The Government must be relishing its announcement in the Summer Budget on 8thJuly, designed to simplify dividend taxation and bring the treasury an additional revenue of £2.5bn per year. Yet the Chancellor said that 85% of those who receive dividends will see no change, or be better off. So where is this additional revenue going to come from? How will savers be impacted, and in particular business owners, who depend largely on dividends for their income?
How will dividend taxation change?
Currently basic rate taxpayers do not pay tax on UK dividends, beyond the notional 10% tax credit. Higher rate tax payers are liable for 25% and 30.6% for additional rate tax payers.
This is all set to change from 6 April next year.
- The notional 10% tax credit will be abolished.
- A £5,000 tax free dividend allowance will be introduced.
- Dividends above this level will be taxed at new rates 7.5% higher than current levels.
Who will be affected?
The measure will benefit investors with modest portfolios generating less than £5,000 pa in UK dividend income, which is likely to constitute a large proportion of the investment community. Those worse affected, are tax payers with substantial portfolios with dividend income above £5,000.
Most likely, the measure will change the economics of operating a business as a limited company. Many owners of private businesses choose to be paid through a combination of minimum wage designed to preserve entitlement to the State Pension, and a large dividend, in order to minimise National Insurance Contributions (NICs). In particular, top-rate tax payers, who currently have the option of growing their business and paying themselves dividend income at a 30.6% tax rate will find that the top rate of tax will rise to 38.1%.
The impact is illustrated below, assuming a salary of £8,000 is drawn to preserve State Pension and minimise NICs, there is no other income, the personal allowance and income tax bands are based on respective 2015/16 and 2016/17 years:
Note the personal allowance trap for income in excess of £100,000 results in greater tax liabilities. Every £2 of income over £100,000 results in a £1 reduction in the personal allowance, therefore to £6,600 in 2015/16 and £7,000 in 2016/17.
Business owners are faced with a double whammy, when these changes are taken into account alongside Corporation Tax paid on profits before distribution, albeit the impact will be offset sligthly by the planned reduction in Corporation Tax. Neverthelss, many business owners may question whether the risk and hard work involved in incorporating their business was actually worth it, now that they’ll be taxed in much the same way as an employee, who took no risk at all.
Indeed, Chancellor George Osborne said the change was intended to deter small businesses from incorporating for tax reasons. This, he said, was a prerequisite for a planned further reduction in corporation tax to 19 per cent in 2017 and to 18 per cent in 2020. However, this, along with living wage hikes, would seem to go against the grain of the government providing incentives for people to get back into work and take the risk of starting up a business and working for themselves.
Nevertheless, although it appears there will be little tax advantage to incorporation, there are other necessary reasons such as limitation of liability, allocation of shares to employees and investors, and businesses that expect to grow significantly.
Taking a larger salary instead of a dividend is not necessarily a better alternative. Although salaries are tax deductible before corporation tax and facilitate larger pension contributions, they still incur employees NIC at 12% and employers at 13.8%.
What can our clients do to protect themselves against the impact of the tax changes?
Since the change does not come into effect until 6 April 2016, clients should use the period between now and 6 April to discuss strategies with their financial planner. Here are some strategies (advice should always be sought).
- Bring forward any dividends that may otherwise be payable in 2016/17 to this tax year.
- For businesses jointly owned between spouses/civil partners, spread taxable income to the lower earning spouse, directing taxable dividends to the lower rate tax payer.
- Reduce other taxable income, moving down a tax band if possible. Defer withdrawals from a drawdown pension until a new tax year.
- Deploy spare profits to increase pension contributions (capped at the annual allowance, £40k for 2015/16**). Tax relievable personal contributions can be made to 100% of an individual’s salary, and extend your basic rate tax band by the amount of the gross pension contribution. This increases the amount of dividends subject to basic rate as opposed to higher rate tax. Dividends also grow tax free in a pension wrapper. **Care should be taken when making large pension contributions. If your net adjustable income (income plus gross pension contributions) exceeds £150,000 pa, you could gradually lose your annual allowance and fall foul of tax charges on the pension contributions).
- The new pension freedoms now mean that pensions provide some great investment and tax planning opportunities, especially from a wealth preservation perspective.
- Invest in other tax efficient vehicles such as a Venture Capital Trust. VCTs generate tax free dividends and carry 30% tax relief which can be used to offset your income tax bill. VCTs invest in smaller companies which are inherently higher risk.
- Direct profits into other allowances, such as investment in new equipment, adding value to the business when sold and boosting revenues.
- Make sure you fully utilise your tax shelters. Make pension contributions, use your annual NISA allowance (£15,240 for 2015/16), or invest in offshore bonds. Dividend growth is tax free within these wrappers.
- Be clever with yield. For higher yielding dividend bearing investments, Shares and funds worth up to £15,240 (2015/16) can be transferred using bed-and-NISA or bed-and-pension. This involves sale and buy-back which is CGT chargeable but there is an £11,100 exemption.
- Make in specie contributions of existing shareholdings into pensions.
- Make sure spouses and civil partners are each in a position to make use of their £5,000 dividend allowances by balancing out enough of their investments to ensure this happens. Transfers of investments between spouses are free of CGT.
Written by Pippa Oldfield