From the tax year 1999/2000, dividends will carry a tax credit of only 10 per cent of the grossed-up equivalent dividend. Non-taxpayers will not be able to reclaim this credit while higher-rate taxpayers will pay a special rate of 32.5 per cent on the grossed-up equivalent dividend, receiving a credit for the actual tax credit.
The tax credit will satisfy the liabilities to lower-rate and basic-rate tax, leaving such taxpayers unaffected.
How does this affect the salary versus dividends argument when considering the private limited company shareholder? An important factor is the new rates of National Insurance contributions to be paid from 1999/2000, not the least an employer's rate of 12.2 per cent on all earnings above £4,316 if the individual is not contracted out.
If we look at a higher-rate-taxpaying shareholding director who wants to extract £100,000 from his company, should he do this by salary or dividends from 1999/2000? The answer depends on the effective corporation tax rate that would be paid if this money was retained in the company.
Assume that the shareholder owns 100 per cent of the company's shares. It is appreciated that profits may spread across effective corporation tax bands but I have looked at each of the rates individually.
From April 1, 1999, corporation tax rates are expected to be:
Profits/gains up to £300,000 – 20 per cent.
Profits/gains over £1.5m – 30 per cent.
Profits/gains between these figures – 32.5 per cent (effective).
If the £100,000 is extracted via salary and NICs (assuming the shareholder would not be liable for employee's NICs because he is already receiving salary in excess of the upper earnings' limit), then an amount of increased salary of £89,127 could be paid. This would result in additional employer's NICs of £10,873 (12.2 per cent of £89,127). The total of £100,000 is the salary plus NICs (£89,127 plus £10,873).
The entire amount would be deductible from company profits for corporation tax purposes. The salary of £89,127 would be taxable at 40 per cent (£35,651), leaving a net amount for the director of £53,476. He originally earned £100,000, so an effective tax rate (including NICs) of 46.52 per cent has been paid.
If the money is extracted by dividend payment, the result depends on which of the three effective corporation tax rates applies. It must be remembered that dividend payments are not deductible from company profits for corporation tax purposes.
If the company is a 20 per cent taxpayer, a dividend of £80,000 could be paid. The company would eventually have a corporation tax bill of £20,000 on the £100,000 profits so could not reasonably pay a higher level of dividend from this tranche of money.
The director receives a dividend of £80,000 with an attaching tax credit of £8,889 (10 per cent of the gross equivalent of £88,889). He is due to pay a further amount of tax of 22.5 per cent (32.5 per cent less the 10 per cent already deemed paid) of £88,889, that is, £20,000. He thus enjoys a net dividend of £60,000 (£80,000 less £20,000).
The effective tax rate is thus 40 per cent, that is, 6.52 per cent lower than if the money is extracted by salary and NICs.
For a 30 per cent or effective 32.5 per cent company, the figures are shown in the table below. It can be seen the dividend route for a 30 per cent company gives an effective tax rate of just over 1 per cent more than the salary/NIC route. For an effective 32.5 per cent company, the dividend route is 2.86 per cent more expensive.
One conclusion is that it is unwise to use the dividend route if the company pays corporation tax above the smaller company rate of 20 per cent. The salary route will give a better net result. But there are other reasons for declaring dividends than just numerical ones.
Where the salary route appears better for an individual, this should give great scope for executive pension planning to reduce the effective tax rate on extraction of profits from the company even further. For a 20 per cent company in these circumstances, it can be seen that dividends have become a more powerful tool in the extraction game. This may lead to a reconsideration of how funds can be built up for retirement.