Since the start of the 2016 tax year, dividends are taxed at a more punitive rate than previously and will cost many contractors thousands each year in additional tax.
Here we look at what the changes mean for limited company owners.
What was the motivation behind this tax change?
Section 1.185 of the Budget document explains that the current way dividends are taxed was implemented over 40 years ago when Corporation Tax was far higher than it is today, and some individuals paid effective rates of over 80% on their dividends.
Now that Corporation Tax stands at 19%, the Government believes that dividends paid to shareholders should be taxed in a different way, i.e. the majority should pay more to help boost the Treasury’s coffers.
Making sure that those with ‘modest’ shareholdings are not worse off as a result, it is clear from the official statement that another of the Chancellor’s main objectives is to reduce the attractiveness of working via limited companies, a.k.a. ‘tax-motivated incorporation’.
“These changes will also start to reduce the incentive to incorporate and remunerate through dividends rather than through wages to reduce tax liabilities.”
How dividends were taxed before April 2016
To work out your dividend tax bill for the year ending 6th April 2016 and beforehand, a system of tax credits exists, whereby a notional tax credit is applied to net dividends to create the gross dividend amount upon which dividends are taxed.
Once a company decides to distribute some of its retained profits to shareholders, the funds are paid, and each shareholder receives a dividend voucher, detailing the net and gross amounts paid.
At self-assessment time, shareholders need to work out how much dividend tax will be payable. Gross dividends are taxed at three rates, depending upon the tax band this income falls into;
- Basic Rate (10%)
- Higher Rate (32.5%)
- Additional Rate (37.5%)
Once the notional tax credit has been taken into account, basic rate taxpayers pay no dividend tax at all, higher rate taxpayers pay 25%, and any income falling into the additional rate bracket pay 30.56%.
At Budget 2015, the Government labelled tax credits as an “arcane and complex feature of the tax system”.
How dividends are taxed now (from April 2016 onwards)
As a result of changes announced during the 2015 Budget, this ‘arcane’ way of calculating dividend tax was replaced by a simpler system. The notional tax credit was abandoned altogether, and replaced by three new dividend tax rates, as follows:
- Basic Rate (7.5%)
- Higher Rate (32.5%)
- Additional Rate (38.1%)
Seemingly to dampen the effect of the new tax rates, a new ‘dividend allowance’ of £5,000 was implemented, however, it now appears that this will have little benefit to most, as it sits within a taxpayer’s existing tax band for taxation purposes. This allowance is due to be reduced to £2,000 from April 2018 – a mere 2 year’s following its implementation.
How much more tax will you pay?
The simple answer is – if you work via your own company, you are highly likely to be worse off as a result of this measure.
The Chancellor himself stated his desire to reduce “tax-motivated incorporation”, and despite the fact that contractors can only work via their own companies (or via an umbrella company), most will pay thousands more in tax from April 2016 onwards.
Here are some examples.
In these examples, we have not taken into account any future changes to National Insurance Contributions in the 2016/17 tax year, and have assumed that the ‘dividend allowance’ does sit within taxpayers’ existing tax bands, as confirmed on the GOV.UK site.
£8,060 salary, £7,500 dividends
Total income tax in 2016/17 = zero (no change)
£8,060 salary, £60,000 dividends
Total income tax in 2016/17 = £10,169.50 (a tax hike of £2,892.63)
£8,060 salary, £90,000 dividends
Total income tax in 2016/17 = £19,919.50 (a tax hike of £3,937.88)
£8,060 salary, £120,000 dividends
Total income tax in 2016/17 = £34,252 (a tax hike of £7,978.13)
Try our online dividend calculator to work out how much dividend tax you are liable to pay.
You can access more examples, and a comparison table at our main site, ITContracting.
What should you do to reduce the impact of this tax change?
There have always been perfectly legitimate ways to minimise your exposure to dividend tax, via careful tax planning. Clearly, your accountant and/or financial adviser should be your first port of call, as they will be able to advise you based on your own personal situation. Some things you may consider include:
- Sharing your company shareholding with your spouse, to make the most of your partner’s personal allowance and basic rate band.
- Consider sheltering some of your investments within an ISA, as any dividends paid on investments including within an ISA can be withdrawn free of tax.
- Considering investing in a pension, or increasing your existing contributions (consult an independent financial advisor).
- You may consider shutting down your company entirely, if you have built up substantial cash reserves. There are several ways to achieve this, but once again, you should seek professional advice first.