Dividend Tax Revolution means big tax increases for many owner-managers
The current system of taxing dividends is so bizarre, involving notional tax credits and other incomprehensible devices, that I am not even going to try and explain it. What I can say is that the end result of a lot of unnecessarily complicated legislation is that dividends that fall within an individual's personal income tax allowance or basic rate tax band incur no further charge to UK tax; dividends that fall within an individual's 40% tax band suffer additional tax of 25% of the amount of the dividend received; and dividends that fall within an individual's 45% tax band suffer additional tax of 30.56% of the amount of the dividend received. For these purposes, dividends are always treated as being the uppermost element of an individual's income.
It will be welcomed by many practitioners that the Chancellor has abolished the old regime; but he has replaced it with a new system that will see a material increase in the tax burden for many owner-managed companies that structure their affairs by paying themselves a modest salary and large dividends. This produces material tax savings compared to just paying a salary because dividends are not liable to national insurance. For example, George is a director and 100% shareholder of P Limited which earns profits of £100,000 a year and George pays himself the entire £100,000 as a salary. George receives around £59,000 net of all taxes in his own hands. However, after changing his accountants, George is advised to reduce his salary to around £8,000 per annum and pays the rest of the profits out as a dividend. George then receives nearly £72,000 net of all taxes; a massive tax saving of nearly £13,000.
The Chancellor's new system for taxing dividends will be effective from 6 April 2016. There will no longer be any notional tax credit and instead there will be new tax rates for taxing dividends as follows: the first £5,000 of dividends received, plus any amount of dividends received that fall within an individuals personal tax allowance, will suffer no additional tax; dividends that fall within an individual's basic rate tax band will suffer additional tax of 7.5% of the amount of the dividend received (currently this is 0%); dividends that fall within an individual's 40% tax band will suffer additional tax of 32.5% of the amount of the dividend received; (currently this is 25%); and dividends that fall within an individual's 45% tax band will suffer additional tax of 38.1% of the amount of the dividend received (currently 30.56%).
But George is not happy. After April 2016 he will only end up with around £68,300 net of all taxes; an increased tax bill of around £3,700. He is still much better off than the old salary strategy, but the tax reduction has narrowed from £13,000 to around £9,300.
George may well be advised to look at declaring a rather large dividend prior to 6th April 2016. This will probably reduce his longer-term tax liabilities, but there are a number of things to consider, such as the loss of his personal allowances if his total income exceeds £100,000 for the tax year and also hitting the 45% tax rate if his total income exceeds £150,000. George will definitely be meeting up with his accountants before April 2016 to explore the options.