Salary or dividends: Where are we now?

Alan Pink takes a fresh look at the perennial question of profit extraction by company owners in the light of recent tax changes.  

This is just one area of business taxation covered in our popular tax report 'Tax Efficient Ways To Extract Cash From Your Company' 2022/23 edition.

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The majority of the readers of Business Tax Insider will either be involved in running owner-managed businesses (OMBs) or in advising them. The purpose of this article is to have a look at the question of how owner-managers should extract their annual income from the company’s profits.  

The commercial reality and (following on from that) the tax consequences are completely different between the OMB sphere on the one hand, and the quoted or charitable sectors on the other. In an OMB, the income you take out of the company, whether in the form of salary or dividends, can be regarded in a sense as already ‘yours’, and the tax treatment in some ways reflects this essential fact.  

Everyone’s situation is different 

At the risk of repeating a truism, the first thing I should say is that it’s not sensible, in my view, simply to pose the bald question: are dividends or salary better? Everyone’s situation is different, and a number of factors need to go into the equation before you can decide which method of extracting income from the company ends up with the most money in your own pocket, and the least with HMRC.  

Although an article like this can set out the parameters and give some general pointers to the answer, there is never any substitute for ‘doing the sums’ in a particular company and personal situation. For example, the tax applying to the company can vary depending on the availability of losses and allowances, and the tax position of the individual will depend on their other income (if any) and issues such as whether the individual wishes to make pension contributions. So, beware of rules of thumb and easy answers.  

Moving goalposts 

Under the original scheme of corporation tax (known as the ‘imputation’ system), the idea was that profits received by a company, charged to corporation tax, and then paid out to individuals as dividends, should bear exactly the same effective rate of tax as if the income had just been received directly by the individual. This is no longer the case, with no tax credit being available on dividends, and the reduction in the rate of tax applying to dividends (8.75%, 33.75%, or 39.35% for 2022/23, depending on your overall marginal tax rate) not fully compensating for the fact that the income you receive as a dividend has already been taxed once, in the company.  

From next April, we are also promised an increase in the rate of corporation tax to a top rate of 25%. But I have not seen any hints that the rates of personal tax on dividends, paid after this 25% tax has been suffered in the company, will be reduced to compensate. So, the goalposts seem to be moving every year. Let’s look at a couple of examples of the impact of that.  

Example 1: The dividend route  

There are £10,000 of profits in Herbert Limited, which Mr Herbert, the 100% shareholder and sole director, wishes to pay out to himself either by salary or dividend. If he pays a dividend, the tax applied to this £10,000 profit is as follows: 

This is equivalent to an overall rate of tax of just over 26%.  

Now let’s consider the total imposition of tax and National Insurance contributions (NICs) if the £10,000 is paid out as remuneration. The first thing that one has to bear in mind is that remuneration has employer’s NICs put on top, and we will assume the new rate of 15.05% applies because Mr Herbert has already received a basic salary which uses up the nil band, and this £10,000 is a kind of ‘bonus’.  

In order to cover the employer’s NICs out of the available £10,000, the gross figure for the salary has to be £8,692: a figure, with the addition of the 15.05% employer’s NICs, amounts to £10,000. Then come the employee deductions, which will be 20% income tax and 13.25% employee’s NICs, making a total deduction of 33.25%. So HMRC gets another £2,890 through the PAYE system, meaning that Mr Herbert is left with £5,802 in his pocket, out of the original profits he has made in his company of £10,000: a staggering effective overall ‘tax’ rate of 42%.  

This example brings out the point I made earlier, that you need to consider all the facts before making a snap judgment. If the rate of NICs had been nil because Mr Herbert was taking no other earned income out of the company, the effective imposition of government duties may have been less (even substantially less) going down the salary route than going down the dividend route.  

New corporation tax rates 

Although there will be a new top rate of corporation tax of 25% from 1 April 2023, the 19% rate will still apply to companies whose profits are no more than £50,000. The rate gradually increases between £50,000 profits and £250,000 profits, reaching the full 25% rate at the latter figure.  

This gives us a marginal rate of tax for profits between £50,000 and £250,000, which is actually higher than the full rate (a situation familiar to those who remember the old small companies rate and full rates of corporation tax), and an effective marginal rate of 26.5% applies to profits in this band of £200,000.  

Let’s have a look at how that would apply to our Mr Herbert. 

Example 2: Dividend and marginal corporation tax rates 

Taking £10,000 of profits in the company, and assuming that, if not paid out as salary for Mr Herbert, it will effectively suffer the marginal corporation tax rate of 26.5%, gives us the following calculation: 

This is equivalent to an overall rate of tax of just under 33%.  

So, in this particular case, the dividend route is still substantially better than the salary route, even though the situation is a lot worse, from Mr Herbert’s point of view, than it was. 

A free choice? 

All comparisons like the above, of course, depend on the assumption that the individuals concerned have a free and unshackled choice about whether they pay out profits as dividends or as salary.  

Sometimes difficulties can arise with this, in particular, where there is more than one shareholder and their percentage shareholdings do not match up to the agreed share of profits. This can sometimes be achieved by changing the classes of shares so that different rates of dividends can be paid to different shareholders, but watch out for a possible attack from HMRC on the grounds that the dividends are really remuneration, which should have PAYE and NICs applied to them.  

HMRC have a case on their side if they do decide to mount such an attack, the case of PA Holdings Ltd v Revenue and Customs Commissioners [2011] EWCA Civ 1414. However, that case, like so many, was decided on its own particular facts and it would be worth looking at the reasons for the decision in that case before designing any kind of arrangement involving paying dividends instead of salary on different share classes. 

Practical tip 

Never adopt a ‘knee-jerk’ reaction, but always do the calculations to see whether dividends or salary are better in your particular circumstances. Do not forget that there may be other ways of extracting profits from the company which are more efficient than either salary or dividends: for example, payment of rent for the company’s occupation of property; payment of interest on loans to the company by the individual concerned; or straightforward drawdown of amounts standing to the individual’s credit in the company’s books.