New dividend tax changes from 6th April 2016

There’s been limited coverage in the news about the changes to the dividend tax system that are due to take effect in April 2016, and many contractors and consultants are unsure of what the changes will mean.

Some contractors are even asking if it is financially viable to work for themselves with all the changes and if the dividend tax will wipe out any financial benefits gained by working for yourself. In this article, we’ll give you the facts around the dividend tax changes as well as some examples to show you that whilst the changes do have a financial impact, you are still better off trading as a limited company than any other trading vehicle.

The dividend tax system is going through a period of modernisation to reflect how many of us work – through a limited company as a tax-efficient trading vehicle and then recoup some of the dividend tax revenue available from limited companies large and small.

So what are the main dividend tax changes?

  1. From 6 April 2016, the dividend tax credit will cease to exist and it will be replaced by a £5,000 tax-free allowance and a new dividend taxation system.
  2. The tax is payable by individuals (not the company) receiving dividend income. The tax will be calculated on your individual Self Assessment Tax Return and payable as normal before the 31 January deadline following the tax year end.
  3. The rates will be:
    a. 7.5% on dividend income within the basic rate band (vs 0% today).
    b. 32.5% on dividend income within the higher rate tax band (vs 25% today).
    c. 38.1% on dividend income within the additional rate band (vs 32.5% today). 

Yes, there will be an impact on the amount of tax paid by contractors and consultants, but the overall change is lessened by other factors which we’ll explain in more detail. It is worth noting at this stage, that even with the new taxation system you are still better off financially trading through a limited company than any other trading vehicle.

Positive changes lessening the impact of the new dividend tax

Before we talk about the positive changes linked to the new dividend tax system, it’s worth noting that there is still no National Insurance Contributions (NICs) payable on dividends. This means that dividends are still a great tax-efficient source of income.

In tandem with the new system, the Government has also announced that the rate of corporation tax is reducing over the next 4 years from 20% today, to 19% in 2017 and 18% in 2020. This means that in the longer term, the reduction in corporation tax will lessen the impact of the increased personal income tax incurred when drawing dividends as income.

Examples – how the tax allowance works

Tax calculations are complex, so we’ve illustrated the direct impact on dividends only. Remember, this calculation shows the impact in 2016, the reduction in corporation tax will lower your company’s tax bill by 2020 and therefore lessen the overall impact of the changes. We’ve assumed that the personal allowance has been used up by salary payments.

Essentially, if you plan to stay within the basic rate tax threshold, you’d need to increase your rate by around £1/hr to counter the increase.

15/16 dividend tax rules 16/17 dividend tax rules Increase
Dividend payment Tax Credit Gross Dividend Tax payable Dividend payment Tax payable
5,000 556 5,556 0 5,000 0 0
10,000 1,111 11,111 0 10,000 375 375
20,000 2,222 22,222 0 20,000 1,125 1,125
30,000 3,333 33,333 348 30,000 1,875 1,527
40,000 4,444 44,444 2,848 40,000 4,625 1,777
50,000 5,556 55,556 5,348 50,000 7,875 2,527
60,000 6,667 66,667 7,848 60,000 11,125 3,277
70,000 7,778 77,778 10,348 70,000 14,375 4,027
28,607* 3,179 31,785 0 32,000* 2,025 2,025

*This example is when dividends are paid up to the higher rate threshold

The figures above show the reality of the changes, we’ve also included some examples from HMRC to show you how the tax works for extra clarity.

The calculations use the following April 2016 allowances and thresholds:

  • Personal Allowance: £11,000
  • Basic Rate Limit: £32,000
  • Higher Rate Threshold: £43,000

Example 1

For someone receiving a non-dividend income of £18,000 (i.e. salary) and dividends of £22,000. Note the total income (£40,000) is still below the higher rate tax threshold.

  • On the £18,000 non-dividend income:
    • £11,000 is covered by the Personal Allowance
    • The remaining £7,000 is taxed as the Basic Rate
  • Of the £22,000 dividend income:
    • The Dividend Allowance covers the first £5,000
    • The remaining £17,000 of dividends will be taxed at the Basic Rate (7.5% vs 0% previously).

Example 2

For someone receiving a non-dividend income of £12,000 (i.e. salary), and dividends of £40,000. Note that the total income (£52,000) means the person would be a higher rate tax payer.

  • On the £12,000 non-dividend income:
    • £11,000 is covered by the Personal allowance
    • The remaining £1,000 is taxed at the Basic Rate
  • This leaves £31,000 that can be earned within the basic rate limit before the higher rate threshold is reached.
  • Of the dividends paid, the £5,000 allowance is applied and not subject to tax.
  • The next £26,000 of dividends (using the £31,000 up to the higher rate threshold) is subject to 7.5% tax (compared to 0% previously).
  • The remaining income of £9,000 over the higher rate threshold would be subject to the higher rate tax of 32.5% (vs 25% previously).

Example 3

For someone receiving a non-dividend income of £40,000 (i.e. salary), and dividends of £9,000. Note the total income (£49,000) means this person would be a higher rate tax payer.

  • On the £40,000 non-dividend income:
    • £11,000 is covered by the Personal Allowance
    • The remaining £29,000 is taxed at the basic rate
  • This leaves £3,000 of income that can be earned within the basic rate limit before the higher rate threshold is reached.
  • The dividend allowance covers the £3,000 in the basic rate tax band and £2,000 of the dividend in the higher rate tax band. This means that £5,000 of the dividend income is covered by the allowance and not subject to tax.
  • The remaining £4,000 of dividends are all taxed at the higher rate 32.5% (vs 25% previously).

What you should do now

For most contractors and consultants, it will be a case of carrying on as normal, but be aware of the new tax. This will mean that you’ll continue to pay yourself in the same way as before, but you’ll need to make provision for additional personal tax liabilities.

We’re updating the higher rate tax calculator in preparation for the start of the new tax year on 6th April 2016 so you’ll be able to keep track of the new dividend tax that will be paid via Self Assessment.