All change for the taxation of dividends

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From 6 April 2016, dividends received by individuals and trusts will be taxed differently. The changes may make life simpler, but may mean a higher tax bill depending on your circumstances. We explain how the new rules work.

From 6 April 2016, dividends received by individuals and trusts will be taxed differently. The changes may make life simpler but at a cost: currently, a dividend received by an individual is treated as net of a 10% tax credit. So a £90 dividend received, is grossed up to £100 of dividend income but with a 10% tax credit. The appropriate tax rate is applied – currently 10% for a basic rate taxpayer (covered by the tax credit), 32.5% for a higher rate taxpayer and 37.5% for additional rate taxpayers and trusts. The 10% tax credit is then deducted and the balance is the income tax due.

Why a 10% tax credit? That is a good question – there is no real explanation for it or justification for the complexity it brings, so it has to be welcomed that George Osborne has decided to scrap this from 6 April 2016.

Furthermore, to compensate for the loss of the tax credit, the chancellor has introduced a tax free dividend allowance of £5,000. Dividend income up to this limit will attract no tax but, above the limit, the dividend rates will be applied. Trusts will not benefit from the £5,000 allowance, although they can distribute the income to beneficiaries who may at least be able to claim some tax refund.

However, the new dividend tax rates are certainly not as generous as the current regime. The rates from 6 April will be:

  • For a basic rate taxpayer – 7.5%
  • For a higher rate taxpayer – 32.5%
  • For an additional tax taxpayer and trusts – 38.1%

Under the new regime, the maximum additional tax that could be payable on a £90 dividend is £34.29, an increase of £6.79 – or, put another way, a 25% increase in tax! The new rules will increase tax for those with large dividend incomes, but where dividend income is more modest the effect of the dividend allowance will soften the blow, as the following examples illustrate.

Let’s assume Paul is a 40% taxpayer, who receives £15,000 of dividend income. How much tax will he pay? 

   Tax in 2015/16   Tax in 2016/17  
 Dividend income received  15,000  15,000
 Add tax credit  1,667  n/a
 Gross dividend  16,667  15,000
 Less annual exemption  n/a  5,000
 Taxable dividend income  16,667              10,000
 Tax due at the dividend rate for a higher rate taxpayer (32.5%)  5,417  3,250
 Less tax credit  1,667  n/a
 Tax to pay  3,750  3,250

In this example, Paul is actually better off by £500, but what if Paul’s dividend income was £25,000?

   Tax in 2015/16  Tax in 2016/17  
 Dividend income received   25,000  25,000
 Add tax credit  2,777  n/a
 Gross dividend  27,777          25,000
 Less annual exemption  n/a  5,000
 Taxable dividend income  27,777  20,000
 Tax due at the dividend rate for a higher rate taxpayer (32.5%)  9,027  6,500
 Less tax credit  2,777  n/a
 Tax to pay  6,250  6,500

This shows how a modest increase in dividend income of just £10,000 means that Paul is £250 worse off under the new regime. These changes will perhaps affect hardest those who use dividends to extract profits from their business to avoid the higher rates of employment income tax and national insurance.

For those with investments, the changes should certainly encourage more people to ensure they utilise their ISA allowances to get the benefit of the tax free environment they offer. It should also encourage trustees of family trusts to consider how best they can either manage their income levels or maximise the benefits of making income distributions to beneficiaries, although care will still be needed to consider the impact of the complex “tax pool” income tax rules before any such distributions are made.

The Government is already concerned that the impact of these rules will simply encourage taxpayers to convert income into capital. It is not surprising therefore that they are already proposing anti-avoidance rules targeted at such planning – watch this space!

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