Tony Mudd: All change again for dividend taxation

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In 1973, the UK had an imputation system for dividend taxation. This was a method of giving credit to the recipient for the tax paid by a company making the distribution. It always felt appropriate and in line with many other tax systems around the globe.

However, that has not stopped numerous chancellors from mucking about with it. Whether this has been on the promise of creating a fairer tax system or for the benefit of the exchequer is open for debate.

What cannot be disputed is that from the first step taken by Norman Lamont in 1993 through to Gordon Brown severing the link between tax credit and corporation tax paid, the imputation system has been eroded.

Finally, we have a chancellor in Mr Osborne who has, arguably, taken the logical decision to scrap tax credits completely. This ends the imputation system. While he could have left matters there, he also announced:

  • A £5,000 dividend allowance from 2016/17
  • New rates of tax above this allowance of 7.5 per cent, 32.5 per cent and 38.1 per cent for basic rate, higher rate and additional rate taxpayers respectively.

According to the Treasury, 85 per cent of individuals in receipt of dividends will either be better off or no worse off at all. If we assume that the average dividend yield on a portfolio of equities is 3 per cent, this leads us to the conclusion 85 per cent of investors have portfolios of no more than £166,000. For those with portfolios in excess of this level, the position from 2016/17 is very different to where we are now.

The question is, who are the taxpayers that will benefit from this? The answer is arguably perverse:

  • For investors paying tax at the higher rate, the £5,000 allowance is worth £1,250 (£5,000 x 25 per cent)
  • For investors who pay tax at the additional rate, the allowance is worth £1,527 (£5,000 x 30.55 per cent)
  • For investors falling within the basic rate, the allowance provides no benefit whatsoever

The bad news for basic rate taxpayers does not end there. While they currently would not pay any tax until their income fell into the higher rate threshold from 2016/17, they will now pay 7.5 per cent tax over the allowance.

These changes could also have knock-on effects to some of the standard tax advice around normal portfolio construction. The end to grossing up dividend income will have a material effect on those investors selecting tax wrappers based on ensuring income does not take them into the next threshold for income tax. Furthermore, for many clients, the value of stocks and shares Isas will now only be in terms of capital gains tax, which few investors are liable for in any case.

We also have the issue of investment bonds. On the face of it, over and above the dividend allowance tax rates of 7.5 per cent, 32.5 per cent and 38.1 per cent does not compare well with onshore bond gains taxed at 0 per cent, 20 per cent and 25 per cent. Unfortunately, we do not yet know whether, or to what extent, these changes will affect the rate of tax levied on dividends within life company funds, although it is something all of us will be looking carefully at.

A further interesting twist, with corporation tax itself reducing to 18 per cent by 2020, is whether this will result in higher net dividend yields and further changes to the effective rate of tax on dividend distributions. Changes that, frankly, the majority of investors do not understand. But perhaps that is the point.

Tony Mudd is divisional director, tax and technical support, at St. James’s Place