Changes to the taxation of dividend income

The Chancellor, George Osborne, took the opportunity of the first wholly Conservative budget for nearly 20 years to look at how individuals are taxed on dividend income. For many years company owners have been able to take money from their companies as dividends on the shares they own rather than by taking a salary. One of the principle reasons for doing this was to avoid National Insurance both for the shareholder and for the company and reduce the overall level of taxes they pay.

This has meant that individuals who chose not to run their businesses through companies; either as sole traders or partnerships; pay higher taxes than company owners. In some cases the difference in tax between the self-employed and companies could be substantial if the company owner decided to roll-up profits and not distribute them.

This imbalance between company and individuals’ tax rates has resulted over the past decade in a huge number of business owners choosing to run their businesses through limited companies rather than operate as self-employed.

It is this perceived imbalance that the Chancellor has taken steps to address.

The current system of dividend tax is largely a relic of an old tax system that saw high rates of company taxes and very high rates of personal taxes, particularly on investment income such as dividends. It was designed to avoid the excessive double taxation of dividends with both the company and individual shareholder paying tax on the profits.

So, based on what we know from the budget speech and press releases; from April 2016 the notional “tax credit” of 10% given on dividend income will be abolished. In its place will be a “dividend allowance” for all taxpayers meaning that the first £5,000 of dividend income will be tax free.

After that dividends taxed at the basic rate of tax will be taxed at 7.5%, higher rate taxpayers will pay 32.5%, and additional rate taxpayers earning over £150,000 will be taxed at 38.1% on dividend income. These rates are effectively 7.5% higher than the old rates.

There will also be a reduction in the Corporation Tax Rate paid by company between now and 2020. The combined impact of all these changes is as follows; the effective tax cost for a higher rate taxpayer extracting profits from a company by way of dividend is currently 40%. This will increase to a maximum of 45.3% in 2017 before falling back to 44.6% in 2020.

We are yet to see the legislation to confirm exactly how the new regime will work so there are a few unanswered questions, such as “Will the dividend allowance be available to all taxpayers?” But broadly, anyone taking the bulk of their income as dividends or holding significant shareholding portfolios are likely to see higher tax bills from April 2016. However, based on what we know at this stage there seems little benefit in switching to a salary rather than dividends.

For smaller businesses it might also be the time to consider whether it is worthwhile operating your business through a company at all.

How you structure your income from April 2016 and indeed, whether you carry on running your company, need careful planning. We will be looking at these issues and other tax measures for our clients over the coming months as the new rules become clearer and contacting them to offer advice.

If you need any advice in the meantime or want to discuss the changes, please do not hesitate to contact us.