Planning Ahead For The Fall In The Dividend Allowance

Sarah Bradford explores the planning opportunities for family companies ahead of the reduction in the dividend allowance from 6 April 2018.

The way in which dividends are taxed was changed with effect from 6 April 2016 onwards. For 2016/17 and later tax years, all taxpayers, regardless of the rate at which they pay tax, are entitled to a dividend allowance. 

Dividends sheltered by the allowance are taxed at a zero rate. To the extent that dividends are not covered either by the personal allowance or the dividend allowance, they are treated as the top slice of income and taxed at 7.5% to the extent that they fall within the basic rate band, at 32.5% to the extent that they fall within the higher rate band, and at 38.1% to the extent that they fall within the additional rate band.

It should be remembered that dividends are paid out of post-tax profits (i.e. on profits which have already suffered corporation tax) and that the company can only pay a dividend if it has sufficient retained profits available to pay that dividend. 

The dividend allowance is available to all taxpayers, regardless of whether they pay tax at the basic, higher, or additional rate. Furthermore, the allowance is set at the same level for all taxpayers. The dividend allowance was introduced from 6 April 2016 as part of the reforms to the taxation of dividends. It was set at £5,000 for 2016/17 and 2017/18. However, it is to be reduced to £2,000 for 2018/19.

The dividend allowance is more of a zero-rate band than an allowance, in that it uses up a slice of band earnings. 

Many family and personal companies pay a small salary (equivalent to either the earnings threshold for National Insurance contributions purposes or the personal allowance, depending on whether the National Insurance employment allowance is available), and extract any remaining profits that they wish to withdraw from the company in the form of dividends. Consequently, changes to the taxation of dividends will potentially affect the tax payable by family company owners.

For 2017/18, the dividend allowance is £5,000. For 2018/19, it is only £2,000. Assuming a shareholder in a family company extracts dividends of at least £5,000 in each year and that the personal allowance has already been utilised, the fall in the dividend allowance will mean that an additional £3,000 of dividends will be taxed in 2018/19 compared to 2017/18. The tax cost of this will depend on whether the recipient is a basic rate, higher rate, or an additional rate taxpayer. 

The additional tax payable as a result of the fall on the dividend allowance is shown in the table below.

Basic rate taxpayer £225

Higher rate taxpayers £975

Additional rate taxpayers £1,143

Luke and Lucy have a family company. Each year, they draw a salary equal to the personal allowance and take a dividend of £20,000 each.

In 2017/18, the first £5,000 of the dividend is sheltered by the dividend allowance and is taxed at a zero rate. The remaining £15,000 of the dividend falls within the basic rate band and is taxed at 7.5%. Consequently, Lucy and Luke each have a tax bill in 2017/18 of £1,125 (£15,000 @ 7.5%).

In 2018/19, the policy remains the same. However, for 2018/19 the dividend allowance is only £2,000. This means that only the first £2,000 of the £20,000 dividend is taxed at the zero rate and the remaining £18,000 is taxed at the dividend ordinary rate of 7.5%. Thus in 2018/19, both Lucy and Luke must pay tax of £1,350 (£18,000 @ 7.5%) on their dividend - £225 more than in 2017/18.

Maria is employed as a recruitment consultant on a salary of £50,000. She also has a personal company from which she draws a dividend of £10,000 each year.

In 2017/18, the first £5,000 of the dividend is covered by the dividend allowance and taxed at the zero rate, whereas the remaining £5,000 of the dividend is taxed at the dividend higher rate of 32.5%. Consequently, in 2017/18 Maria must pay tax of £1,625 (£5,000 @ 32.5%) on her dividend.

In 2018/19, only the first £2,000 of the dividend is covered by the allowance and received tax-free. The remaining £8,000 is taxed at the dividend higher rate of 32.5%. Consequently, in 2018/19, Maria must pay tax of £2,600 (£10,000 @ 32.5%) – an increase of £975 (60%!) compared to 2017/18.

The reduction in the dividend allowance does not take effect until 6 April 2018. The allowance remains at £5,000 for the current tax year. Consequently, there are some steps that a family company can take to make the most of the higher allowance.

For 2017/18, it is possible to enjoy dividends of £5,000 tax-free once the personal allowance has been used up. The dividend allowance is lost if it is not used in the tax year. 

Family and personal companies which have not paid dividends of at least £5,000 to shareholders in 2017/18 may therefore wish to review their financial position and consider paying a dividend to mop up any unused dividend allowance.

David has a personal company. As at 31 December 2017, he has paid dividends of £2,000 in 2017/18. 

Provided that his company has sufficient retained profits, David would be advised to pay further dividends of £3,000 in 2017/18, to ensure that his dividend allowance for 2017/18 of £5,000 is not wasted. This will enable him to take further profits out of the company without suffering a personal tax liability.

If shareholders have dividend allowances which have not been fully used in 2017/18, it may be worthwhile advancing a planned dividend so that it is payable before 6 April 2018 rather than on or after that date, to take advantage of any unused dividend allowance for 2017/18.

Helen has a personal company. Her personal allowance is utilised from her salary from her part-time job. She plans to pay her first dividend of £5,000 in May 2018.

If her profits allow, it would be better to pay the dividend before 6 April 2018. If she does that, the full dividend will be covered by the dividend allowance (£5,000 for 2017/18), and Helen will not have to pay any tax on the dividend.

If she sticks with her original plan and pays the dividend in May 2018, only £2,000 will be covered by the dividend allowance, and will be received tax-free. The remaining £3,000 will be taxed. If Helen is a basic rate taxpayer, this will mean a tax bill of £225. If Helen is a higher rate taxpayer, the tax bill will be £975. Paying the dividend earlier reduces the tax payable, and takes advantage of the higher dividend allowance for 2017/18 (and keeps the 2018/19 dividend allowance free for subsequent dividends).

An ‘alphabet’ share structure potentially allows different dividends to be declared and paid in respect of each class of share – allowing dividends to be tailored to achieve the best tax outcome.

As the dividend allowance is available to all taxpayers regardless of their marginal rate of tax, increasing the number of shareholders increases the amount that can be extracted tax-free from the family company (although each shareholder must actually receive the money). In a family company scenario, the family may be happy for other members of the family to be shareholders and to receive dividends – and this can be a useful way to extract profits from the company. A company with four shareholders can extract dividends of £20,000 (4 x £5,000) tax-free in 2017/18, and of £8,000 (4 x £2,000) in 2018/19. Where there is only one shareholder, the maximum amount of dividends that can be extracted tax-free (in addition to the personal allowance) is £5,000 in 2017/18 and £2,000 in 2018/19. 

Planning ahead for the reduction in the dividend allowance can generate tax savings.