The Impact Of ‘Dividend Tax’ On Profit Extraction And Business Structuring

Alan Pink considers how the recent abolition of the dividend tax credit might affect the way company owners extract value from their businesses; or even how the business is structured.

Some of us are old enough to remember the time when the ‘imputation system’ of tax on dividends paid by companies seemed a relatively new and quite clever idea. I’m not at all convinced that what has now replaced it is equally clever. 

Under the old system, somebody receiving a dividend from a company was given a ‘tax credit’ (which could be repaid if appropriate) to allow for the fact that the dividend was being paid out of post corporation tax profits of the company. At a time when the ‘small companies rate’ of corporation tax was the same as the basic rate of income tax, there was something like complete symmetry between the case where profits were received by an individual directly on the one hand, and were received by a company and then paid out as a dividend after corporation tax on the other. There was a problem with this symmetry where the company was paying the full rate of corporation tax, but nothing was perfect, even then. 

Gordon Brown started eroding the logic and elegance of the system when he made tax credits non-refundable back in 1997. Ten years later, George Osborne effectively abolished the imputation system (which was already moribund thanks to Gordon Brown), and gave us a completely new system based on some fairly approximate estimates of the effect. 

BO (that is, before Osborne) a basic rate income taxpayer had no tax liability at all in respect of dividends because the tax credit was equal to the notional rate of tax due on the dividend (this had been reduced to 10%, I believe so that the UK could grab more of the tax in double taxation situations with other countries). A 40% income taxpayer, on the other hand, had a liability equivalent to 25% of the net amount of the dividend, to take account of the fact that, very broadly, 20% corporation tax charged on 100 gave you 80 to pay out as a dividend and, therefore, another 20 (i.e. 25% of 80) brought the total tax paid, between company and individual, to 40%. For those privileged individuals in the 45% tax band, the effective rate of tax on the net dividend was just over 30%.

After Osborne, in fact from 6 April 2016 onwards, there has been a £5,000 tax-free band for dividends (which confusingly applies even though dividends are generally treated as the top slice of one’s income), and subject to that the rate of tax is 7.5% for basic rate taxpayers, 32.5% for higher rate taxpayers, and about 38.1% for top rate taxpayers. 

The logic of taxing dividends more highly now, than before, is not at all clear. It takes place in the context of an election promise not to increase income tax and could be seen as distinctly dubious in that context. However, a cynic will no doubt simply dismiss it as another raid on businesses and those who invest in businesses to bolster up the government finances. 

This is what you might call the ‘classic’ question of owner-managed business (OMB) tax planning. Assuming that the same people are both directors and shareholders in a company, which is the predominant situation in the OMB sector, there is a planning choice between extracting income from the company as director’s remuneration or as dividends on the shares. 

In almost all cases, hitherto, dividends tend to be preferred to remuneration because dividends don’t give rise to a liability to National Insurance contributions (NIC). With NIC rates at a maximum of 12% for the employee, and 13.8% for the employer, this is a massive extra levy; and only those who need to show specifically earned income for other purposes (e.g. for mortgage applications) will voluntarily be incurring this sort of charge now. 

Post ‘dividend tax’, the basic decision is likely to be the same in almost all cases. Although dividends now give rise to roughly another 7.5% (over the nil band), this is still much less of a penalty than the alternative, which is NIC. So, I suspect that OMB companies will continue to pay the bulk of their proprietors’ income out as dividends; merely contributing a little bit more to the Exchequer in doing so.

But dividends and remuneration aren’t always the only choices available. For example, where the owners of the business also own premises from which the company trades, outside the company’s ownership, there is the option of paying rent. In the context of what we are talking about here, there is a clear advantage in this because rent does not give rise to NIC, and so beats remuneration as a method of ‘profit extraction’; but it also doesn’t give rise to this additional 7.5% ‘leakage’ of tax which happens when you pass money out as dividends. There is a big caveat here, however; where you hold the business property outside the company and charge rent, this can have the effect of denying the availability of capital gains tax (CGT) entrepreneurs’ relief if you ever sell the company and the property at around about the same time. So, be very cautious about switching from dividends to rent if this is at all a likely outcome. 

Another alternative option to taking money out of the company as rent is taking it as interest on director’s loans. If you’ve capitalised the business by way of loans to any extent rather than share capital, even if this is undrawn remuneration from previous years, there’s no reason why the company shouldn’t pay you a fair rate of return on the amount it owes you on loan account. Like rent, interest is an allowable deduction against the company’s profits (providing it isn’t excessive in amount) and incurs neither NIC nor the 7.5% ‘dividend tax’.

Possibly most radically, the change brought about by Mr Osborne from 6 April 2016 onwards could have an impact on how one sets up the business. It could be argued that, if all of the business income is paid out of the business to the individual owner-managers, all you are doing by passing the income through a limited company is adding an extra layer of tax at 7.5%. 

A sole trader does not do this, and the income tax rate payable could, therefore, be significantly lower than using a company. Alternatively, if you need limited liability because of the nature of the business, operating through a limited liability partnership (LLP) gives you the same tax result combined with personal financial protection.

However, there’s always a catch in these situations, and if the income is earned income, this catch consists in the Class 4 NIC charge of 9% which applies to trading income received by individuals (or partners/members of LLPs). On the other hand (again), this 9% rate does not apply across the board, but only on the first £40,000 or so of earned income: above a certain threshold it goes down to 2%. So, if enough bulk of your income is in the Class 4 NIC band of 2%, this is obviously preferable to passing the income through a company and incurring 7.5% dividend tax. The difference could be several thousand pounds per annum, and whilst you probably wouldn’t undergo a massive upheaval of changing the structure of an existing business to save a few thousand pounds, there’s no substitute for doing the sums before making your final decision on how to structure the business.

Where the business concerned is one that doesn’t give rise to NIC, for example exploiting properties for rent, personal ownership seems to score most highly. It is also arguably preferable from the point of view of CGT, since if you hold an investment property portfolio, say, as an individual (or through an LLP) there is only one layer of tax on sale of that property, versus the potentially two layers of tax if the investment business is run through a company, and the assets are sold, with the post corporation tax proceeds then being paid out as another taxable transaction, i.e. a dividend or a distribution on winding up of the company.