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Are Dividends Still Tax Efficient?

Dividends – taxed differently from 6 April 2016

For many years owners of SMEs have sought to reap the rewards of their labour by extracting profits from their companies in the most tax efficient manner, ie low salary: high dividends. This has been long standing, straightforward and acceptable tax planning for many years and makes perfect sense. The 2015 summer Budget however announced significant changes in the way dividends are to be taxed from 6th April 2016 and caused a rethink as to how directors can remunerate themselves in the most effective way possible.

Background

Prior to 5th April 2016, someone receiving a dividend is treated as if they had received a payment from which 10% tax had been deducted. In reality, this tax was never physically deducted from the dividend and paid over to HMRC but rather it is pretended that tax has been deducted. This is called the notional tax credit. A cash dividend of £1,800 therefore is treated for tax purposes as a payment of £2,000 from which tax of £200 has been deducted.

From 6th April 2016 the notional tax credit is abolished, so the dividend a person receives is the amount that will be taxed. In addition, the following rates of tax will apply to dividend income:

Tax bandRate of tax from 06.04.16Previous effective rate*
Basic rate7.5%0%
Higher rate32.5%25%
Additional rate38.1%30.56%

* Effective tax rate is the rate that is applied to a net dividend.

Whilst a new dividend allowance will exempt the first £5,000 of dividends from tax in 2016/17, it will nevertheless form part of a person’s basic rate tax band. So, whilst a person receiving £5,000 of dividends will not pay any tax on this income they will have £5,000 less of their basic rate available to use against other income.

Salaries and bonuses

Up to 5th April 2016 dividends were always attractive due to not attracting NIC and being tax free where a person was a basic rate taxpayer. However, for corporation tax purposes they are not tax deductible and are paid out of post-tax profits. Salaries and bonuses on the other hand are tax-deductible and therefore save 20% corporation tax. This tax saving however does not fully offset the costs of NIC that salaries and bonuses attract where they are in excess of £155 p.w (£8,060 p.a), the point at which employee’s NIC becomes payable at a starting rate of 12%. Employers NIC is payable at a rate of 13.8% on earnings in excess of £156 p.w (£8,112 p.a).

Illustration

A company pays a bonus of £20,000 (including employers NIC). It’s corporation tax position will be as follows:

£
Gross bonus (inc. employers’ NIC)20,000
Less: corporation tax relief (20%)(4,000)
Net cost to company16,000

The company can therefore pay an all-inclusive bonus of £20,000 or a dividend of £16,000 and be in the same net position. The overall tax efficiency of remuneration is determined by comparing how much money the shareholder/director ends up with in their hand.

Example 1: Income within basic rate band

Phil is sole director/shareholder of his IT company. He draws a basic salary equivalent to his personal tax allowance and has already used up his £5,000 dividend allowance. His company has surplus income of £16,000 to pay out, which will have to cover tax and/or NIC as well as the bonus or dividend. Either way he wants his company to be in the same net position.

2015/162016/17
££
Option 1: Bonus
Gross bonus (inc. employers’ NIC)20,00020,000
Less: Employers’ NIC @13.8%(2,425)(2,425)
Gross bonus to employee17,57517,575
Less:
Basic rate tax (20%)(3,515)(3,515)
Employee’s NIC (12%)(2,109)(2,109)
Net income11,95111,951
Option 2: Dividend
Dividend (leaving company in same position)16,00016,000
Less: Effective tax rate: 0%/7.5%( Nil )( Nil )
Net dividend16,00014,800
Saving by taking a dividend4,0492,849

Although Phil will pay £1,200 more tax to HMRC in 2016/17 on his dividend income, the total cost of employers’ and employee’s NIC makes the bonus route far less tax efficient.

Example 2: Higher rate taxpayer

Aisha runs her own management consultancy firm. She has used up all her basic rate band and already taken dividends that utilise the tax-free dividend allowance from 2016/17. Like Phil, she is pondering whether to extract surplus company funds of £16,000 as a bonus or dividend. The calculation is similar to Phil’s but employee’s NIC will fall to 2% above the upper earnings limit of £42,385 (2015/16) and £43,000 (2016/17).

2015/162016/17
££
Option 1: Bonus
Gross bonus to employee (as per Phil above)15,57515,575
Less: Higher rate tax (40%)(7,030)(7,030)
Employee’s NIC (2%)( 352)( 352)
Net income10,19310,193
Option 2: Dividend
Dividend16,00016,000
Less: Effective tax rate: 25%/32.5%(4,000)(5,200)
Net dividend12,00010,800
Saving by taking a dividend1,807607

It is clear that Aisha is better off taking a dividend in 2015/16 and also in 2016/17 but the new dividend tax regime reduces the net benefit in 2016/17.

Example 3: Additional rate taxpayer

Tomasz has already drawn salary and dividends from his engineering company well in excess of £150,000. The comparison of a £20,000 bonus or £16,000 dividend is as follows:

2015/162016/17
££
Option 1: Bonus
Gross bonus to employee (as per Phil above)15,57515,575
Less: Additional rate (45%)(7,909)(7,909)
Employee’s NIC (2%)( 352)( 352)
Net income9,3149,314
Option 2: Dividend
Dividend16,00016,000
Less: Effective tax rate: 30.56%/38.1%(4,890)(6,096)
Net dividend11,1109,904
Saving by taking a dividend1,796590

Like Aisha, it will be beneficial for Tomasz to take dividends but the new dividend tax regime significantly limits the net benefit of dividends from 6th April 2016 onwards.

For those that wish to continue with a policy of low salary: high dividends there will continue to be savings to be made albeit not as great as in previous tax years.

Example 4: Basic rate taxpayer – low salary:high dividends

2015/162016/17
££
Option 1: Salary up to NIC primary threshold
Salary8,0608,060
Dividends34,32534,940
Less: Tax on dividends( Nil )( Nil )
Net income42,38540.975

By taking a salary up to the primary threshold (point at which employee’s NIC is triggered) not only is a corporation tax saving of £1,612 achieved but also no NIC or tax is payable as this is covered by the personal allowance. The remainder remuneration, taken in dividends, fully utilises the balance of personal allowance and the full basic rate band.

Rates & allowances

2015/16 (£)
2016/17 (£)
Personal allowance10,60011,000
Tax bands:

20%

 

0 – 31,785

 

0 – 32,000

40%31,786 – 150,00032,001 – 150,000
45%Over 150,000Over 150,000

Planning tips

Spouses and civil partners

Consider gifting shares to a spouse/civil partner to utilise their dividend allowance and also to shelter substantial dividend payments from the higher rate tax charge. As long as the couple are living together there are no capital gains tax consequences and, provided the shares are ordinary shares with equal rights, there are no Settlements Legislation implications.

Don’t neglect salary altogether as a salary up to the NIC Lower Earnings Limit of £5,824 is the point at which State Pension Credit starts to be ‘earned’.

Other factors

When considering a remuneration strategy the following factors should also be considered, where appropriate:

  • The director/shareholder prefers salary as relevant earnings in order to make pension contributions, although in a lot of cases the PSC will be funding the pension scheme.
  • The high income child benefit charge is triggered where ‘adjusted net income’ exceeds £50,000.
  • Student loans – unearned income (e.g dividends) in excess of £2,000 p.a counts as income when calculating student loan repayments.
  • Personal allowance starts to be withdrawn where adjusted net income exceeds £100,000.

Why not take a look at our accountancy packages which include taxation services or learn about salary/dividends strategies?

Our specialist contractor accountants are here to help – Contact us if you have any questions or wish to discuss how we can help you.