How to Prevent Payments on Account

In the UK, the majority of tax is collected before the income is actually received by the taxpayer; the method of collection being either under the PAYE system or via deduction of tax at source on other income. Tax that has not been collected via either one of these methods requires the submission of an annual tax return to confirm the amount of tax due. Thus should the calculation show additional tax payable at higher rates on investment income in any one year, for example, a tax return needs to be submitted to HMRC by 31 January after the tax year end (if filed electronically, or by 31 October if a ‘paper’ return is filed), and payment of the outstanding tax must be paid by the same date. 

Unfortunately, the tax rules go further, and require that should the tax liability be in excess of a particular limit, then not only is the payment due on income that has been received during the past tax year, but a payment on account (POA) of the current year’s potential tax liability is also due on the same date; two payments that can sometimes be very painful in terms of cash flow. 

POAs were devised as a way of supposedly helping taxpayers spread their tax bill. However, it often results in increased financial hardship not least for those who find it difficult paying the lump sum due at the end of the previous year. POAs are made twice yearly, on 31 January and 31 July, calculated as 50% of the total tax payment made for the previous tax year.

However, there two instances where no POA is required:

1. Where the prior year’s tax bill was less than £1,000; or 

2. 80% or more of the tax was deducted at source in the previous tax year.

Dividends are treated as a special case under the tax collection system, such that dividends received carry a 10% tax credit for individual shareholders. The tax credit is allocated because the dividend has already been taxed under corporation tax before receipt. However, although the 10% credit satisfies the tax liability for basic rate taxpayers, higher rate taxpayers are taxed on dividend income at a rate of 32.5%, leaving 22.5% to pay over and above the tax credit. So clearly there is an advantage of ensuring that the dividend income is kept within the basic rate tax band.

John is the director of a newly-formed company who wishes to withdraw £45,000 net in dividends from his company every year. The dividends in both examples do not attract the deduction of the personal allowance being allocated against other income; therefore the personal tax liability payable by 31 January 2015 amounts to £6,071.32:

2013/14 Tax liability:

£45,000 net dividend = £50,000 gross

       £

Basic rate band: £32,010 x 10% 3,201.00

Higher rate band: £17,990 x 32.5% 5,846.75

Less: Tax credit   (5,000.00)

Tax due 30.01.2015 4,047.45

POA calculation 2014/15

50% x £4,047.45 2,023.87

Total 31.01.2015 payment £6,071.32

Being a new business, John would prefer to defer payment of any tax bill for as long as possible - can this be done without reducing the amount of dividend withdrawn? 

By fluctuating the amount of dividend received and only drawing sufficient to take advantage of the basic rate tax band in alternate years, no POA will be due, hence producing a cashflow advantage.

John (see Example 1) should reduce the net dividend amount for 2013/14 to £32,805 net (£36,450 gross; tax credit £3,645)

2013/14 Tax liability:

Basic rate band: £32,010 x 10% 3,201.00  

Higher rate band: £4,440 x 32.5% 1,443.00 

Less: Tax credit   £(3,645)

Tax due 31.01.2015 £  999.00

POA calculation 2014/2015    NIL

As the additional tax liability for 2013/14 is less than £1,000, no POAs are payable for the next tax year 2014/2015. If the company pays dividends totalling £57,525 (£45,000 + £12,195) in 2014/15, this will produce a higher rate tax liability but the value in this method of extracting dividends is that over the two year period the same amount of dividends are withdrawn but the tax due thereon is deferred for as long as possible (in this case until 31 January 2015). In comparison, had the dividends remained at £45,000 for each of the tax years POA would be payable in equal instalments on 31 January 2014 and 31 July 2014 - a year and six months earlier for the taking of the same amount. 

This method of deferring tax can be used every other year which, in John’s case means for the tax year 2015/16 with no POAs for 2016/17. 

The earlier the dividend payment in the tax year, the longer the credit period for the paying of the higher rate tax on that dividend. As the shareholder/ owner of the company, the choice of when to withdraw dividends is the directors’ decision to make. 

Dividends are treated as paid on the date when the money is unreservedly placed at the disposal of the directors/shareholders as part of their current account with the company. HMRC consider this to be the date of entry in the company’s books (see HMRC’s Corporation Tax manual at CTM20095). 

The Companies Act 2006, s 830 states that “a company may only make a distribution out of profits available for the purpose”. This means that for the dividend to be allowable a company needs to have sufficient retained profits to cover the dividend at the date of payment. Just because the bank account is in credit does not necessarily mean that a dividend can be paid. 

When calculating how much can be distributed, losses must be taken into account. Any dividend paid in excess of the amount of distributable profit, or out of capital or possibly when losses are included in the calculation is ‘ultra vires’ and, in effect, ‘illegal’. An ‘illegal’ dividend must be repaid and if it is not will be deemed to be a loan to the director and be taxed accordingly (see BTI, February 2013 - Dividends (Part 2)).

The company’s annual accounts for the previous year showed distributable profits of £50,000, but since then the company has been making losses, those losses must be deducted from the £50,000 to arrive at the ‘distributable profits’ figure. 

Prepare management accounts as the financial status of the company needs to be considered each time a dividend payment is made. This is best done by preparing a draft set of accounts prior to any dividend being declared to prove that there is sufficient profit to cover the payment. The amount of dividend can be varied to suit the amount of profit in the company, unlike a salary which must be paid at the same amount on a regular basis.