Budget 2016: The new dividend allowance explained

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Donald-Drysdale By Donald Drysdale for ICAS

17 March 2016

Wednesday's Budget has confirmed the way dividends are to be taxed from 6 April onwards, explains Donald Drysdale.

Old news

The current system of tax credits on dividends was introduced in 1973, when the standard rate of corporation tax was 52%. In 1973/74, income tax on investment income could be as high as 90%, and this rose to 98% in the following year.

Tax rates have fallen since those times. In his Summer Budget last year the Chancellor announced that, alongside further cuts to corporation tax rates for all businesses, the government would reform and simplify the system of dividend tax, while maintaining the extensive tax reliefs for investments held in ISAs and pensions.

From 6 April, 2016 a new dividend allowance of £5,000 a year is to be introduced for all taxpayers, and the dividend tax credit will be abolished.

On 17 August, 2015 HMRC published a Dividend Allowance factsheet clarifying, to a limited extent, some aspects of the new regime.

Misunderstandings

It is not always appreciated that, in the new dividend tax regime, the pre-existing tax credit equal to 1/9th of the net dividend received will cease to exist. Instead, the old ‘net' becomes the new ‘gross'. For example, a cash dividend of £900 received on 5 April, 2016, with its accompanying non-repayable tax credit of £100, comprises gross income of £1,000; a cash dividend of £900 received on 6 April, 2016 is gross income of £900, with no tax credit.

The introduction of the dividend allowance will coincide with implementation of the new personal savings allowance, and this has caused some confusion. The personal savings allowance relates to non-dividend savings income such as bank and building society interest. The dividend allowance relates only to dividend income.

When the dividend allowance was first announced, it was understood that it would be an exemption from tax for the first £5,000 of dividend income, but this is not strictly so.

HMRC subsequently explained in their factsheet: "The Dividend Allowance will not reduce your total income for tax purposes. However, it will mean that you don't have any tax to pay on the first £5,000 of dividend income you receive. Dividends within your allowance will still count towards your basic or higher rate bands, and may therefore affect the rate of tax that you pay on dividends you receive in excess of the £5,000 allowance."

How the dividend allowance will work

Dividend income will be regarded as the highest part of the taxpayer's income. The dividend allowance will operate as a nil rate band, overlaying the existing tax bands and extinguishing tax on the lowest portion of the taxpayer's dividend income up to a maximum of £5,000. Any excess of dividend income over the allowance will be treated as the top slice of income and taxed at 7.5%, 32.5% and 38.1% within the basic, higher and additional rate bands respectively. These rates were announced provisionally last year and have been confirmed in Wednesday's Budget.

Example: In 2016/17, Seonaid has a salary of £41,000 and dividend income of £12,000. Her personal allowance is £11,000, and the basic rate band is £32,000.

Salary    £41,000
Dividend income    12,000
Total income    53,000
Less: Personal allowance    11,000
Taxable    £42,000
    
Tax on salary minus personal allowance £30,000 @ 20% £6,000
Dividend allowance at 0% within basic rate band £2,000   0
Dividend allowance at 0% within higher rate band £3,000   0
Tax on dividend income minus dividend allowance £7,000 @32.5% 2,275
    £8,275

Tax planning implications

From 6 April, 2016 it will be possible for an individual to receive annual income of up to £17,000 free of income tax, if they can fully use their dividend allowance and personal savings allowance in addition to their personal allowance. In practice most taxpayers with modest share portfolios and unexceptional savings in banks and building societies will pay no tax on their investment income.

Taxpayers who are subject to restriction of personal allowance (on total income above £100,000), or liable to the high income child benefit charge (on total income above £50,000), should note that the dividend allowance does not reduce their total income for these purposes.

Subject to other tax and non-tax considerations, spouses or civil partners may wish to transfer shareholdings between them soon in order to maximise the use of their dividend allowances in 2016/17 and future tax years.  Don't leave this until too late, otherwise dividend income will already have arisen in the wrong hands.

The new dividend tax regime aims to discourage tax-motivated incorporation of businesses, but is likely to be bad news for anyone with high dividend income. This will include, for example, those in retirement who rely on investment income from share portfolios rather than pensions. In such cases investment strategy may have to be reviewed – ensuring that optimum advantage is taken of available tax allowances such as the annual exempt amount for capital gains tax.

Those who are able to control their flow of dividends, such as proprietors of owner-managed companies, might be able to save tax in the short term by bringing forward dividends from 2016/17 to 2015/16. Where the company has distributable reserves but insufficient working capital, a dividend might still be taken early but then paid back to the company as a director's loan. Looking ahead, the tax comparison between remuneration and dividend is changing significantly and strategies for extracting company profits need to be reviewed.

Proprietors of owner-managed companies should also note that the rate of tax payable by close companies on loans to participators has been increased by Wednesday's Budget to keep it in line with the higher rate of tax on dividends – thus preventing loans from being treated more favourably than remuneration or dividends. The tax rate will be increased from 25% to 32.5% with effect for loans, advances and arrangements made on or after 6 April, 2016.

Article supplied by Taxing Words Ltd

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