Dividend tax changes – how will this affect the small company?

What changes have been announced?
Under the current rules any dividends that fall into the basic rate tax band do not incur a personal tax liability for the shareholder. The key changes announced in the July 2015 Budget were as follows:

• From April 2016, notional 10% tax credit on dividends will be abolished
• A £5,000 tax free dividend allowance will be introduced
• Dividends above this level will be taxed at 7.5% (basic rate), 32.5% (higher rate), and 38.1% (additional rate)
• Dividends received by pensions and ISAs will be unaffected

Why has he made these changes?
The Chancellor expects to collect £2.5bn in additional tax in the 12 months from April 2016 from his new dividend taxation plan. The proposed changes are aimed to tax small companies who pay a small salary designed to preserve entitlement to the State Pension, followed by a much larger dividend payment in order to reduce National Insurance costs.

How will the tax work from April 2016?
Currently all UK dividends are paid with a notional 10% tax credit, so for every £1,000 of dividend income received it is assumed that £111 in basic rate tax has already been paid (the total dividend is therefore £1,111). This is why non and basic rate tax payers have no further tax liability on dividends received. This tax credit is being scrapped, so in future all dividend income will be treated as gross income.

All taxpayers will have a tax-free dividend allowance of £5,000 a year. After this, the rate of tax payable on dividends will depend upon the investor’s other taxable income. If dividend income takes an individual from one band into the next, they will pay the higher dividend rate on that portion of income.

What action should be taken?
The dividend tax does not come into effect until the next tax year, so there is nothing to do immediately. We won’t know how the new rules will work in practice until the draft legislation has been published, but you can expect to pay more tax from 6 April 2016.

In the majority of circumstances dividend remuneration will still offer a tax saving over salary remuneration. It may be best to wait until the rules are clearer to postpone thinking of incorporating your business.

The National Insurance bands for next year have yet to be published and so it isn’t possible to calculate the point at which incorporation is worthwhile. It looks as if incorporation at earnings even as high as £30,000 will now deliver a very marginal benefit.

Tax rules and allowances can always change in future. Any tax benefits also depend on individual circumstances.

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