Taxing Dividends

February Tax Technical Update by Lakshmi Narain

The announcement in the summer budget of a radical overhaul of the UK dividend tax system from April 2016, was greeted, quite justifiably, with concern. In part, the concern is driven by the fact that the accompanying Treasury documents showed that the government expects to raise £2.5 billion through the measure in the first year and £6.8 billion over the next five years.  Whilst 85% of taxpayers are expected to pay less, the remaining 15% will pay significantly more.  Clearly, it is important to understand how the new system is to work in order to restructure finances. Unsurprisingly there is still some doubt - particularly as regards dividends from foreign companies.

Current system

At present, there is a nominal tax credit associated with a UK dividend (amounting to one-ninth of the sum receivable: effectively 10% of the grossed up some).  This tax credit is, however, not repayable and operates to meet the tax liability of individuals liable at the basic rate of tax (20%). For those otherwise liable at the higher rate of tax on income, dividends are liable at an effective  rate of 25% and those at the additional rate (45%), dividends are liable at 30.6%. Because of the grossing up of the dividend for the tax credit, the nominal rates are 32.5% and 37.5% respectively. For example, a higher rate taxpayer receiving a dividend of £90, would be liable on that at an effective 25%: tax of £22.50 (technically this is tax at 32.5% on a grossed up dividend of £100 less the tax credit of £10).

Clearly this is a complex system that was ripe for reform. What we will have in its place is, unfortunately, hardly simpler .  The Office of Tax Simplification is going to have to work extremely hard to make any significant impact on the UK tax code.

New system

In simple terms, there is to be a dividend allowance of £5000 and any dividend (with no grossing up) in excess of that allowance is liable at 7.5%, 32.5% or 38.1%. It is important to note that the dividend allowance is not an exemption: it will be necessary to determine what the rate of tax would be if the dividends were, generally, the top slice of the taxpayers income.

By way of illustration: for 2016/2017 the personal allowance is expected to be £11,000, the basic rate band will extend to the next £32,000 of income and the higher rate run from £43,000 to £150,000. Hence for a taxpayer with £12,000 of dividends the tax charge will, in the following three cases be as follows:

A         With other income (assuming all is earned, e.g. remuneration)  of £15000, total income is £27,000 : dividends of £7000 at 7.5% (£5000 covered by the dividend allowance). Under the current regime there would have been no tax to pay.

B         If, other income (assuming all is earned, e.g. remuneration)  £34000, total income is £46,000: dividends of £3000 at 32.5% and £4000 at 7.5%. Under the current regime £3000 would have been taxed at an effective 25%.

C         Other income (assuming all is earned, e.g. remuneration)  £144000, total income is £156,000: dividends of £6000 at 38.1% and £1000 at 32.5%. Under current regime, £6000 at an effective 25% and £6,000 at an effective 30.6%.

The clear loser here is the basic rate taxpayer who would have had no further tax to pay as the notional tax credit would have satisfied any tax liability.

Can anything be done?

One target of this change, given the proposed reductions in corporation tax rates, is the company proprietor who could have extracted a significant amount of the company profits by way of a dividend. In order to counter the possible switch from dividend payments to capital, targeted anti-avoidance legislation is being introduced; for example, to prevent phoenix - type structures. This is to be achieved by treating a distribution in a winding up, intended to secure a tax advantage, as if it was an income distribution.  In particular, this will apply where, within a two year period after the distribution, the individual continues to be in a similar trade or activity.  There is also to be a tightening of the transactions-in-securities anti-avoidance legislation. With a £5,000 allowance, not all is lost but extreme care will be needed when restructuring.

Other issues

The proposed personal savings allowance (PSA) is also worthy of note. The PSA is to be introduced from April 2016 and comprises an allowance of £1000 for basic rate taxpayers or £500 for higher rate taxpayers. As for the dividend allowance, the PSA is not a deduction in arriving at total or taxable income. Further, the transition from £1000 to £500 and from £500 to nil will give rise to very large marginal rates of tax (the loss of the £500 for a basic rate taxpayer - an additional £100 tax for an extra £1 of income will be extremely irritating for those affected. Savings income will continue to be defined as now - broadly interest income.

The operation of the PSA and the savings rate together with the removal of the need for most deposit takers to withhold income tax from interest payments will have compliance consequences.

If you have comments on these changes, I will be delighted to hear from you.  Next month, I will look at the proposed SDLT "surcharge" on additional properties.