The 2015 summer Budget heralded significant changes to the taxation of dividends from April 2016. The 10% notional tax credit will be abolished, and – despite pre-election promises – the effective rates of tax on dividend income are also set to rise, as follows:
- Basic rate band 7.5% (i.e. previous effective tax rate of 0% + 7.5%)
- Higher rate band 32.5% (i.e. previous effective tax rate of 25% +7.5%)
- Additional rate band 38.1% (i.e. previous effective tax rate of 30.56% + 7.5%)
This article will look at how the changes will affect net dividend income, and the relationship between salary and dividends.
Background
For several years, dividends have proven to be very attractive. Salary and bonuses are tax-deductible for the company, so will currently save 20% corporation tax. But this saving does not fully offset the substantial costs of National Insurance contributions (NIC) of making a payment through PAYE. Employees’ NIC starts at 12%, and employers’ NIC stands at 13.8%: at some salary levels, they are worth more to HMRC than the basic rate of income tax. Currently – and particularly while there is no additional income tax to pay on dividend income up to the personal allowance and basic rate limit (£42,385 in 2015/16) – dividends are a clear winner.
If the company pays out a bonus, it will get 20% tax relief on the payment. So it can theoretically pay a bonus of £10,000 (including employers’ NIC) because its corporation tax bill will be reduced by £2,000. These figures will apply for either 2015/16 or 2016/17, as the corporation tax rate is 20% in each year (although it is set to fall to 19% in 2017/18, and 18% in 2020/21):
£
Gross bonus (including employers’ NIC) 10,000
Less: Tax relief in company (20%) 2,000
Net cost to company of bonus of £10,000 (including employers’ NIC) 8,000
The company can therefore pay out either an ‘all-inclusive’ bonus of £10,000, or a dividend of £8,000, and be in the same net position. The overall efficiency of either route is determined by comparing how much money the shareholder/director walks away with, after all taxes, NIC, etc.
Example 1: Income within basic rate band
Caroline is a director of and shareholder in her consultancy company. She draws a basic salary of £25,000, and has negligible benefits in kind or other income, except for a £5,000 dividend she receives from her husband’s company. Her company has £8,000 spare to pay out, which will have to cover tax and/or NICs as well as the bonus or dividend – either way, she wants the company to be in the same net position.
2015/16 2016/17
£ £
Option 1: Bonus (basic rate)
Gross bonus including employers’
NIC @ 13.8% 10,000 10,000
Less:
Employers’ NIC (13.8%) 1,213 1,213
Gross bonus to employee 8,787 8,787
Less:
Basic rate tax (20%) 1,757 1,757
Employee’s NIC (12%) 1,054 1,054
Net income from salary 5,976 5,976
Option 2: Dividend (basic rate)
Dividend to shareholder (leaves
company in same position): 8,000 8,000
Add:
Notional tax credit (10% of gross
dividend or 1/9 of net dividend) –
abolished 2016/17 onwards 889 N/A
Gross dividend for tax purposes 8,889 8,000
Less:
Tax thereon (10% / 7.5%) 889 600
Net dividend to shareholder 8,000 7,400
Saving by taking dividend 2,024 1,424
In the above example, the total cost of employers’ and employees’ NICs makes the bonus route far less tax-efficient, even when the company effectively has to pay tax on the amount set aside for dividends, and Caroline pays tax on the dividends as well. But Caroline will pay £600 more tax to HMRC in 2016/17, when the new dividend regime commences.
Example 2: Higher rate taxpayer
Asif runs his own company. The company’s profits support his usual £60,000 salary, and he has already taken a dividend of £5,000, that fully utilises the tax-free dividend allowance from 2016/17. Like Caroline, he is weighing up whether to take a £10,000 bonus or an £8,000 dividend (after setting aside £2,000 to pay the additional corporation tax). The calculation is very similar to Caroline’s but employees’ NIC will fall to 2% above the upper earnings limit of £42,385.
2015/16 2016/17
£ £
Option 1: Bonus (higher rate)
Gross bonus to employee
(as per Caroline above) 8,787 8,787
Less:
Higher rate tax (40%) 3,515 3,515
Employee’s NIC (2%) 176 176
Net income from salary 5,096 5,096
Option 2: Dividend (higher rate)
Dividend to shareholder
(leaves company in same position): 8,000 8,000
Add:
Notional tax credit (10% of gross
dividend or 1/9 of net dividend) –
abolished 2016/17 onwards 889 N/A
Gross dividend for tax purposes 8,889 8,000
Less:
Tax thereon (32.5%) 2,889 2,600
Net dividend to shareholder 6,000 5,400
Saving by taking dividends 904 304
Clearly, while Asif is comfortably better off taking a dividend in 2015/16, the new dividend regime will reduce the net benefit from 2016/17. This is because the new dividend regime is significantly more punitive – in particular, although dividends are no longer ’grossed up’ in the new regime, the 10% tax credit is sorely missed.
Example 3: Additional rate taxpayer
Rita has already drawn a salary of £200,000 from her company and again has taken a small dividend of £5,000 (which utilises the tax-free dividend allowance introduced in 2016/17. The comparison of a £10,000 bonus or £8,000 dividend is as follows:
2015/16 2016/17
£ £
Option 1: Bonus (additional rate)
Gross bonus to employee (as per
Caroline above) 8,787 8,787
Less:
Additional rate tax (45%) 3,954 3,954
Employee’s NIC (2%) 176 176
Net income from salary 4,657 4,657
Option 2: Dividend (additional rate)
Dividend to shareholder (leaves
company in same position): 8,000 8,000
Add:
Notional tax credit (10% of gross
dividend or 1/9 of net dividend) –
abolished 2016/17 onwards 889 N/A
Gross dividend for tax purposes 8,889 8,000
Less:
Tax thereon (37.5% / 38.1%) 3,333 3,048
Net dividend to shareholder 5,556 4,952
Saving by taking dividends 899 295
Like Asif, Rita will be comfortably better off taking a dividend in 2015/16, but the new dividend regime again significantly restricts the net benefit of dividends from 2016/17 onwards.
Conclusion
The above examples are deliberately simplified, to illustrate the main effect of the new dividend regime – which is that more tax will be payable, from 2016/17 onwards. It seems that, while there may still be a slight benefit, the saving will fall considerably. Other factors to consider will be where:
- the shareholder/employee prefers salary as relevant earnings in order to make pension contributions (although employer contributions should not be discounted);
- income levels are around the £100,000 level at which the tax-free personal allowance starts to be withdrawn;
- use of the new dividend allowance that will make the first £5,000 of dividend income tax-free
- where the bonus or dividend may cross into a higher tax band;
- higher incomes child benefit charge; and
- student loans
Practical Tip:
In short, careful and tailored calculations (and an eye to the legislation itself, once released) will be required in order to determine if the dividend route will remain quite so popular in years to come. It seems unlikely. It may in some cases be better to take additional dividends now, rather than in 2016/17.
