Never completed a tax return before? Watch out! – you might now have to.
The subjects for some of my website postings are dictated by the time of year, such as the Budget commentary, whereas for others I just choose topics I feel are currently relevant or of general interest. This time I thought I’d check what happens in our field this month, so typed ‘financial calendar – August’ into a well-known search engine. Predictably, nothing of interest came up, but what I did see was that a lot of big name companies pay an interim dividend in August. Aha! Dividend tax. Well, what do you expect in the middle of the holidays?
So why dividends? Well, the way in which dividends are taxed changed in April 2016 with the result that, in some circumstances, a higher rate taxpayer might be better off than a basic rate taxpayer, and some who have never completed a tax return before might now need to. First though, we need to understand the pre-2016 position. Note, however, that everything that follows does not apply to assets held within an ISA or a pension, or to dividends from Venture Capital Trusts (VCTs) which are tax-free.
The old regime
Until April 2016 dividends were paid with a notional 10% tax credit. If you were a basic rate taxpayer (and the dividend didn’t take you over the threshold into the higher rate bracket), then your tax liability was satisfied by this credit. Regular readers will know that I like to explain things with examples, so…
Our client receives a dividend of £100 from his shares. The way the tax credit works means that this actually represents only 90% of the taxable amount, so to work out the taxable amount it needs to be ‘grossed up’ to 100%. You do this by taking the 100 and dividing it by 0.9, which gives a gross dividend of £111.11.
The basic rate tax due on dividend income was 10%, so tax of 10% on £111.11 is £11.11. You then deduct from this the 10% tax credit of £11.11, which, surprise surprise, leaves £0 to pay in tax. So as I say, basic rate tax is satisfied by the tax credit.
That is basic rate covered, but what if our client was a higher rate tax payer? Higher rate tax on dividend income was 32.5%. Re-running the calculation, where the grossed up dividend is £111.11, the tax due at 32.5% would £36.11. Deducting the £11.11 tax credit means our client would have £25 to pay in tax or, if you prefer, 25% of the £100 net dividend actually received. For additional rate tax payers the dividend rate was 37.5%.
It might be a little complicated but you can see that, at an effective rate of 25% for a higher rate taxpayer, a dividend was preferable to a salary taxed at 40% hence, for many small business owners, structuring remuneration at least partly via dividends rather than salary has been appealing (not to mention the National Insurance savings).
The current regime
The notional 10% tax credit has now gone and been replaced with a tax-free dividend allowance, such that no tax is payable on the first £5,000 of dividend income per year (reducing to £2,000 from April 2018*). Above that, how much tax you pay depends on whether, and how much, the dividend income falls within the basic, higher or additional rate tax bands. The rates are 7.5%, 32.5% and 38.1% respectively.
How much tax you pay will depend on how much other income you have. For example, someone with only a pension of say £10,000 and dividends of £4,000 will pay no tax at all. The £10,000 falls within the personal income tax allowance and the dividend is entirely covered by the dividend allowance. But someone with a salary of £60,000 and £8,000 of dividend income would pay 32.5% on £3,000. That’s because their salary already makes them a higher rate taxpayer and only the first £5,000 of the dividend income is covered by the dividend allowance, leaving £3,000 to be taxed at the dividend higher rate of 32.5%.
This can lead to some complicated calculations where other income is close to, but below, the higher rate threshold when dividend income takes the total over the threshold.
The old against the new
So, the question is who is better off and who is worse off under the current regime? For many there will be no change, such as those who have only a small amount of dividends from a few demutualisation shares. Some will be better off, but many are worse off – it goes without saying that the Chancellor is hardly likely to make a change which pulls in less overall tax! Here are some examples (with the old regime updated to current year allowances and bands):
Mrs A has a pension income of exactly £11,500, and receives dividends of £5,000
So Mrs B, the basic rate taxpayer, is worse off than Mrs C, the higher rate taxpayer, even though both receive the same amount of dividend income. In pounds and pence terms Mrs B pays less tax on the same dividend, but in comparative terms she is worse off.
The reduction in the dividend allowance next April will drag many more people into the dividend tax net. After all, it would only take a £50,000 investment paying a dividend of 4% for this to be reached, and there are 30 shares in the FTSE 100 with dividend yields currently over 4% (dividenddata.co.uk).
There is a further consequence that needs to be considered. Previously, where basic rate dividend tax was satisfied by the 10% tax credit, it was only higher rate taxpayers that needed to complete a tax return. From next April, with basic rate tax payable on dividend income over £2,000, there will be many who have previously not needed to complete a tax return who will find that they may now have to.
The current rule is that, for dividends between £5,000 and £10,000, you can contact HMRC to request an amendment to your tax code, but for dividends over £10,000 you will need to complete a tax return. It seems a bit much for Mrs B above who will now need to complete a tax return just for £750 of tax. Furthermore, from next April when the dividend allowance will be £2,000, we don’t know yet where the boundaries will lie for mandatory completion of a tax return.
*In the Spring Budget of 2017 the Chancellor announced that the dividend allowance would be reduced to £2,000 from April 2018, but this was dropped from the Finance Bill because of the general election in June; however, it is expected that the dropped measures will be reintroduced in the next parliamentary session and that the reduced dividend allowance of £2,000 will still be effective from April 2018.
Philip Chandler APFS, CFPTM, Chartered MCSI
Chair of Aspinalls Technical and Investment Committee