One of the surprises of the summer 2015 Budget was the Chancellor’s announcement that the dividends tax rules are to be radically reformed from 6 April 2016.
The move will hit the many personal and family companies who withdraw profits predominantly in the form of dividends, while some higher and additional rate taxpayers for whom dividends represent a secondary source of income may well pay less tax.
Under the rules as they currently apply, dividend are paid net of a 10% tax credit. The gross dividend (i.e. the net dividend plus the associated tax credit) is taxed at the relevant dividend tax rate – 10% for basic rate taxpayers, 32.5% for additional rate taxpayers and 37.5% for higher rate taxpayers. The 10% tax credit is set against the liability, so the net effect is that a basic rate taxpayer pays no additional tax on dividend income, a higher rate taxpayer pays tax on dividend equivalent to 25% of the net dividend and an additional rate taxpayer pays tax equivalent to 30.6% of the net dividend. This means that it is possible to pay dividend up the level at which higher rate tax is payable (£42,385 for 2015/16 – being personal allowance of £10,600 plus basic rate limit of £31,785), before it is necessary to pay any further tax on the dividends. The liability is settled by the associated tax credit. This makes it highly effective for personal and family companies to extract profits in the forms of dividends, at least until the basic band is used up.
The rules are radically reformed from 6 April 2016. From that date, the dividend tax credit is abolished – and with it the need to perform a grossing up calculation. Instead, all individuals will receive a tax-free allowance for dividends of £5,000. Above this level, basic rate taxpayers will pay tax on dividend income at 7.5%, additional rate taxpayers will pay tax at 32.5% and additional rate taxpayers will pay tax at 38.1%.
Winners and losers
Basic rate taxpayers paying taxable dividends of more than £5,000 (once the personal allowance has been used up) will pay more tax on those dividends in 2016/17 than in 2015/16. Where taxable dividends payable to basic rate taxpayers are below £5,000, the position is unchanged and no further tax is payable on those dividends under either the current or new rules. Taxpayers who have other sources of income which fully utilises their basic rate band may pay less tax in 2016/17 on their dividend income than in the current year due to the availability of the £5,000 dividend allowance from 6 April 2016.
It is necessary to evaluate any dividend extraction policy in advance of 5 April 2016 and, if necessary, accelerate payment of dividends to before the end of the 2015/16 tax year, particularly if the basic rate band has not been fully utilised, to take advantage of the favourable rules dividend tax rules applying for that year.
Need to know: The rules taxing dividends are being fundamentally reformed from 6 April 2016.