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Understanding dividends

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The chancellor George Osborne wasn’t exaggerating when he said he was undertaking a “major and long overdue reform to simplify the taxation of dividends” in his Summer Budget speech.

The current dividend system was set up more than 40 years ago to avoid double taxation of profits. At the time, corporation tax was more than 50% which meant that some individuals saw an 80% tax on their dividends.

Today corporation tax is 20% (and due to fall to 18% from April 2020) but the taxation of dividends has remained unchanged. This has provided owner-managed businesses with financial incentives to incorporate and extract profits as dividends. Osborne said the government cannot reduce corporation tax further while there are “rapidly growing opportunities for tax planning”.

So the “complex and archaic system” of tax dividends will be overhauled in April 2016 with ‘a simplified structure and different tax rates. The final rules are still subject to legislation but HMRC released a factsheet of how it envisages the rules will apply on 17 August 2015. The examples in this article are based on the details from the factsheet.

Changes at a glance

There are 4 main changes that will come into  effect from April 2016.

  1. The 10% dividend tax credit will be abolished.
  2. Individuals will have a £5,000 a year tax-free dividend tax allowance. This allowance will not reduce total income for tax purposes and will only apply to dividend income.
  3. Dividend income exceeding the annual allowance will be taxed according to an individual’s income tax band. Basic rate taxpayers will pay 7.5%, higher rate 32.5% and additional rate 38.1%.
  4. No tax will be deducted at source; it will be paid through self-assessment.

Dividends paid within pensions funds and those received in shares from ISAs will stay tax-free.
The £1,000 savings allowance (£500 for higher rate taxpayers) due to come into effect in April 2016 excludes dividend income.

Who will be affected?

The government predicts that 85% of people will pay the same or less tax under the new rules. The other 15% are likely to be basic rate or non taxpayers who receive dividends exceeding £5,000 a year. This could be a business owner who receives an annual salary below the personal allowance and takes the rest of their remuneration in dividends.

Investors would need a portfolio of more than £140,000 with a 3.5% annual yield to exceed the £5,000 annual allowance.

Current rules

Dividends are paid as though 10% tax has already been deducted. This 10% is called a dividend tax credit and is equal to a ninth of the dividend. For example, a £90 dividend has a £10 dividend tax credit attached to it. For basic rate taxpayers, the 10% tax is deemed sufficient and there is no more tax to pay.

For higher and additional rate taxpayers the dividend and the dividend tax credit are added together and this figure is taxed according to an individual’s income tax band at the following rates:

  • higher rate: 32.5%
  • additional rate: 37.5%

These taxpayers can reclaim the dividend tax credit from the tax due.

You can read more by downloading our information PDF leaflet.