In is Summer Budget, the Chancellor announced far-reaching reforms to the way in which dividends are taxed. If you are the director of a personal or family company and extract profits in the form of dividends, this will affect you.
Under the rules as they currently stand, it is preferable from a tax and National Insurance perspective to operate as a limited company and to take a small salary to preserve entitlement to the state pension and certain contributory benefits and to withdraw additional profits in the form of dividends. Although dividends must be paid out of after-tax profits (once corporation tax has been paid), withdrawing profits as dividends has a number of advantages:
– no National Insurance contributions are payable on dividends; and
– the availability of the 10 per cent tax credit attaching to dividends means that there is no further tax to pay until total income reaches the threshold at which higher rate tax becomes payable (£42,385 for 2015/16). Thereafter, the effective rate of tax on the net dividend is 25% for a higher rate taxpayer and 30.6% for an additional rate taxpayer.
What is changing? From 6th April 2016 the 10% tax credit on dividends is being abolished. This means that it will no longer be necessary to gross up the amount of dividend actually paid to take account of this tax credit or to deduct the tax credit from the tax that you owe – the amount paid by your company will from 6 April 2016 be the gross amount of the dividend.
To compensate for this loss of tax credit, a new tax-free allowance of £5,000 will be available for dividends. Once this allowance has been used up, dividend income will be taxed at the appropriate dividend tax rate, which will be 7.5% for a basic rate taxpayer, 32.5% for a higher rate tax payer and 38.1% for an additional rate taxpayer.
This means that anyone whose dividends are taxed at the basic rate and who, once the personal allowance has been used up, has dividend income of more than £5,000 a year will pay more tax on their dividends from April 2016. It will no longer be possible to pay a small salary (covered by personal allowance) and to then pay dividends until the higher rate threshold is reached without having to pay any further tax on those dividends. It will also be necessary to ensure funds are available to pay the additional tax that will be due on the dividend.
It is advisable to speak to your tax adviser as to how these changes will affect you and to discuss your optimal profit extraction strategy going forward. Although the new dividend rules do not come into force until 2016/17, it is also advisable to review your dividend extraction strategy for 2015/16 as it may be beneficial to accelerate dividend payments to before 6 April 2016 to take advantage of the more favourable dividend tax rates applying before that date.
One-man companies to lose employment allowance It should also be noted that the National Insurance employment allowance will not be available to companies where the director is the sole employee from 6 April 2016 onwards. For personal companies this will affect the optimal salary level and impact on the profit extraction strategy.
Is a limited company still the best option? You may also wish to consider whether operating through a limited company remains the best option for you. However, before making a decision you may wish to see what the Chancellor does to Class 4 National Insurance Contributions, which are payable by the self-employed on their profits. At the time of the March 2015 Budget the Chancellor announced his intention to consult on the abolition of Class 2 National Insurance contributions and the reform of Class 4 contributions to provide benefit entitlement. The consultation is expected later in the year. However, it should be noted that as things currently stand, disincorporation relief, which allows a company to transfer assets to its shareholders without triggering a tax charge, is only available where the transfer of assets occurs before 31 March 2018. If you are thinking of disincorporating, you may wish to do so before that date.