To describe last summer’s announcement of the new rules on dividend taxation as a surprise hardly does justice to the extent of the tremors felt throughout the taxpaying community.
Not only has the Chancellor increased the rate of tax on dividend income (some would say in direct conflict with the Conservative’s pre-election pledge not to increase rates of income tax), he has also made the system significantly more complex (38.1% rate of tax, anyone?) and changed the entire basis on which dividends in the UK are taxed.
Rabbits out of the hat appear to be George Osborne’s speciality but this particular rabbit has teeth. And sharp ones.
Taxation of Dividends – What’s it all about?
So what has actually changed? And why?
Dealing with the second question first, it seems that this is another step along the road of discouraging businesses to incorporate. Having gradually reduced the headline rate of corporation tax over successive years, the Government is apparently now surprised to find that businesses are incorporating to take advantage of these lower tax rates. In response, the Chancellor has introduced a number of measures to try and counter this. Increasing the tax rate on dividend income (perhaps to address the anomaly that dividends do not attract national insurance?) is just one of those measures.
Fortunately (or not, depending on your viewpoint) the new rules do not further complicate the system by trying to distinguish between dividends from owner-managed businesses on the one hand and those from passive investments on the other.
The Chancellor’s proposals, due to take effect in April 2016, do three things:
- Change the basis of dividend taxation;
- Increase the rate of income tax applicable; and
- Introduce a £5,000 exemption that isn’t really an exemption.
Let’s deal with each of these in turn.
Change in the basis of dividend taxation
Under the current system, dividend income is subject to a complex regime whereby the receipt is deemed to carry with it a notional 10% tax credit. In assessing the amount of tax due, the dividend received is “grossed-up” for the credit and then subjected to the relevant dividend rate of tax (10%, 32.5% or 27.5% depending on whether you are a basic rate, higher rate, or additional rate taxpayer). The 10% credit is then deducted.
Well, you’ll be relieved to know that, under the new regime, all of this complexity is swept away and the tax will be calculated on the actual dividend receipt.
Increase in the rate of income tax applicable
The relevant rate will be 7.5%, 32.5% and 38.1%, depending again on which category of taxpayer you are. This represents an increase of 7.5% on the effective rate payable previously.
A £5,000 exemption?
The good news is that the new rules incorporate a proposal for an exemption of £5,000 per taxpayer per year. However, this exemption is referred to as a “Dividend Allowance” and while it is true that this amount will not be subject to tax, it counts nonetheless towards your total income when assessing, for example, the rate of tax payable on other forms of income or the availability of personal allowances. This is explained further below.
Winners and losers
Clearly some taxpayers will be better off and some will be worse off. It is difficult to be too prescriptive as to the composition of each group, but we can draw some broad conclusions from what we know:
Individuals in receipt of dividend income of less than £5,000 p.a. in total will be no worse off and might actually benefit.
Passive investors with more significant income from UK shares could be better or worse off depending on (1) the amount by which their dividend income exceeds £5,000 and (2) the tax bracket into which they fall.
On the other hand, those whose dividend income constitutes a large proportion of their total income (business owners, for example) are likely to see their net income significantly reduced.
So what’s to be done? How can the new rules be avoided or their impact reduced?
There seem to be three main approaches that can be adopted:
- For the passive investor, using tax-free shelters such as ISAs will eliminate the new higher rate of tax. Dividends in ISAs remain tax-free under the new proposals.
- For the business owner, this new tax charge, together with other measures which the Chancellor has introduced, for example abolishing tax deductions for amortisation of goodwill, have eroded many if not all of the significant tax advantages of incorporation. A review should be undertaken as to whether this is still the right business structure going forward and such an analysis can only be carried out on a case by case basis.
- Consideration should be given to the acceleration of dividends so that the payment date falls before, rather than after, 5th April 2016. This will be subject to a number of factors. The tax payment date will also be accelerated and there must be sufficient distributable reserves in the company. Most importantly, the dividend receipt itself could push the taxpayer into a higher marginal rate thus eliminating part, if not all, of the benefit of the acceleration.
It is clear that this new regime needs a new approach, particularly in the area of remuneration planning. It may also affect investment strategy overall since dividends will no longer be as attractive as other types of investment return, from a tax perspective, and alternative methodologies may be required.
A thorough review of your financial position, particularly if you run your own company, could pay dividends (excuse the pun!) and here at CBW we would be delighted to help.
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