The New Dividend Tax Rules

As of April 2016, the dividend tax rules changed. The notional 10 percent tax credit on dividends was abolished, and replaced with a £5,000 tax free dividend allowance. But is the new £5,000 allowance going to cost or save you money? The government says one million tax payers will benefit from the changes, so let’s take a closer look at the impact of the latest changes in real terms.

What changes were made?

The Finance Act 2016 made major changes to the way dividends are taxed. This included:

  • Abolishing the notional 10 percent tax credit on dividends;
  • Introducing a £5,000 tax free dividend allowance;
  • Taxing dividends above this level at 7.5 percent (basic rate), 32.5 percent (higher rate) and 38.1 percent (additional rate);
  • No changes were made to dividends received from pensions and ISAs;
  • Dividend income is to be treated as the top band of income;
  • Basic rate taxpayers who receive more than £5,001 in dividends need to complete a self assessment tax return.

The impact of these changes

The government has suggested the changes were made because the way dividends were taxed before was too ‘arcane’ and ‘complex’. In reality, the April 2016 tax change was designed to plug a tax revenue gap by getting more money out of small businesses and limited company contractors.

Many limited companies pay their owners and directors a small salary to preserve their entitlement to the State Pension, followed by a much larger dividend payment in order to reduce their National Insurance costs. It is contractors and small business owners who take money out of their company in this way that are being hit hardest by these changes.

The dividend tax changes in real terms

Although the first £5,000 of any dividend is tax free, there will be at least 7.5 percent tax to pay on any dividends after that:

  • Basic rate payers pay 7.5 percent tax compared with 0 percent in 2015/16;
  • Higher rate payers pay 32.5 percent compared with 25 percent in 2015/16;
  • Upper rate tax payers are pay 38.1 percent compared with 30.55 percent in 2015/16.  

So what does this mean for you?

Let’s take a look at a couple of examples to see how the typical small business owner or limited company contractor is likely to be affected.

Example 1

In this example, we are assuming a salary of £11,000 and dividends of £50,000.

  • The £11,000 salary takes up the entire personal allowance for 2016/17;
  • The first £5,000 of dividends is included in the dividend allowance;
  • That means £27,000 of dividends are taxed at the basic rate of 7.5 percent – (27,000 x 0.075) = £2,025;
  • That leaves £18,000 of dividends to be taxed at the higher rate of 32.5 percent (18,000 x 0.325) = £5,850
  • The total dividend tax liability is £7,785 (compared to £5,348 in 2015/16);
  • The individual is £2,527 worse off.

Example 2

In this case, an individual takes a salary of £8,060 and dividends of £80,000.

  • The salary of £8,060 is included within the personal allowance;
  • The first £2,940 of dividends is also included in the £11,000 personal allowance;
  • The next £5,000 of dividends is included within the dividend tax allowance;
  • £27,000 of dividends are taxed at the basic rate of 7.5 percent – (27,000 x 0.075) = £2,025;
  • The remaining £45,060 of dividends are taxed at the higher rate of 32.5 percent (45,060 x 0.325) = £14,644.50;
  • This produces a total dividend tax liability of £16,669.50 (compared to £12,276.88 in 2015/16)
  • The individual is £4,392.62 worse off.

You can read the government’s dividend allowance factsheet here, or more information about the most tax efficient way of taking money and assets out of company via a solvent liquidation, please get in touch with our team.