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Contractors should plan in advance for dividend tax changes

A leading contractor accountancy firm explains why contractors should act now to mitigate against an increase in dividend tax rates from April 2016.

Background

The Chancellor announced major changes to dividends in this summer’s Budget. The old system of tax credits will be replaced by a set of fixed dividend tax rates, which will result in higher taxes for most limited company contractors from April 2016.

If you currently receive dividend income, then you will be affected.

Here, specialist accountants Intouch, explain why you should familiarise yourself with the changes now so that you are prepared in advance.

What are the rules surrounding dividends?

Dividends are currently distributed to shareholders net of tax. To work out the tax payable, the net dividend is firstly grossed up – by 10/9, to produce the ‘gross’ dividend upon which income tax is paid.

There are three current dividend tax rates – 10% (basic), 32.5% (higher) and 37.5% (additional). But after the tax credit has been taken into account, you actually pay 25% tax on dividends if you’re a higher rate taxpayer.

How will the rules be changed from April 2016?

The new rules will see an end of this 10% notional tax credit.

Instead, dividends will be now be taxed at three new rates; basic rate (7.5%), higher rate (32.5%) and additional rate (38.1%).

A new £5,000 dividend allowance has been introduced, but this actually sits within the existing tax bands and is not the ‘perk’ many hoped it would be when first announced.

ISAs and pension schemes will remain unaffected by the changes.

What is the purpose of the changes?

The proposed changes to dividends are expected to collect an additional £2.5bn in tax following the 12 months after April 2016. In line with other measures being considered by the Government, the Chancellor is particularly keen to clamp down on ‘tax-motivated incorporation’ – reducing the incentive for individuals to work via limited companies.

Paying yourself a smaller wage and high dividends is, of course, one of the major advantages of contracting, so it’s important now to make sure you understand where you stand when the changes to dividends come into force.

What you should do next

Here are a few points to consider before the changes to dividends come into play:

  1. Make use of the tax-free dividend allowance (although this will typically only benefit contractors who do not draw down large amounts of dividends – see this Government factsheet).
  2. Capitalise on each spouse’s basic rate tax allowance and tax bands.
  3. Use your ISAs to their full potential.
  4. Ensure your other incomes are balanced.
  5. Think about dividends before 6 April 2016.

Make sure that you are considering your limited company structure and whether you have missed any opportunities to have different classes of shares or additional shareholders to minimise the amount of tax you pay.

If you have any questions about the forthcoming tax change or need a calculation to see how the new dividend tax will affect you, make sure you speak to your accountant.

Final thoughts and resources

  • Whether you’re already contracting through your limited company, or are considering making the move into contracting, the changes to dividends should not be considered in isolation. There are so many other benefits to running your own company.
  • To find out how much the dividend tax changes will cost you, try this dividend tax hike calculator from ITContracting.

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Last updated: 22nd February 2021