The chancellor expects to collect £2.5bn in additional tax in the 12 months from April 2016 from his new dividend taxation plan. Not yet enshrined in law, how is dividend taxation likely to change and how can investors avoid the potential of additional tax pain?
How it works now
The taxation of dividends has always been one of the more complex issues to get to grips with. The new system announced in George Osborne’s summer Budget, is simpler, but to understand it, we need to start with the current situation.
Dividends are a distribution of company profits, made after corporation tax has been deducted. As such, dividends from UK shares and stock market funds are received by the shareholder net, as though basic-rate tax has already been deducted. The dividend comes with a 10 per cent dividend tax credit, which can be offset against personal tax liabilities but not reclaimed by non-taxpayers.
A £1,000 net dividend received by an investor is accompanied by a tax credit of £111. The gross dividend is the combined net dividend and tax credit, in this case £1,000 + £111 = £1,111.
This gross income is added to other taxable income and taxed accordingly. The tax credit recognises that corporation tax has been paid on the dividend before declaration and reduces the impact of double taxation.
In the case of non-taxpayers and basic-rate taxpayers, the personal tax liability on the gross dividend is deemed to have been satisfied by the 10 per cent tax credit. Higher and additional-rate taxpayers have an additional liability, part of which can be offset by the tax credit, as illustrated in Table 1.
How it will work
From 6 April 2016, dividends will continue to be paid after corporation tax is deducted. What is now treated as a net dividend will become a gross dividend with no accompanying dividend tax credit – these will be abolished.
Instead, all taxpayers will have a tax-free dividend allowance of £5,000 a year. This is in addition to the personal allowance and personal savings allowance. The dividend allowance applies to taxable dividends and not tax-free dividends such as from Isa or Venture Capital Trusts (VCTs). After this, the rate of tax payable on dividends will depend upon other taxable income as at present and there will be special tax rates applicable to dividend income. Essentially, once you start to pay tax on dividends, the personal tax liability for taxpayers increases by 7.5 percentage points compared to the position today This is shown in Table 2.
Dividends will all be paid gross and tax liabilities assessed and paid through self-assessment.
Winners and losers from the dividend tax change
Apart from the wealthiest, the biggest losers are likely to be basic-rate taxpayers who have taxable dividends over £5,000 a year. Those regularly using Isas will be pleased they have and should continue to do so.
There may not be many investors who fall into this bracket, but the chancellor’s main target is the substantial number of business owners who currently mix their remuneration between salary, bonus and dividend. Expect to see businesses bringing dividends forward to the current tax year ahead of the change. Pension contributions also look an increasingly attractive way for business owners to take profits.
Non-taxpayers will see no change. The level of income from dividends will remain the same with no further tax to pay.
If receiving a dividend income of £5,000 or less, basic-rate taxpayers will be no worse off and their income level will remain the same. But for a dividend income of £5,000 or more, basic-rate taxpayers will pay 7.5 per cent more tax on the excess over £5,000. For example, £12,000 worth of taxable dividend income falling into the basic-rate tax band now, has no further tax liability. However, from 6 April the investor will be faced with a £525 tax charge.
Meanwhile, the new £5,000 tax-free dividend allowance means that some higher-rate taxpayers will be better off under the new regime.
There will be a dividend income break-even point where the tax payable on dividends under the current system equals the tax on the new system. For higher-rate taxpayers this level of dividend income is £21,667. This point is shown in Box 1.
This means that higher-rate taxpayers will be better off as long as their dividend income does not exceed £21,667, but worse off if their dividends exceed this level.
Additional rate taxpayers
The £5,000 of tax-free dividends means that additional rate taxpayers will also be better off under the new regime providing their dividend income does not exceed £25,401 – their break-even point – but worse off if their dividends exceed this level.
Further complications
The tax system is full of quirks and pinch points where effective tax rates escalate. For example those with income over £100,000 start to lose their personal allowance at an effective tax rate of 60 per cent on earnings or interest income. Dividends falling within this band could be subject to an effective tax rate of 52.5 per cent.
Can VCTs or offshore bonds help the dividend tax?
For taxpaying, sophisticated investors, happy to take higher risks, VCTs generate tax-free dividends and offer upfront tax relief up to 30 per cent of the amount invested, subject to an investment cap of £200,000. Investors cannot reclaim more income tax than is paid. Tax-free dividends will be payable in addition to tax-free dividends from an Isa and tax-free dividends within the new £5,000 dividend allowance.
Dividend income within an offshore investment bond grows almost free of taxation (there may be a small amount of withholding tax). Investors only pay tax when profits are withdrawn. Furthermore, withdrawals of up to 5 per cent of the original capital a year can be taken without immediate tax charge.
Dividend income can therefore be deferred and timed to when lower rates of tax might be paid. For example, a higher-rate taxpayer will pay 32.5 per cent dividend tax after the dividend allowance, whereas if deferred until the investor is a basic-rate taxpayer, withdrawals from an offshore investment bond would be taxed at 20 per cent.
It is important to note that income withdrawals from an offshore bond do not count within the dividend allowance and a portfolio to maximise this tax break should be considered first.
Danny Cox is a certified financial planner and a chartered financial planner at Hargreaves Lansdown
