In his budget speech on 8th July, George Osborne announced that he would be launching major reforms to the way that dividend income is taxed from April 2016. The current system of dividend tax credits, was designed to avoid double taxation of business profits, by offering a 10% tax credit on all dividend income. This, in effect, meant that taxpayers under the higher rate threshold for income tax were not required to pay any further tax on their dividend income as the tax was deemed to have been included in the corporation tax applied to the business profits, before the profit distribution was made (ie the dividend).
The new system will offer taxpayers a £5,000 tax free dividend allowance and applies a lower dividend tax rate of 7.5% on basic rate dividend income, 32.5% on higher rate dividend income and 38.1% on Additional Rate dividend income.
The Chancellor stated in his speech that “Those who either pay themselves in dividends or have large shareholdings worth typically over £140,000 will pay more tax; 85% of those who receive dividends will see no change or be better off.”.
So how will this work in practice? Here’s an example.
Under the current system of dividend tax credits (tax year 2015-16) a company director paying himself an annual salary of £8,000, dividends of £27,000 (net) and with a company making profits chargeable to corporation tax of £40,000 the tax situation would be as follows:
Salary Income £8,000
Dividend Income £30,000 (Grossed up)
Total Income £38,000
Less Personal Allowance £(10,600)
Taxable Income £27,400
Tax due on dividend income (£27,400 x 10%) = £2,740
Minus tax credit on dividend income £(£2,740)
Tax Payable £Nil
The company would have £8,000 in corporation tax to pay on its profits of £40,000 at the rate of 20%.
Under the new system (tax year 2016-17) a company director paying himself an annual salary of £8,000, dividends of £27,000 and with a company making profits chargeable to corporation tax of £40,000 the tax situation would be as follows:
Salary Income £8,000
Less Personal Allowance £(10,800)
Taxable Income £nil
Dividend Income £27,000
Tax Free Dividend Allowance £(5,000)
Taxable Dividend Income £22,000
Tax Due on Dividend Income (£22,000 x 7.5%) = £1,650
The company would still have £8,000 in corporation tax to pay on its profits of £40,000 at the rate of 20% as the corporation tax rates are not due to be reduced until 2017. It seems clear from this example that the Chancellor is seeking to reduce the benefits associated with running a small business through a limited company and perhaps encourage more business owners to operate as sole traders or partnerships. It may be coincidental that the average tax saving for small business owners by incorporating their business was 7.5% (in terms of national insurance saved).
Other announcements affecting small business owners included:
- The rates of corporation tax will be reduced to 19% in 2017 and 18% in 2020.
- The National Insurance employment allowance will be extended and increased to £3,000 in 2016.
- The National Minimum wage will be replaced by a National Living wage (NLW), which will be increased to £7.20 per hour from April 2016 for over 25s. The Chancellor aims for the NLW to reach £9 per hour by 2020.
- The Annual Investment allowance will be permanently fixed at £200,000 from January 2016.