“The government has identified a number of areas of the tax system where imbalances have developed over time and where certain reliefs are disproportionately benefiting certain groups of individuals.” – Summer Budget 2015
A tax hike of 7.5% on dividend income is one of the ways that George Osborne’s Summer Budget 2015 is looking to redress the balance. Not exactly welcome news for contractors and small business owners.
Following a dividend tax reform, anyone earning taxable dividend income up to the basic rate threshold of £32,000 per year will pay a maximum of an extra £350 in taxes, And for higher rate taxpayers, the extra 7.5% equates to an income tax rate of 46%, significantly higher than they pay now. This will be introduced in April 2016.
The current system
Under the current system individuals receiving dividends get a 10% tax credit. For example, this means that for basic rate taxpayers the 10% tax credit effectively reduces their dividend tax liability to zero.
This tax credit means that the current tax rates on dividends are:
- Zero for individuals in the 20% basic rate of income tax band;
- 25% for individuals in the 40% higher rate of income tax band
- 6% for individuals in the additional 45% rate band.
The new system
Under the new system, the 10% tax credit will be scrapped and a new tax-free dividend allowance of £5,000 will be introduced. So, although all those who receive dividends won’t pay tax on the first £5,000, the remainder will be taxed at the following new higher rates:
- 5% for basic rate taxpayers
- 5% for higher rate taxpayers
- 1% for additional rate taxpayers.
Under the old system, the tax that individuals pay on their profits is pretty much in line with the income tax that an employee on a comparable salary would have to pay. Basic rate taxpayers pay no additional income tax on dividends, and higher rate taxpayers pay 25% on net dividends. Now, individuals who are basic rate taxpayers will pay 7.5% on their dividend income, and higher rate taxpayers 32.5%.
A couple of quick examples
Example 1 – Higher rate tax payer
ABC is a contractor limited company with a salary of £11,000 and profits of £100,000. After corporation tax the distributable profits via dividends are £80,000.
The new Dividend Tax Allowance of £5000 will be deducted to give a taxable dividend amount of £75,000.
If the contractor decides to take all of their dividends this would mean that a portion of their tax would be eligible at the higher rate band. The dividend tax calculation would look like this:
- The basic rate band is £11,000 – £43,000, so £32,000 of the total amount will be taxed at that new 7.5% basic rate. This equals £2,400.
- For the higher rate band of the calculation, taxpayers will still pay the 20% corporation tax rate, which would be £20,000 for this example, plus the new higher rate tax rate of 32.5% (an extra 7.5% on the old rate of 25%) on net profits. This would be £6,000, and equates to a 6% increase in overall taxation.
This example highlights that contractors and small business owners could be paying more tax come April 2016.
Example 2 – basic rate tax payer
DEF is a contractor limited company with a salary of £11,000 and profits of £46,250. After corporation tax the distributable profits via dividends are £37,000.
The new Dividend Tax Allowance of £5000 will be deducted to give a taxable dividend amount of £32,000.
If the contractor decides to take all of their dividends, then £32,000 of the total amount will be taxed at the new 7.5% basic rate. This equals £2,400. Under the old system this would have been £2,050. So, in this example DEF will pay £350 more than they did before.
So, is being an employee better?
To answer the original question, it’s a matter of choice. If you’re a basic rate taxpayer then moving to employment will almost certainly not be the right move, dependent on earnings and expenses.
If you’re a higher rate taxpayer, that decision is a little bit more significant and will require some clever accountancy to ensure that you’re using all of your tax allowances to the best of your advantage. And any accountant worth their salt should know exactly what to do on a case-by-case basis.
So, don’t worry, as we’ll be getting you up-to-speed ahead of the new tax rates kicking in. We’ll keep you posted on key dates and information; we can set up a free tax review to discuss your situation in plenty of time; and our umbrella service is also an option should we identify that this would be more beneficial to you.