The new dividend regime, which started in April 2016, means that most family companies will be paying more tax. But will dividends still be cheaper than bonuses? We shall look at the different scenarios in this article.
Recap of the new dividend regime
In the summer 2015 budget, Mr Osborne ‘delighted’ family company owners up and down the UK by announcing that he would continue his march on corporation tax rates by abolishing the dividend tax credit, and breaking a pre-election promise not to mess with tax rates by…increasing the personal tax rate on dividends.
While ‘smaller’ companies may benefit from further corporation tax reductions below the 20% rate that has persisted for ‘small’ profits for many years, the increased cost of dividends will be comparatively much worse.
The ‘sweetener’ is a £5,000 new dividend ‘allowance’, which is in fact a nil rate band especially for dividend income, for those who care about the distinction – it does not cancel out dividend income and uses up part of whatever main tax band it is in – basic rate, higher rate, etc.
The dividend allowance will be great news for those who receive modest amounts of dividends (which will now in many cases be entirely tax-free), and will probably mean that a greater number of people will benefit under the new regime than lose out. But the tax cost for those who do lose out is likely to be much more significant.
Dividends – new vs old regimes
Tom, who is director and 100% shareholder in his own company, takes a salary of £7,800 (£650 per month) and £30,000 a year in cash dividends, in both 2015/16 and 2016/17. He should not have paid any tax (or NIC) on such a small salary.
In 2015/16, Tom’s £30,000 cash dividend is ‘grossed up’ by 10/9, and he is deemed – only for tax purposes – to have received £33,333 but to have paid £3,333 in tax, hence the cash receipt of £30,000.
As most readers will know, Tom will have paid no tax in 2015/16. But he will have to pay £1,635 in tax for 2016/17, despite the increase in tax-free personal allowance in 2016/17 to £11,000.
2016/17 2015/16
Income Tax Income Tax
£ £ £ £
Salary 7,800 7,800
Dividend in rest of personal
allowance 3,200 2,800
11,000 10,600
Balance of dividend
2016/17 0% ‘New dividend
allowance’ 5,000 - N/A N/A
2016/17 7.5% balance of £30,000 21,800 1,635
2015/16 10% balance of £33,333 30,533 3,053
Deduct: Deemed tax credit
(2015/16 only) N/A ( 3,053)
Tax payable 1,635 --
Salary/bonus vs dividend from 2016/17
Having seen from the above example that dividends are generally set to become significantly more expensive from now on, how do they compare to salary, or bonuses, for the director/shareholder of a family company?
If we start with the standard small salary, this will still be more tax-efficient than dividends. The first (roughly) £8,000 of salary paid by the company to an employee will be free of tax and National Insurance contributions (NICS) cost, (assuming the employee has no other income sources within the scope of PAYE), as it will be covered by the personal allowance and earnings threshold(s) respectively. Even better, salary is tax-deductible for the company, so basically a ‘win-win’.
Dividends, however, are paid out of a company’s ‘post-tax profits’, so are not tax-deductible in the company. So the question boils down to whether or not dividends are still so tax-efficient for the individual – despite the new, more expensive regime – that they remain better overall.
Working the numbers
Jerry owns his own company. He takes a relatively small salary – say £12,000 – and dividends of £18,000 each year. His company has had a good year and can afford to pay him an extra £10,000. So, should it be in the way of a bonus addition to his salary, or should it be a dividend?
Paying a bonus – Jerry’s company will first have to pay for the employers’ NIC out of the £10,000 available. Employers’ NIC currently runs at 13.8%, so it will be 13.8%/113.8% x £10,000 = £1,213.
The company would then be able to pay £10,000 - £1,213 = 8,787 as a gross bonus to Jerry.
Jerry will have to pay Employees’ NIC (12%) and basic rate income tax (20%) on his bonus of £8,787.
He will be paying 32p in every £1 in tax and NICs (and this is on top of the company’s contributions as Jerry’s employer, as above).
He will therefore get 68p in the £1, or 68% of his gross bonus.
£8,787 x 68% = £5,975 as his net bonus, in his hand.
Paying a dividend – Jerry’s company will first have to pay off its additional corporation tax bill:
£10,000 x 20% = £2,000, leaving just £8,000 to pay as a dividend.
Since Jerry has already taken £18,000 of dividend income this year, he will already have used his £5,000 dividend ‘allowance’, and he will have to pay income tax on the additional dividend:
£8,000 x 7.5% = £600, leaving him with £7,400 net of tax, in his hand.
While Jerry is a basic rate taxpayer, he will be significantly better off taking a dividend
£7,400 net dividend v £5,975 net bonus = £1,425 better off.
Bearing in mind that we started off in both alternatives with £10,000, the ‘net yield’ to Jerry can be turned into percentages – 74% as a dividend, and 59.75% as a bonus, or a margin of 14.25% in favour of dividends.
Higher tax bands
Dividend tax rates in the new regime become relatively more punitive in higher bands:
- basic rate – 7.5% - up to £43,000 total income in 2016/17;
- higher rate – 32.5% - up to £150,000 total income in 2016/17; and
- additional rate – 38.1% - above £150,000 total income in 2016/17.
The rise in tax rates when moving to the higher rate significantly narrows the margin.
Higher rate
Let us assume that Jerry is taking a salary of £50,000 and dividends of £10,000 as the baseline, and is deciding whether or not to take the extra £10,000 as a bonus or as a dividend.
Paying a bonus – Jerry is now comfortably a higher rate taxpayer and, while the company will still have to pay the same amount of employers’ NIC leaving him with a bonus of just £8,787, his own NIC cost will have fallen to just 2%, so his combined 40% tax and 2% NICs cost will be 42p in the £1.
He will now get just 58p in the £1, or 58% of his gross bonus.
£8,787 x 58% = £5,097 as his net bonus, in his hand.
Paying a dividend - £8,000 x 32.5% = £2,600, leaving Jerry with £5,400 net of tax, in his hand.
Jerry is now just £303 better off taking a dividend; his net yields are now 54% v 50.97% = 3.03% margin, in favour of dividends.
Additional rate
Paying a bonus – the only change is that Jerry’s income tax rate has increased to 45%, so after 2% NIC he will get 53% of his bonus of £8,787.
£8,787 x 53% = £4,657 as his net bonus, in his hand.
Paying a dividend – £8,000 x 38.1% = £3,048, leaving Jerry with £4,952 net of tax, in his hand.
Jerry is now just £295 better off taking a dividend, with net yields being 49.52% vs 46.57%, or a 2.95% margin in favour of dividends.
Practical Tip:
Looking only at the basic maths, dividends remain preferable to bonuses but, while the margin is relatively decent for basic rate taxpayers, it soon narrows for higher rate taxpayers, and even more so where incomes exceed £150,000 and the additional rate comes into play.
But care is needed, for example, where incomes approach new tax bands, or other important thresholds such as the child benefit clawback (£50,000), or the loss of personal allowance (£100,000), because the relatively lower personal income from taking dividends may effectively defer the onset of more punitive rates. Advisers face numerous long-winded calculations in the months and years to come!
