The times they are a-changin - Dividend Tax Rates

If you are one of the fortunate people who is able to pay themselves a small salary and top-up with dividends, you will hopefully be aware that the goal-posts will move in April 2016, and the advantageous tax benefits of this method of tax planning will reduce. Following looking into 2016/17 dividend and tax planning for a 3D FD client, we thought it would be kind to share our findings!

It’s getting worse
In the 2015 / 16 tax year, dividends paid within the basic rate tax band (i.e. up to £31,785 excluding £10,600 personal allowance) would effectively be tax free. However, for 2016 / 17 onwards, everyone will get up to £5,000 of dividends (on top of their £11,000 Personal Allowance) tax free, but then be required to pay 7.5% within the basic rate tax allowance.

In both the last tax year, and the next, it may still be more tax efficient to pay via a nominal salary topped up with dividend rather than wholly via PAYE / payroll. However, the tax cost of taking payments from the company via dividend will increase for the vast majority. If you require further information, or tailored modelling and advice, you should contact your accountant, or a 3D FD consultant.

[Practical tip: For those who were utilising their basic tax allowance thresholds, they might not have needed to be in the habit of personally putting tax to one side on dividend income, but from April 2016, they would owe 7.5% tax on a substantial proportion of their dividend income.]

A bit more detail…

2015/16 Employment [Salary]
Let’s cover what may have been a common practice for director-shareholders in the 6 April 2015 to 5 April 2016 tax year: As a registered employer, the company may have paid a salary of either £8,060 per annum, or £10,600 per annum. The former £8,060 would fully utilise the National Insurance (NI) Lower Earnings Limit (LEL); not incurring any NI or Pay As You Earn (PAYE) tax, and the full amount processed would ordinarily be paid as both gross and net salary. This maintains NI contributions for the employee on their record without any NI being paid. The aforementioned £10,600 is the 2015/16 personal allowance – the amount one can earn before being taxed and would be subject to a little Employee’s NI (£304.32), and Employers NI (343.32). In a small company with few staff, the Employers National Insurance may be refunded in full or part as a result of the £2k Employers Allowance. Within the mix of bespoke tax planning, the effective rate of either of those payments is often as efficient as it gets. Assuming the individual wants to earn more than £10,600 per annum, the balance of their earnings would often be topped up by dividend from the company. [Caveat – bear in mind the national minimum wage (NMW). The NMW may not apply for directors, but be careful if a non-director employee is paid at that rate that it is still legal – employees cannot opt-out of NMW. Also, ensure dividend payments are not deemed to be disguised remuneration.]

2016/17 Employment [Salary]
The National Insurance LEL is remaining the same for 2016-17 as it was in 2015-16 at £8,060, whilst the Personal Allowance is increasing to £11,000 per annum, and the Employers NI Allowance will increase to £3,000 per annum.

A brief history of dividends
Before declaring a dividend, the company needs to have the distributable reserves (profits) to be able to do so, and it should be legal (consider appropriate paperwork, parity for that class of shareholders etc..).

In 1973 (before my time!), with the introduction of the Advance Corporation Tax (ACT), dividends were then received with a tax credit, to compensate for the tax that had already been paid in advance. In 1999, ACT was abolished but the tax credit remained, at that time reducing from 20% to 10%. This left us with a system which was not entirely easy to understand, whereby dividends were grossed up, and taxed, but then received a tax credit. It is a source of confusion for a number of shareholders – with dividend tax rates at basic rate 10%, higher rate 32.5% and additional rate 37.5%, but each benefitting from a 10% tax credit to give rise to effective rates of 0%, 25% and 30.56% respectively.

With the intent of simplifying the system (which I welcome), the dividend tax credit is being abolished with effect from 6 April 2016. There won’t be the need to gross up a net dividend by multiplying it by 10/9 anymore – the dividend declared and paid will be the same, and the recipient taxed once they have used up their tax-free allowances for that year.

New dividend rates
From 6 April 2016, each person will have a tax-free dividend allowance of £5,000 (in addition to the aforementioned personal allowance of £11,000). Dividends up to £5,000 don’t incur any tax, and after that, the tax rate is 7.5% for basic rate taxpayers, 32.5% for higher rate and 38.1% additional rate.

Example
The table below compares paying via salary with dividend top-up and paying wholly via PAYE for both 2015/16 and 2016/17 tax years. It shows a position in 2015 / 16 of a nominal £8,060 salary and using the remainder of the basic rate band with dividend payments to give rise to a £nil personal tax liability. With the same effective cost to the company of £45,130 it is compared to PAYE only for the same year, and both scenarios again for the 2016 / 17 year. For alternative scenarios, please do get in touch.

I’ll finish with the last verse of a Bob Dylan classic: “The line it is drawn, and the curse it is cast. The slowest one now will later be fast; as the present now will later be past. The order is rapidly fading, and the first one now will later be last, for the times they are a-changin'.”

Further reading:
Dividend Allowance Factsheet
2016-17 Tax Rates and Thresholds
ICAEW - Taxation of Dividends