Will dividends still be tax efficient from 6th April 2017?

There are, no doubt, many contractors that reap the rewards of their labour by extracting profits from their companies in the most tax efficient manner, ie low salary: high dividends. This has been long standing, straightforward and acceptable tax planning for many years and makes perfect sense. The 2017 Budget proposed some changes to narrow the gap of National insurance which took a U- turn this week.

Background

Until April 2016, someone receiving a dividend was treated as if they had received a payment from which 10% tax had been deducted. In reality, this tax is never physically deducted from the dividend and paid over to HMRC but rather it is pretended that tax has been deducted. This is called the notional tax credit. A cash dividend of £1,800 therefore is treated for tax purposes as a payment of £2,000 from which tax of £200 has been deducted.

From 6th April 2016 the notional tax credit was abolished, so the dividend a person receives is the amount that will be taxed. In addition, the following rates of tax will apply to dividend income:

Tax band Rate of tax from 06.04.16 Previous effective rate*
Basic rate 7.5% 0%
Higher rate 32.5% 25%
Additional rate 38.1% 30.56%

* Effective tax rate is the rate that is applied to a net dividend.

Whilst a new dividend allowance will exempt the first £5,000 of dividends from tax in 2017/18, 2018 budget proposed to reduce this to £ 2500 April 2018. it will nevertheless form part of a person’s basic rate tax band. So whilst a person receiving £5,000 of dividends will not pay any tax on this income they will have £5,000 less of their basic rate available to use against other income. 

Salaries and bonuses

Dividends have always been attractive due to not attracting NIC and being tax free where a person is a basic rate taxpayer. However, for corporation tax purposes they are not tax deductible and are paid out of post-tax profits. Salaries and bonuses on the other hand are tax-deductible and therefore save 20% corporation tax. This tax saving however does not fully offset the costs of NIC that salaries and bonuses attract where they are in excess of £157 p.w (£8,164 p.a), the point at which employee’s NIC becomes payable at a starting rate of 12%. Employers NIC is payable at a rate of 13.8%.

Example

A company pays a bonus of £10,000 (including employers NIC). It’s corporation tax position will be as follows:

  £
Gross bonus (inc. employers’ NIC) 20,000
Less:  corporation tax relief (20%) (4,000)
Net cost to company 16,000

The company can therefore pay an all-inclusive bonus of £20,000 or a dividend of £16,000 and be in the same net position. The overall tax efficiency of remuneration is determined by comparing how much money the shareholder/director ends up with in their hand.

Example 1:  Income within basic rate band

Jackie is sole director/shareholder of her Cable company. She draws a basic salary equivalent to her personal tax allowance and has already used up her £5,000 dividend allowance. Her company has surplus income of £8,000 to pay out, which will have to cover tax and/or NIC as well as the bonus or dividend. Either way she wants her company to be in the same net position.

  2017/18
£
Option 1:  Bonus
Gross bonus (inc. employers’ NIC)
Less:  Employers’ NIC @13.8%
20,000
(2,425)
Gross bonus to employee
Less:
Basic rate tax (20%)
Employee’s NIC (12%)
17,575

(3,515)
(2,109)

Net income 11,951
Option 2:  Dividend
Dividend (leaving company in same position)
Less:  Effective tax rate:  7.5%
16,000
(1,200)
Net dividend 14,800
Saving by taking a dividend 2,849

Although Jackie will pay £2,250 more tax to HMRC in 2017/18 on his dividend income, the total cost of employers’ and employee’s NIC makes the bonus route far less tax efficient.  The reduction of Dividend allowance in April 2018 will increase the tax by £ 187.50 which still leaves Jackie with a savings of £ 2661.50.

Example 2: Higher rate taxpayer

Irina runs her own management consultancy firm. She has used up all her basic rate band and already taken dividends that utilise the tax-free dividend allowance from 2017/18. Like Jackie, she is pondering whether to extract surplus company funds of £16,000 as a bonus or dividend. The calculation is similar to Jackie’s but employee’s NIC will fall to 2% above the upper earnings limit of £45,000 (2017/18).

  2017/18
£
Option 1:  Bonus
Gross bonus to employee
(as per Adrian above)
Less:
Higher rate tax (40%)
Employee’s NIC (2%)
17,575

(7,030)
(352)

Net income 10,193
Option 2:  Dividend
Dividend
Less: Effective rate of tax; 32.5%
16,000
(5,200)
Net dividend 10,800
Saving by taking a dividend 607

It is clear that Irina is better off taking a dividend in 2017/18. However, the reduction in the Dividend allowance in April 2018 will reduce her allowance to £ 2500.00 and increase her tax by £ 812.50 making the bonus route more attractive.

Example 3: Additional rate taxpayer

Adam has already drawn salary and dividends from his engineering company well in excess of £150,000. The comparison of a £20,000 bonus or £16,000 dividend is as follows:

  2017/18
£
Option 1:  Bonus
Gross bonus
(as per Adrian above)
Less:
Additional rate (45%)
Employee’s NIC (2%)
17,575

(7,909)
(352)

Net income 9,314
Option 2:  Dividend
Dividend
Less:  Effective rate of tax; 38.1%
16,000
(6,096)
Net dividend 9,904
Saving by taking a dividend 590

Like Irina, it will be beneficial for Adam to take dividends but the new dividend tax regime significantly limited the net benefit of dividends from 6th April 2016 onwards. This will further reduce in April 2018 when the allowance is reduced to £ 2500 at which point bonus route will be more attractive.

For those that wish to continue with a policy of low salary: high dividends there will continue to be savings to be made albeit not as great as in previous tax years.

Example 4: Basic rate taxpayer – low salary: high dividends 

  2017/18
£
Option: Salary up to NIC primary threshold
Salary
DividendsLess:
Tax on dividends
8,164
36,836
45,000(2,137)
Net income 42,863

By taking a salary up to the primary threshold (point at which employee’s NIC is triggered) not only is a corporation tax saving of £1,633 achieved but also no NIC or tax is payable as this is covered by the personal allowance. The remainder remuneration, taken in dividends, fully utilises the balance of personal allowance and the full basic rate band.

Rates & Allowances

  2016/17 (£) 2017/18 (£)
Personal allowance 11,000 11,500
Tax band 20%
Tax band 40%
Tax band 45%
0 – 32,000
32,001 – 150,000
Over 150,000
0 – 33,500
33,501 – 150,000
Over 150,000

 Planning tips

Accelerating dividends

As dividend becomes less attractive or not at all you can declare dividend to cover any un-utilized income up to the higher limit before 5th April.

Spouses and civil partners

Consider gifting shares to a spouse/civil partner to utilise their dividend allowance and also to shelter substantial dividend payments from the higher rate tax charge. As long as the couple are living together there are no capital gains tax consequences and, provided the shares are ordinary shares with equal rights, there are no Settlements Legislation implications.

 Other factors

When considering a remuneration strategy the following factors should also be considered, where appropriate:

  • The director/shareholder prefers salary as relevant earnings in order to make pension contributions, although in a lot of cases the PSC will be funding the pension scheme.
  • The high income child benefit charge is triggered where ‘adjusted net income’ exceeds £50,000.
  • Student loans – unearned income (e.g dividends) in excess of £2,000 p.a counts as income when calculating student loan repayments.
  • Personal allowance starts to be withdrawn where adjusted net income exceeds £100,000.

 

At Outsourced ACC we provide a range of services to help contractors wanting to work by Setting up a Limited Company to take advantage of the flexibility and tax savings. Our all-inclusive package starts as little as £ 1800+VAT per year which includes all services from Setting up your company, Payroll, Accounts, tax returns, VAT & Personal taxes.  Call us today  0208 249 6007 or email us at info@outsourcedacc.co.uk and take advantage of our free consultation.

 

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