Dividend tax changes from 2016 – impact on business owners

One of the key announcements from the second 2015 Budget was a complete overhaul of the dividend taxation system from April 2016, which will result in higher taxes for limited company shareholders.

The current system of dividend tax credits will be replaced by new rates of dividend tax, together with a single £5,000 ‘allowance’.

How dividends are taxed now

At the moment, all net dividends are grossed up by 100/90 before they are taxed. A nominal 10% tax credit is applied to compensate for the fact that company profits have already been subjected to corporate tax (at 20%).

There are three dividend tax rates for the 2015/16 tax year – 10%, 32.5% and 37.5%, corresponding to the basic, higher and additional tax rates. After you’ve taken the tax credit into account, the effective tax rate is 0%, 25%, and 30.56% for the respective tax bands.

New dividend tax rules for 2016/17

The current way of calculating dividends will be scrapped.

A new £5,000 tax-free dividend allowance will be introduced, which is in addition to the £11,000 personal allowance for 2016/17.

The new tax rates will be 7.5% (basic rate), 32.5% (higher rate), and 38.1% (additional rate).

The new rules aim to counteract the ‘tax planning’ opportunities available to limited company owners, who typically pay themselves small salaries, and tax the bulk of their incomes in the form of dividends, with no National Insurance liabilities.

How much more tax will I pay?

In 2016/17, you can earn £11,000 (personal allowance), plus an additional £32,000 (basic rate band), before hitting the higher rate threshold at the £43,000 mark.

The Treasury have confirmed, via the ICAEW (14th August 2015), that the £5,000 dividend ‘allowance’ is really just a zero rate dividend tax band that sits within the Basic Rate Income Tax band, which means limited company shareholders will be worse off than many commentators expected when the Budget was delivered, as this £5,000 band is not in addition to the Basic Rate Band. See * below.

For family-owned companies, in particular, this measure is fairly punitive – especially if the shares of a company are split between a husband and wife, as the following examples demonstrate.

In these examples, we assume that the dividend allowance sits within the Basic Rate Band.

£8,000 salary, £30,000 dividends, 2 shareholders

In this example, a husband and wife pay themselves salaries of £8,000 each from their company, and split the £60,000 dividends equally in 2016/17.

• The first £8,000 in salary is tax-free, as part of the £11,000 personal allowance.
• The first £3,000 of dividends are tax-free, as part of the £11,000 personal allowance.
• The next £5,000 in dividends are tax-free, as part of the £5,000 dividend allowance*.
• The next £22,000 of dividends are taxed at 7.5% = £1,650.
• Total dividend tax = £1,650 per shareholder.

In 2015/16, the extra tax payable on this level of dividends is zero.

This results in an additional £1,650 dividend tax liability in 2016/17 per shareholder (£3,300 combined between husband and wife).

£8,000 salary, £50,000 dividends example

In this example, a company director pays himself £8,000 in salary in 2016/17, and £50,000 in net dividends.

• The first £8,000 in salary is tax-free, as part of the £11,000 personal allowance.
• The first £3,000 of dividends are tax-free, as part of the £11,000 personal allowance.
• The next £5,000 in dividends are tax-free, as part of the £5,000 dividend allowance*.
• The next £27,000 of dividends are taxed at 7.5% = £2,025.
• The remaining £15,000 of dividends are taxed at 32.5% = £4,875.
• Total dividend tax = £6,900.

In 2015/16, the extra tax payable on this level of dividends = £4,763.38.

This results in an additional £2136.62 dividend tax liability in 2016/17.

£8,000 salary, £80,000 dividends example

• The first £8,000 in salary is tax-free, as part of the £11,000 personal allowance.
• The first £3,000 of dividends are tax-free, as part of the £11,000 personal allowance.
• The next £5,000 in dividends are tax-free, as part of the £5,000 dividend allowance*.
• The next £27,000 of dividends are taxed at 7.5% = £2,025.
• The remaining £45,000 of dividends are taxed at 32.5% = £14,625.
• Total dividend tax = £16,650.

In 2015/16, the extra tax payable on this level of dividends = £12,263.38.

This results in an additional £4,386.62 dividend tax liability in 2016/17.

Further information

Use our 2016/17 Dividend Tax Calculator to see how much you will pay.

A useful article from the Ross Martin Tax Consultancy explains how there are two ways the new dividend allowance may be calculated (in our examples, we use ‘method 2’).

The ICAEW has published a document written by Rebecca Benneyworth which illustrates the likely impact of these dividend tax changes on the overall tax burden of limited company owners, compared to other business structures.