Are you concerned about the forthcoming changes to dividends?
The proposed new taxation system for dividends, announced by George Osborne in the Second Budget 2015, is evidently one of ‘give and take’ – while individuals will be given an annual £5,000 dividend tax allowance from 6 April 2016, the long-established dividend tax credit is to be taken away.
This somewhat unanticipated announcement has sparked debate, confusion and some negative commentary, for example that this represents an ‘attack on entrepreneurship’. However, it is unhelpful to view this policy change in isolation – rather, it should be considered in combination with various other measures announced in the Budget, such as the increased personal allowance, the introduction of the personal savings allowance and further reductions to corporation tax as these will all factor in the overall take-home pay picture and also reduce the impact of the new dividend tax regime – whatever that may prove to be.
In the 12 months following implementation, the Chancellor expects to collect a staggering £2.5 billion in additional tax which, of course, begs the question ‘who will bear the brunt of the new regime?’
Basic rate taxpayers – who currently pay 10%, although this is completely offset by the current tax credit – will pay 7.5% on dividends over and above the £5,000 allowance once the new rules take effect. Higher rate taxpayers will pay 32.5% – up from the 25% paid once the tax credit is applied – while additional rate taxpayers will pay 38.1%.
These rates remain below the main rates of income tax and, according to the Chancellor, will result in around 85% of investors paying the same or less tax. It is therefore the remaining 15% of investors, representing those with a portfolio worth upwards of £140,000 (if a 3.5% yield is assumed), who will feel the negative effects of the new regime in the form of an increased tax bill.
As with any policy there will always be winners and losers – but according to these projections, those in the latter category are in the minority.
Why the change?
The obvious question when any such new policy is announced is ‘why?’ Although undoubtedly a ‘simpler’ system for dividends, this could be viewed as no more than a welcome side-effect as the driving force behind the measure is in fact to counter tax-motivated incorporations to level the playing field between trading via a company versus an unincorporated business.
A common strategy has been for director shareholders to extract profits from their company by way of dividends, in preference to paying themselves a salary, so as to negate the need to pay National Insurance Contributions and income tax. However, with the tax advantage of taking payment as a dividend being effectively wiped out for some once the new rules come into play, those operating limited companies may be left scratching their heads as to the best way forward.
What is the best way forward?
This, of course, depends on individual circumstances but the good news is that there are certainly ways to enable vigilant investors to navigate their way around the new rules in order to avoid excessive tax increases.
Take full advantage of the £5,000 allowance
Take advantage of the introduction of the £5,000 tax free allowance by making full use of it. Married couples and civil partners would be wise to spread their taxable portfolios between them in order to make full use of each partner’s allowance.
Make use of tax bands
Married couples and civil partners should ensure taxable dividends are paid to the spouse/partner who enjoys the lowest tax band.
As the extensive tax reliefs for investments held in ISAs are set to remain, here represents an opportunity to make full use of the ISA allowance (currently £15,240) as there is no further tax to pay on dividends from ISA investments.
Consider the use of a SIPP (self-invested personal pension) as these also have the benefit of tax-free dividends.
Be wise with yield
Individuals with diverse portfolios comprising shares and funds which generate different levels of dividend income yield would be wise to shelter those with a greater yield in an ISA or SIPP in order to maximise the dividend income tax allowance.
Use the new personal savings allowance for corporate bonds
From April 2016, the first £1,000 (£500 for higher rate taxpayers) of interest income from fixed interest funds and corporate bonds will be free of income tax under the new personal savings allowance thus providing an opportunity for tax-free income in addition to the dividend allowance and ISA income.
Reduce other income
After the £5,000 dividend allowance has been used, the rate of dividend tax you pay will be directly linked to your rate of income tax, therefore reducing your other taxable income could also reduce the amount of dividend tax you pay. This could be achieved in various ways such as by transferring income bearing assets such as cash deposits to a lower earning spouse or deferring withdrawals from a drawdown pension until a new tax year.
A further option is to use pension contributions to reduce dividend tax liabilities by taking advantage of the tax relief on the contribution. Effectively, the basic rate tax band is increased by the amount of the pension contribution, meaning larger gains could be realised before the higher rate of dividend tax is payable.
Invest in VCTs
Sophisticated investors who are happy to take higher risks could consider investing in Venture Capital Trusts. Not only do these generate tax-free dividends but they will be payable in addition to tax-free dividends from ISAs as well as tax-free dividends within the new £5,000 allowance.
Defer taxation using an offshore investment bond
Dividend income within an offshore investment bond grows almost entirely free of taxation (aside from a possible small amount of withholding tax). Investors into such bonds only pay tax when profits are withdrawn. Dividend income could therefore be deferred to a time when lower rates of tax might be paid.
Speculative effects of the new dividend regime
Some have already speculated that this marks the beginning of an alignment in dividend and PAYE tax. If this is the case, it is perhaps not unreasonable to consider where is the reward for the risk of being a business owner? Will this discourage entrepreneurial activity and enterprise? With small businesses being the powerhouse of the UK economy, this could have far more widespread effects than simply an increased tax bill for high earners. Although the Treasury counter this claim by stating that the tax system “will continue to encourage entrepreneurship and investment, including through lower rates of corporation tax”, it is a concern that has nevertheless been raised.
Will we see the dawn of the partnership emerge as the tax vehicle of choice? No doubt there will be some who will require changes to their company structure.
However, in the absence of further details emerging from HMRC since the Budget and without the benefit of the passage of time, these questions remain, for now, unanswered.
The introduction of the £5,000 annual exemption will certainly have the positive effect of simplifying tax reporting and compliance for the many thousands of taxpayers who own share portfolios less than £140,000. It is hard to view this as anything other than a good thing.
However, it is not the introduction of the exemption, but rather the abolition of the tax credit that has sparked debate. Despite initial negative press, it is by no means all doom and gloom for those with portfolios greater than £140,000 – as outlined above, a variety of options exist to enable effective planning and tailored solutions so as to mitigate the impact of the new regime. Please do not hesitate to make contact if we can be of assistance in this respect.
For information of users: This material is published for the information of clients. It provides only an overview of the regulations in force at the date of publication, and no action should be taken without consulting the detailed legislation or seeking professional advice. Therefore no responsibility for loss occasioned by any person acting or refraining from action as a result of the material can be accepted by the authors or the firm.