The way dividends are taxed has changed dramatically from 6 April 2016 when the Government’s new rules on the taxation of dividends came into play.
This impacts anyone who receives dividends from shares or unit trusts, when held outside of an ISA or Pension arrangement.
However, the largest impact is on owner-managers of limited companies, where business owners rely on dividend extraction as part of their remuneration package.
In the previous tax year (2015/16) any dividends drawn by a company owner that formed part of their basic rate taxed income (so included within the band of total earnings of up to £31,785) were effectively received tax free by the company owner.
Where the dividends formed part of the owners income that is taxed at the higher (total income band from £31,786 – £150,000) or additional rate (total income over £150,000), the additional tax due was effectively 25% and 30.56% respectively.
However from 6 April 2016 this all changed.
Dividends being effectively tax free if forming part of an individuals basic rate income band was abolished in lieu of flat rate dividend allowance of just £5,000.
This means any dividends received by an individual in excess of £5,000 will be taxed as follows:
• 7.5% if your dividend income is within the basic rate band
• 32.5% if your dividend income is within the higher rate band, and
• 38.1% if your dividend income is within the additional rate band
It should be noted that the £5,000 allowance is not an exemption but a nil rate tax band. The full dividends still count as income, e.g. for calculating the effect on personal tax allowances.
For example, a director shareholder who receives a £27,000 net dividend from his company each year and whose income falls into his basic rate band, would have had no additional tax liability in 2015/16, as in the last tax year any dividends taxed as part of a person’s basic rate band were effectively tax free.
However, with no change in strategy, for the current 2016-17 tax year the same dividend will create an extra personal tax liability of £1,650.
Although interestingly, a higher rate tax payer receiving the same £27,000 cash dividend will only be £400 worse off.
So in short this means that taking dividends will now “cost” company owner’s more in tax.
However, paying dividends instead of salary will continue for most to be the most tax efficient way to extract value from your company if you wish to gain access to the cash immediately.
This is because salaries would attract both employees’ (12%) and employers’ (13.8%) National Insurance Contributions and although the gross salary and employers’ NIC would attract a Corporation Tax deduction in the company, in most cases the overall tax exposure to salaries as compared to dividends will continue to be higher.
This does depend on the exact circumstances of the owner and the company though and as always we would recommend that you seek professional tax advice before making any decision yourself to ensure your profit extraction is planned as tax efficiently as possible.