Fewer tax advantages for dividends?

The Chancellor has announced a major reform to dividend taxation which will have owners of small and medium sized businesses up in arms.

The Chancellor has announced a major attack on the profit extraction strategy of small and medium sized businesses owners. On the one hand the reduction in corporation tax rates to 19 per cent from 2017 and 18 per cent 2020 will likely be offset by increases in dividend tax rates leaving the director shareholder worse off in most cases.

Equalising benefits

The new rules are designed to move towards equalising the benefit of taking dividends rather than salary and have been highlighted due to the progressive lowering of corporation tax rates over recent times.

Details of the new rules are sketchy at this stage but we know they will take effect from 6 April 2016 and revised rates of taxation have been announced.

Situations it will impact

Under current rules it is common practice for a shareholder director to have a mix of salary and dividend. The main reason for paying the dividends being that in all cases the dividend is cheaper from a tax perspective than paying a bonus. For example, a small company which is owned jointly by a husband and wife where the corporate tax profits are less than £300,000 and the dividends paid to the shareholders are less than the higher rate income tax threshold would only pay corporate tax on the profit earned in the company and no additional income tax. In these circumstances the profits are taxed at an effective rate of 20 per cent (i.e. just the corporate tax). Compare this to taking salary instead and the marginal rate on £1 of profit earned and extracted jumps to just over 40 per cent. For those subject to the higher and additional rate of income tax the differential in tax marginal tax rates per £1 of profit are lower but broadly the saving is around 9 per cent when paying a dividend compared to salary.

A balancing act

The changes announced today are aimed at in part correcting this imbalance but at first sight it seems that the changes will not completely remove the advantage to paying dividends. As at time of publication the Budget Tax Impact Note has not been published which might suggest some confusion within the Treasury.

What do we know? The new rules will introduce new dividend tax rates from 6 April 2016. The rates will be:

Income tax New rate
Existing rate*
Basic rate
Higher rate
Additional rate

*rate of dividend net of 10% tax credit

The rules will also include a £5,000 dividend exemption. It is not clear at this stage whether this will apply all dividend income irrespective of the amount received in a tax year or whether the £5,000 exemption is withdrawn if dividend income is above that level.

What it means

On the face of it a 7.5 per cent increase in income tax for shareholders in a private business will be very unwelcome and whilst it may be an attempt to correct an imbalance it is still a real tax increase. Whilst falling corporate tax rates are welcome, increasing taxes on extracting income will be a bitter pill to swallow for many. It is hard for that not to be seen as an attack on entrepreneurialism and enterprise for small and medium sized businesses who likely view the tax breaks from paying dividends as a way of correcting and imbalance for taking risk in setting up their own business and employing people.

Please contact Craig Simpson if you want to discuss how this might impact you.