Making the most of profit extraction and current dividend tax rules
The way in which dividends are taxed is changing from 6 April 2016. For basic rate taxpayers, the new rules are far less generous than the current rules. With this in mind, profits permitting, it may be worthwhile to pay an additional dividend before the end of the 2015/16 tax year to make the most of the current regime.
Recap: the current rules
Under the rules that apply until the end of the current tax year, no further tax is payable on dividend income to the extent that it falls within the basic rate band. This is because dividends are deemed to be paid net of a 10% tax credit. Conveniently, for basic rate taxpayers, the tax due on their dividend income (being 10% of the gross dividend (the amount actually paid plus the deemed tax credit) is exactly matched by the 10% tax credit, meaning no further tax is due. Consequently, as long as total table income does not exceed the point at which higher rate tax becomes payable (£42,385 for 2015/16), dividends can be paid without any further tax liability.
Once the higher rate threshold is reached, tax is payable at an effective rate of 25% of the net dividend for higher rate taxpayer and at an effective rate of 30.55% of the net dividend for additional rate taxpayers.
From 6 April 2016 the dividend tax credit is abolished. Instead all taxpayers are given a tax-free dividend allowance (in addition to their personal allowance) of £5,000. Above this level, dividends are taxed at 7.5% to the extent to which they fall in the basic rate band, at 32.5% to the extent that they fall in the higher rate band, and at 38.1% to the extent that they fall in the additional rate band.
In a family or personal company scenario, if a shareholder has not utilised his or her basic rate band for 2015/16 (and is unlikely to do so), assuming that there are sufficient profits in the company it may be advisable to advance a dividend payment to before 6 April 2016 to make the most of the opportunity to extract profit tax free.
Jake is a window cleaner who provides his services through his personal company. For 2015/16, he pays himself a salary equal to the personal allowance of £10,600. He also pays himself net dividends of £15,000 a year. He has no other income.
For 2015/16 he will pay no further tax on his dividend income. His taxable income for the year is £27,267 (being his salary of £10,600 and the gross dividend of £16,667 (£15,000 x 10/9). This means that he has £15,118 of his basic rate band (£42,385 - £27,267) unused for 2015/16.
If he continues to pay a salary equal to his personal allowance and dividends of £15,000 for 2016/17, he will pay tax at 7.5% to the extent that his dividend exceeds the dividend allowance of £5,000. This will result in a tax bill of £750.
If instead, he pays £10,000 of the dividend before 6 April 2016, he can effectively pay it tax free as the gross dividend of £11,111 (£10,000 x 10/9) falls within his available basic rate band. Paying the dividend before the end of the current tax year rather than in 2016/17 saves tax of £750.
Need to know
Where some of the basic rate band for 2015/16 remains available, advancing dividend payments to before 6 April 2016 may save tax.
Read earlier tax blogs: