Lee Sharpe looks at the government’s plans to restrict the dividend allowance.
Mr Osborne introduced so many ‘simplifications’ to the UK tax regime that it is difficult to choose a favourite. Indeed, the tax regime he has bequeathed to his successor is now so simple that, two years since the relevant measures were announced, HMRC has been forced to admit that its 2016/17 tax calculation software is shot with errors because it hasn’t really understood how the new rules actually work.
What Mr Hammond has been able to work out is that his predecessor was being far too generous in gouging out only circa £2 billion extra tax a year on dividends from family companies (as per the 2015 Summer Budget ‘Red Book‘), so he needed to fix this urgently, by raising a further circa £1 billion a year.
He, therefore, announced in the 2017 Spring Budget that the so-called ‘dividend allowance‘, whereby the first £5,000 of dividend income is basically tax-free, would be cut to just £2,000 from April 2018. The tax revenue generated by this measure has been estimated at just shy of £900 million a year, almost immediately (hence the extra circa £1 billion mentioned above).
The reality is that the dividend allowance was really a sort of sleight-of-hand to camouflage the huge cost of the other big changes to dividend taxations that were announced in 2015 – the loss of the notional tax credit, and the hike of 7.5% on the effective rates of dividend tax. And now that allowance will be slashed to less than half.
Not long after the Chancellor announced the change, it was dropped from the 2017 spring Budget ahead of the general election. But the government has just confirmed that it intends to re-introduce the measure in the second 2017 Budget, scheduled for September 2017; the new Finance Bill will ‘make provision, taking effect in a future year, about the dividend nil rate of income tax [allowance]‘. While that leaves the government’s options open, I don’t think the Chancellor intends to increase the allowance, given what has gone before. But I am not sure that the Chancellor actually understands how this will work in practice.
Dividend tax mechanism
Most importantly, the dividend ‘allowance‘ is not really an allowance at all. It instead taxes the first £5,000 of a person’s dividend income at 0%. The result is that most family companies will not be that badly affected by the change, as we shall see in the following examples, which assume that the dividend allowance will change from 2018/19 (but that other bands and allowances stay the same for ease or convenience).
Example 1: Dividends start in basic rate
Like many small company owner/directors, Henry takes a salary of £8,000 and the rest of his company income as dividends – usually about £30,000 each year. The change in the dividend allowance will not really be that expensive:
2017/18
£ £ £ £
Salary 8,000 @ 0.00% -
Dividends in Personal Allowance 3,500 @ 0.0% -
Dividends in ‘Dividend Allowance’ 5,000 @ 0.0% -
Dividends in Basic Rate Band 21,500 @ 7.5% 1,612.50
30,000
TOTAL TAX DUE: 1,612.50
2018/19
£ £ £ £
Salary 8,000 @ 0.00% -
Dividends in Personal Allowance 3,500 @ 0.0% -
Dividends in ‘Dividend Allowance’ 2,000 @ 0.0% -
Dividends in Basic Rate Band 24,500 @ 7.5% 1,837.50
30,000
TOTAL TAX DUE: 1,837.50
TAX COST OF CHANGE IN DIVIDEND ALLOWANCE: 225.00
So, the net tax cost of this change will be just £225, where family company owners take a modest salary and the reduction in dividend allowance falls in the basic rate band. Note that, because the dividend allowance is not really an allowance – it does not reduce taxable dividend income but simply taxes some of it at 0% - it would not matter if Henry took £60,000 in dividends and suffered tax at 32.5% on his top slice of dividend income:
2017/18
£ £ £ £
Salary 8,000 @ 0.00% -
Dividends in Personal Allowance 3,500 @ 0.0% -
Dividends in ‘Dividend Allowance’ 5,000 @ 0.0% -
Dividends in Basic Rate Band 28,500 @ 7.5% 2,137.50
Dividends in Higher Rate Band 23,000 @ 32.5% 7,475.00
60,000
TOTAL TAX DUE: 9,612.50
2018/19
£ £ £ £
Salary 8,000 @ 0.00% -
Dividends in Personal Allowance 3,500 @ 0.0% -
Dividends in ‘Dividend Allowance’ 2,000 @ 0.0% -
Dividends in Basic Rate Band 31,500 @ 7.5% 2,362.50
Dividends in Higher Rate Band 23,000 @ 32.5% 7,475.00
60,000
TOTAL TAX DUE: 9,837.50
TAX COST OF CHANGE IN DIVIDEND ALLOWANCE: 225.00
Who really stands to lose out?
What really matters in terms of the effect of the impending reduction in the dividend allowance is where the dividend income starts, in terms of the tax band. Where dividends start in the personal allowance or the basic rate band, the cost of losing £3,000 at 0% instead of 7.5% is not that great. Where someone is already a 40% taxpayer and then takes dividends, the consequences will be significantly more painful.
Example 2: Dividends to a higher rate taxpayer
Henrietta is a children’s entertainer and part-time private detective. Her combined earnings come to £55,000 a year, so she pays tax at the higher rate of 40%. She inherits a portfolio of shares, which generate around £10,000 a year in dividend income (and she has already fully funded her individual savings account).
2017/18
£ £ £ £
Earnings in Personal Allowance 11,000 @ 0.00%
Earnings in Basic Rate Band 33,500 @ 20% 6,700.00
Earnings in Higher Rate Band 10,000 @ 40% 4,000.00
55,000
Dividends in ‘Dividend Allowance’ 5,000 @ 0.0% -
Dividends in Higher Rate Band 5,000 @ 32.5% 1,625.00
10,000
TOTAL TAX DUE: 12,325
2018/19
£ £ £ £
Salary 11,500 @ 0.00% -
Earnings in Basic Rate Band 33,500 @ 20% 6,700.00
Earnings in Higher Rate Band 10,000 @ 40% 4,000.00
55,000
Dividends in ‘Dividend Allowance’ 2,000 @ 0.0% -
Dividends in Higher Rate Band 8,000 @ 32.5% 2,600.00
10,000
TOTAL TAX DUE: 13,300
TAX COST OF CHANGE IN DIVIDEND ALLOWANCE: 975
The tax cost in Example 2 has increased by £750 a year against Example 1 which, for the mathematically inclined, is: £3,000 @ (32.5% - 7.5%) = £750.
It follows that those who are unfortunate enough already to be additional rate taxpayers before their dividend income starts will be smarting from an increased tax bill of £3,000 @ 38.1% = £1,143, which is an increase of £918 on Henry’s position above.
Conclusion
On the basis that very many shareholder/directors operate with relatively modest salaries - fitting comfortably in the basic rate band – I think that Mr Hammond may be disappointed at how little impact this will have on the average family company since he seems to share his predecessor’s antipathy towards your average owner-managed company.
While we do not yet know for certain when the dividend allowance will be restricted under the new Budget program, or by how much, the Chancellor’s steely resolve over the summer when facing calls to loosen the Treasury’s purse-strings does not bode well.
It is worth bearing in mind that owner-managed companies have not yet actually felt the first pinch of the new dividend regime; it will be 31 January next year when most shareholder/directors will look at their first self-assessment tax payment and wonder where all their money went. Perhaps we should all be grateful that the Chancellor’s aim is a little off.
