Dividend Tax Changes: A Whole New Ball Game?

Ken Moody sketches out the effect of the dividend tax changes announced in summer Budget 2015 on incorporation and profit extraction for small businesses from 6 April 2016.

The changes to the taxation of dividends in the Chancellor’s summer Budget 2015 have understandably caused something of a stir in mainstream media, as well as the professional press. It is stated in the Budget documents that the changes will ‘start to reduce the incentive to incorporate and remunerate through dividends rather than through wages’ (my emphasis). 

The proposed changes will not be effective until 6 April 2016, and were not included in the Finance Bill that followed the summer Budget 2015, so we don’t yet have the draft legislation to work with. However, what we know so far is that:

The first change will simplify the taxation of dividends; the second will of course affect any individual in receipt of dividends – not just private company shareholders – though the £5,000 DTA is expected to cover the dividend income of most small-time investors. The dividend tax credit, as some readers will recall, is a feature of the ‘imputation system’ of corporation tax (CT), whereby part of the CT paid by the company is ‘imputed’ to the shareholder as a credit against their income tax liability on dividends. The abolition of the tax credit in effect abandons the imputation system.  

The Chancellor had already taken some of the shine off tax-motivated incorporation by excluding goodwill transferred to a related company from qualifying for CGT entrepreneurs’ relief and from corporation tax (CT) relief for amortisation of intangible assets, in FA 2015. 

The effect of the dividend tax changes on top may make incorporation for tax reasons less attractive, though this remains to be seen. Let’s take a sole trader making annual profits of £60,000, and see what is the saving from incorporation based on the current rules, and how the dividend tax changes will affect the situation in 2016/17. 

The illustration assumes that the company pays a salary of £8,000, leaving a CT profit of £52,000, on which CT at 20% of £10,400 is payable. This leaves reserves of £41,600, all of which are distributed as dividends. The rate of corporation tax is set at 19% for the financial years starting 1 April 2017 to 2019, and will reduced to 18% from 1 April 2020. But for 2016/17 it remains at 20%. 

Sole trader Director 2015/16 Director2016/17

Tax Funds Tax Funds Tax Funds

£ £ £ £ £ £

Profit 60,000 60,000

Salary 8,000 8,000 8,000 8,000

Dividend 41,600 41,600 41,600 41,600

Tax credit 4,622

Total income 60,000 54,222 49,600

Personal allowance (11,000) (11,000) (11,000)

Taxable 49,000 43,222 38,600

IT @ 20%/10%/7.5% 6,400 3,200 2,400*

IT @ 40%/32.5% 6,800 3,647    520

Tax credit (4,322)

IT payable 13,200 (13,200) 2,525 (2,525) 2,920 (2,920)

NIC:

Class 2 150

Class 4 @ 9% on

£43,000 – £8,000 3,150

Class 4 @ 2% on 

£60,000 - £43,000            340

Total NIC 3,640 (3,640)

Funds retained 43,160 47,075 46,680

*After deducting DTA

For comparison purposes, I have used the personal allowance of £11,000 and basic rate band of £32,000 announced for 2016/17, and have estimated minor adjustment to NICs limits. The saving from incorporation for 2015/16 is £3,915 on this basis, which is about the optimum and is mainly due to NICs savings. The sole trader position does not change for 2016/17, but the saving then reduces to £3,520. 

It is unclear at present how the DTA will interact with the personal allowance. I have assumed that the personal allowance will cover the £8,000 salary and £3,000 of dividend income and the DTA will cover a further £5,000 of dividend income. As can be seen from the above, the DTA and the abolition of the tax credit will actually reduce the amount on which higher rate tax is payable, which will to some extent offset the effect of the 7.5% increase. The reductions in the rate of CT from 1 April 2017 will also slightly increase the funds retained for an incorporated business. 

An internet search will bring up a multitude of hits and commentary about the dividend tax changes, but as far as private company owner-managers are concerned they strike me as a ‘damp squib’ (at present). If one were attracted to incorporation in order to save about £4,000 per annum, one is hardly likely to be put off if the saving is some £500 less. Any such saving is not in any case absolute, since operating through a company carries with it a higher burden of accountant’s fees and various compliance costs, plus if company cars are provided the tax and Class 1A NICs on benefits in kind could easily tip the ‘saving’ into negative.

As noted, the dividend changes are intended to ‘start to’ erode the benefit of tax motivated incorporation, but since individual portfolio investors would also be hit by further dividend tax increases, the scope for such increases might therefore be circumscribed by wider political considerations.

Dividends v remuneration

The remuneration alternative to the above scenario for 2016/17 proceeds as follows:

  £

Company profit   60,000

Employer’s Class 1 NICs   (6,269) £60,000 – £8,300* = £51,700 x 100/113.8 x 13.8%

Salary   53,731

Employee’s Class 1 NICs   (4,239) (£41,600**- £8,300 = £33,300 x 12%) + (£53,731 – £41,600 x 2%)

Income tax   (10,692) £53,731 – £11,000 = £42,731 (£32,000 x 20% = £6,400) + (£10,731 x 40% = £4,292)

Funds retained    38,800

*Primary threshold (est.) ** Upper accruals point (est.)

In terms of funds retained, the dividend alternative is still nearly £8,000 better than remuneration so I do not think that the dividend changes are likely to force any widespread abandonment of the typical reward strategy for private companies – unless the dividend tax were raised to a level which would surely be totally unacceptable to other individual investors. The saving from incorporation of course remains only about £3,500 less costs: but if one intends to incorporate anyway, the dividend strategy remains intact.

Dividend v remuneration comparisons can be misleading, since variable effective rates (encompassing CT, IT and NICs) apply to successive ‘slices’ of income, which is difficult to illustrate in a simple way in a short article. However, assuming that personal allowances have been used, remuneration already exceeds the National Insurance contributions upper accruals point (where the remuneration route is taken) and the DTA has also been used, the following table may be useful.

Remuneration Dividends 2016/17

H/rate A/rate H/rate A/rate

£ £ £ £

Profit 100.00 100.00 100.00 100.00

Employer’s Class 1 NICs* (12.13) (12.13)

Salary 87.87 87.87

Employee’s Class 1 NICs @ 2% (1.76) (1.76)

Income tax @ 40% / 45% (35.15) (39.54)

CT @ 20% (20.00) (20.00)

Dividend 80.00 80.00

Income tax @ 32.5% / 37.5% (26.00) (30.00)

Funds retained 50.96 46.57 54.00 50.00

Effective overall tax rate 49% 53.5% 46% 50.00

*see calculations in Example 2.

The above figures are as one would expect. At higher income levels, the differences between the comparative rates become more marginal, but still favour dividends over remuneration. For the years 2017-20 and from 2020-21 onwards, the rates for higher rate and additional rate payers will be as follows, assuming no change in dividend tax rates. The effective overall rates for remuneration are not affected by changes in the CT rate, and so remain the same.

Of course, one of the tax reasons for incorporation is the ability to retain funds that are not required to meet the director shareholder’s living and other costs within the company, and thereby defer the income tax which would otherwise be payable if those funds are withdrawn as income.