Where dividend taxation is concerned, it is the individual’s taxation burden that usually attracts the most attention.
When providing personal financial advice, this makes perfect sense. However, as the corporation tax on profits reduces the dividend that can be paid, both types of tax need to be considered if the overall impact is to be understood.
Until 1973, company profits that were used to pay dividends had already been taxed, and the dividends were then taxed on the individual as income.
In 1973, Advance Corporation Tax (Act) was introduced. This required companies to pay some of their corporation tax in advance by deducting Act when paying a dividend.
With some exceptions and limits, the company could offset the Act they deducted against their corporation tax.
The individual received a tax credit that was equal to the amount of Act paid, which they could reclaim or use to offset their personal tax liability.
Personal taxation principle
Act introduced the principle that personal taxation should take into account any corporation tax that had already been paid. Arguably, this constituted tax relief for the individual, rather than a separate tax.
Box One shows how this worked, based on the 1973/74 tax year.
Box One: Tax year 1973/74
Floyd Ltd made profits of £1,000, which it used to fund a dividend. Floyd Ltd needed to allow for 52 per cent (£520) corporation tax on this profit. The remaining £480 was the gross dividend. Before it was paid, 30 per cent (£144) Act was deducted, resulting in a net dividend of £336.
Floyd Ltd could offset the £144 as a credit against its corporation tax, reducing the final corporation tax payment to £376.
If the dividend was received by James, who is a higher-rate taxpayer, his 55 per cent tax liability could be partially offset by the Act tax credit. He therefore paid £120 tax (£480 x 55 per cent – £144). From the £1,000 profit, a total of £640 tax has been deducted (£520 + £120).
Breaking the link
In April 1993, three changes took place. The first was that a lower basic rate tax rate for dividends was introduced. This was 20 per cent instead of 25 per cent.
The higher rate dividend income continued to be taxed at 40 per cent.
The second was that the Act was set at 22.5 per cent instead of being linked to the rate of basic rate tax.
Finally, the Act tax credit was linked to basic rate tax instead of to the actual Act rate. See Box Two.
Box Two: Tax year 1993/94
Depeche Ltd made profits of £1,000, which it used to fund a dividend. Depeche Ltd needed to allow for 33 per cent (£330) corporation tax on this profit. The remaining £670 was the gross dividend. Before it was paid, 22.5 per cent (£150.75) Act was deducted, resulting in a net dividend of £519.25. The £150.75 credit reduced the final corporation tax payment to £179.25.
If the dividend was received by Lisa, who is a higher-rate taxpayer, her 40 per cent tax liability could be partially offset by the Act tax credit. She therefore paid £117.25 tax (£670 x 40 per cent – £150.75). From the £1,000 profit, a total of £447.25 tax has been deducted (£330 + £117.25).
Abolition of Act
From April 1997, the individual Act tax credit could no longer be reclaimed by non-taxpayers, except for charities and personal equity plans.
Act was then abolished in April 1999, and replaced by a 10 per cent dividend income tax credit that was non-reclaimable for all non-taxpayers, except in Isas until 2004/05.
Despite sounding like a tax was being removed, the abolition of Act increased the total tax paid on dividends. See Box Three.
Box Three: Tax year 1999/00
Fatboy Ltd made profits of £1,000, which it used to fund a dividend. Fatboy Ltd paid 30 per cent (£300) corporation tax on this profit. The remaining £700 was paid as a gross dividend of £777.78 with a 10 per cent tax credit of £77.78.
If the dividend was received by Michael, who is a higher-rate taxpayer, his 32.5 per cent tax liability could be partially offset by the 10 per cent tax credit. He therefore paid £175 tax (£777.78 x 32.5% – £77.78). From the £1,000 profit, a total of £475 tax has been deducted (£300 + £175).
Abolition of dividend tax credit
Although corporation and income tax rates changed over the years, this basic structure of dividend taxation remained in place until April 2016.
From 2016, the dividend tax credit was abolished, the basic rate of dividend tax was reduced and a £5,000 dividend allowance was introduced.
It was then announced that the dividend allowance is to be reduced to £2,000 in 2018/19. See Box Four.
Box Four: Tax year 2017/18
Sheeran Ltd made profits of £1,000, which it used to fund a dividend. Sheeran Ltd paid 19 per cent (£190) corporation tax on this profit. The remaining £810 was paid as a gross dividend.
If the dividend is received by Jessica, a higher-rate taxpayer, she would pay no further tax if the dividend falls within her dividend allowance and £263.25 tax (32.5 per cent) if she has no dividend allowance left.
From the £1,000 profit, a total between £190 tax and £453.25 tax (£190 + £263.25) has been deducted.
Back to the 1970s?
Other than the dividend tax allowance, we have returned to the dividend tax structure that was in place before the 1973 introduction of Act.
Income tax is charged on dividends that have been paid from company profits and that have already been fully subject to corporation tax.
For more than a quarter of a century, the total tax deducted from dividends has remained broadly the same at 44.7 per cent, 47.5 per cent and 45.3 per cent, respectively.
However, this is not the whole story. Since 1993, the corporation tax rate has almost halved, with the difference being made up by income tax.
This shift in the burden of taxation from the business to the individual is not necessarily bad news for the individual.
Pensions tax shelters
As well as the dividend allowance, there are also tax shelters such as Isas and pensions, which can be used so that no personal income tax then needs to be paid on dividends.
For individuals who can hold all of their dividend-producing assets within a tax shelter and/or not exceed their dividend allowance, the total tax paid on dividends can be purely determined by corporation tax, which is due to fall further to 17 per cent by 2020.
Therefore, is this a return to the 1970s?
Structurally it is, but the total tax paid could be as little as one third of what it would have been.
Phil Warner is head of technical at Hargreaves Lansdown
