As a result of the dividend tax increases proposed in the Summer 2015 Budget and now included in the draft Finance Bill 2016, the effective tax rates on company dividends vs. remuneration from 6 April 2016 will be:
% %
Basic rate taxpayer 26 40.2
Higher rate taxpayer 46 49
Additional rate taxpayer 50.5 53.4
These rates, of course, take account of the corporation tax paid on the profits out of which dividends may be paid. The above rates ignore the £5,000 dividend allowance (DA) (referred to as a dividend nil-rate in the draft legislation) which is difficult to factor in (in percentage terms) as the effect is relative to the level and composition of the income and the taxpayer’s marginal tax rate. The preferred reward strategy for many company owner-managers in recent years is to draw a salary up to the National Insurance contributions (NICs) primary threshold of about £8,000 per annum (paying no NICs at that level), and to top up with dividends. For an individual drawing dividends of £37,000, the income payable for 2016/17 would be as follows:
Income Personal BR band HR band
Allowance
£ £ £ £
Salary 8,000 (8,000)
Dividends 37,000 (3,000) 32,000 2,000
Totals 45,000 (11,000) 32,000 2,000
Tax on dividend:
Dividend in BR/HR band 32,000 2,000
DA (5,000)
Taxed at 7.5% / 32.5% 27,000 2,000
Tax payable 2,025 650
Total tax due 2,025 + 650 = £2,675
Clearly, if the DA had not applied, the liability would be an additional £5,000 x 7.5% = £375 and to pay dividends up to the basic rate limit of £32,000 the company would need a profit (net of salary) of £40,000 on which corporation tax of £8,000 is payable, plus income tax of £2,025. This represents an overall tax rate of £10,025/£48,000 = 25%. Spread across the rate bands the DA therefore makes only a marginal difference to the rates given above. Further examples of how the DA works are in HMRC’s Dividend Allowance factsheet
The differences between comparative rates for dividends and remuneration for 2016/17 have indeed narrowed for higher rate and additional rate taxpayers and will narrow by a further 2%, roughly, when the proposed further reductions in the corporation tax rate are factored in. However, the biggest difference is at basic rate level, which is of course because remuneration attracts both employers’ and employees’ NICs. A profit of £40,000 used to pay remuneration attracts employers’ Class 1 of £4,851 (£40,000 x 13.8/113.8 x 100), employees’ Class 1 (on £35,149 @ 12%) of £4,218 and income tax of £7,030, giving a total liability of £16,099 (i.e. 40.2% as above).
The upshot is that, at basic rate level, while paying up to an extra £2,000 in dividend tax is most unwelcome, the overall liability is still up to £6,000 less than paying remuneration. Dividends are always treated as the top slice of income. You can’t ‘pick and mix’ and so the choice is still basically between one or the other. Moreover, the dividend tax increases also affect portfolio investors who are petitioning the government against the changes (though at the time of writing the petition is well short of the 100,000 signatures needed for a debate in Parliament). While it seems likely that the government will press ahead with the changes in Finance Bill 2016, further increases may prove politically unacceptable.
To my mind, the real choice is not between dividends and salary (as the former retain an ‘edge’), but whether to incorporate in the first place (or possibly whether to disincorporate). If the client intends to draw out all the company’s profits to support their lifestyle, commercial reasons apart, I would probably say ‘forget it’. At higher profit levels money may be left in the company, which will at least defer income tax liability, but this may backfire when the company is wound up or sold, since the retention and particularly the investment of cash surpluses may jeopardise the company’s trading status for the purposes of capital gains tax (CGT) entrepreneurs’ relief (ER). If CGT is payable at 28%, then this would actually increase the tax ultimately payable, not least because untainted by the retention of surplus cash the disposal of shares in a trading company would normally qualify for ER.
Company paying rent
It is quite common when incorporating a business for the trading premises to be left out of the company, partly because stamp duty land tax (e.g. on a property in London) may be payable on the market value of the property (FA 2003, s 53), and also any gain on sale of the property may be subject to two levels of tax; corporation tax in the company, and CGT for the individual on capital distributions received in the event that the company is wound up.
Prior to the dividend tax increases, the overall rate of tax on dividends or rent was similar, but from 6 April 2016 payment of rent is more tax-efficient in the short term. The company gets tax relief, though it is a mistake to think of it as tax ‘saved’; the company pays less tax as it has less profit, not because it has saved anything. The individual, of course, pays tax at 20%, 40% or 45%, which is preferable to payment of either dividends or remuneration. Normally for CGT purposes ER would be available, where there is a ‘material disposal’ of shares in a company accompanied by an ‘associated disposal’ of property used by the company, but if the company pays a full commercial rent ER is denied in relation to any gain on disposal of the property (TCGA 1992, s 169P(4)(d), (5)(d)). On the other hand, if the property is subject to a mortgage, the interest can only be offset against rental income, so obviously these factors have to be balanced
Company paying interest
If a director’s loan account (DLA) is in credit, it is tax-efficient for the company to pay a commercial rate of interest on the balance. It is somewhat ironic that it is now advantageous to make payments out of a company so that the individual pays income tax at the rates that the company was formed to help avoid! The question arises, of course, as to what is a commercial rate of interest. If the company services other borrowings, then it would seem unobjectionable for similar rates to be paid on credit balances on DLAs. It may be appropriate to add a premium, since a DLA will usually be unsecured. Current bank overdraft rates might therefore be acceptable.
A DLA will usually be within the loan relationship rules as far as the company is concerned. Loan relationship debits are denied relief (by CTA 2010, s 441(3)) to the extent that the debit is, on a ‘just and reasonable apportionment’, attributable to an ‘unallowable purpose’. An unallowable purpose is defined (by s 442) as a loan relationship for a purpose which is not ‘amongst the business or other commercial purposes of the company’. There is also the ‘independent terms’ assumption (at s 444) which basically applies the terms which would be entered into between independent parties acting at arm’s length, for loan relationship purposes. If the company has no use for the funds advanced it could be argued that the whole purpose of the loan is an unallowable purpose, or even that the advance is not in reality a loan at all. Any interest disallowed is likely to be treated as a distribution or dividend, though one might take the ‘no worse off’ viewpoint in that case. If the company does in fact use the money in its business, it is highly unlikely that any of these provisions will apply, provided that the rate of interest is reasonable. The unallowable purpose test is discussed in HMRC’s Corporate Finance manual (at CFM38100-CFM38200).
Practical Tip:
If interest is paid on a DLA credit balance the company must deduct income tax at 20%, at the time of payment or when credited to the loan account, and pay this to HMRC on a quarterly basis using form CT61 (ITA 2007, s 874). The form cannot be downloaded but has to be requested on-line.
