Tax & admin 18 August 2015

How to deal with the dividend tax shake-up as the owner of a small company

Owners and managers need to crunch numbers to make sure they're getting the best deal
Owners and managers need to crunch numbers to make sure they’re getting the best deal
The unexpected changes to dividend tax announced in July’s Budget will have a significant impact on owner-managers of small companies. The changes are expected to increase tax and change the way that business owners draw remuneration. Katharine Lindley, client director at EQ Investors explains.

Many small companies are structured as limited companies which means that directors can opt to draw income through a combination of salary, bonus and dividends. Under current rules, drawing dividends allows directors to minimise their exposure to personal income tax and also reduces their employer and employee national insurance contributions.

The dividend tax changes announced by the chancellor, George Osborne, will reduce some of the incentives to draw dividends over salary, but a low salary and high dividend strategy will remain tax-efficient after the changes.

We won’t know exactly how these rules will work until autumn when legislation is released in Finance Bill 2016.

Dividend tax rules

Under the current regime, when a shareholder draws dividends from his business, they are paid net and have a notional tenper cent tax credit. Non-tax payers and basic rate tax payers have no further tax to pay. Higher rate tax payers pay an additional 25 per cent and 30.56 per cent on the net dividend received.

From April 2016, the tax credit is to be abolished and dividends will be paid gross. Shareholders will have a tax-free dividend allowance of 5, 000 and excess dividends will be taxed at 7.5 per cent (basic rate), 32.5 per cent (higher rate) and 38.1 per cent (additional rate).

Salary rules

Salary payments, over certain limits, are liable to both income tax and national insurance contributions paid through PAYE. Salary payments also give rise to an employer national insurance liability.

Salary or dividend?

Salary and employer national insurance payments are a direct cost to the business and tax deductible for corporation tax. Dividends are treated as an appropriation of profits and not deductible for corporation tax; they need to be paid from post-tax profits.

The following example compares the situation under current and new rules, for a basic rate taxpayer who has already drawn a salary of 11, 000, using the tax-free personal allowance in full, and wishes to draw a further 20, 000 from his/her company.

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The dividend route remains more tax efficient than salary after April 2016, but the tax gap is closing.

What might this mean in practice?