Since the budget this summer, there has been much discussion about the impact of the changes to dividend taxation announced by the Chancellor. With the publication of further documentation in recent weeks the picture has become a little clearer, but questions still remain. The changes take effect in April 2016.
Firstly it is worth remembering that if you’re receiving dividends within an ISA product which are therefore untaxed now, they’ll remain the same. The changes don’t affect shares and dividends inside an ISA ‘wrapper’. But the impact will be felt by those who are taking a mixture of salary and dividends from their own company far more than most.
For these people, the changes are very significant. Currently, dividend income is ‘grossed-up’, then taxed. This increases taxable income, triggering in some cases an earlier withdrawal of child benefit (between £50k and £60k of taxable income), or personal allowance (over £100k). The new rules require no ‘grossing-up’, so a limited number of people may benefit in this respect from the changes.
So, currently the net dividend paid out is taxed at 0% for basic rate taxpayers, 25% for higher rate, and 30.6% for additional rate taxpayers. The bands are flexed by the ‘grossing-up’ mentioned above, but that is ending so we’ll say no more about it here. Each rate has been raised by 7.5%, so to 7.5%, 32.5% and 38.1%. However, a £5k dividend allowance has been added, reportedly to ensure that small investors with limited dividend income don’t pay tax on dividends after the changes that they didn’t have to pay before (typically, pensioners and other voters!).
The £5k allowance has been clarified most in recent days. This should not be thought of as an allowance, but a 0% tax band, superimposed on the bandings in your tax calculation. So, if you have £20k of dividends in the basic rate band after the changes, you’ll pay basic rate dividend tax (at 7.5%) on £15k of them, the other £5k being tax free. Importantly though, if you have dividends that fall partly into a higher band, the £5k does not reduce your overall income, pulling some or all of the more highly taxed dividends back into the lower band.
For example, if most of your income was dividends, and your total income is £45k, then using next year’s tax bands and thresholds, £11k of your income would fall within the personal allowance and be free of tax. The next £32k would fall into the basic rate band. The final £2k into the higher rate band. The impact of the £5k dividend allowance is to reduce the tax on £5k of the dividends in the basic rate band from 7.5% to 0%, and the top £2k of dividends will still be taxed at the higher 32.5%. The allowance does not reduce overall taxable dividends, an effect which might have been expected.
This gives one or two unusual results. There is the counter-intuitive impact on child benefit and personal allowance withdrawal mentioned above. In addition, the dividend allowance is actually worth more to someone with a large amount of other income. For a basic rate taxpayer, the allowance is worth a tax reduction of up to £375, whereas in the hands of an additional rate taxpayer, it may be worth £1,905! Compare this to the position on the ‘personal savings’ allowance announced previously, expected to operate from April 2016. This allowance is limited for higher rate taxpayers, and not available at all to additional rate payers.
For most incorporation will still offer tax benefits over self employment, and of course tax alone is not the reason most people incorporate. Being your own boss and the prestige of having your own company still appeals to many. The requirements of a contractors customers may motivate others. But one thing’s for sure – the flexible workforce in the UK is definitely going to be a bit worse off next April. Even if many of them won’t be paying the extra tax until January 2018.
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