paying themselves by dividends (that exceed £5,000 for basic rate taxpayers and over £21,667 for higher rate taxpayers) instead of salaries.
So what does this mean for advisers? Well, in the face of such a fundamental change, they have a responsibility to engage with all their SME-owning clients and all investor clients with investments beyond pension and Isa wraps.
The key discussion for SME owners will be how to extract funds from the company in the most tax-efficient way. Dividends are still likely to be the most effective way, in terms of tax and National Insurance, to remove funds from a company after 5 April, just not quite as attractive as they are under the current rules.
Unsurprisingly, given the dividend tax change does not “kick in” until the next tax year, some SME owners and their advisers may be considering making an early (2015/16) dividend declaration. In making the decision you should remember that, although you will secure a lower effective tax rate (assuming you are not a basic rate taxpayer), you will also bring forward the tax payment date in respect of the dividend to 31 January 2017 (from 31 January 2018), assuming it would have been otherwise declared in the 2016/17 tax year.
You should know the deduction of a dividend to avoid next year’s higher tax rates will not be caught by any anti-avoidance or anti-forestalling provisions. HMRC has even planned on receiving tax early because of such actions. After all, good tax cashflow is something that HMRC likes.
For investors there will be an interesting need to re-assess the choices beyond pension and Isa wrappers. Should investments be held “unwrapped” as collectives or “wrapped” in a UK/offshore bond to secure the optimum tax outcome?
There is no easy answer, as it depends on the facts, but the adviser needs to model the future to ascertain the course most likely to deliver the optimum outcome and previous decisions on how to extract funds from a company may need to be reviewed.
Fundamentally, no one can really know whether the wrapped or unwrapped decision will turn out to be the right one by delivering the optimum after-tax outcome. Because the future is essentially uncertain, a process of wrapper allocation based on a range of reasonable probabilities has to be worth considering.
To do this you would simply model (using an appropriate tool) a range of reasonable “futures” for the investor, factoring in a range of different tax, investment and timing variables that could be reasonably relevant. If you get a consistent wrapped or unwrapped outcome for each modelling exercise, then go with that. If you get different outcomes, then simply make a percentage probability assessment for each of the modelled futures and split the portfolio appropriately. Okay, that is a bit simplistic but you get the gist.
There are other ways but this one could reasonably defend against the risk of having all the eggs in one basket. You might even see it as a complement to the better-known process of asset allocation.
Tony Wickenden is joint managing director of Technical Connection