The Difference with Dividends

Dividends are the most tax efficient, and therefore most popular, method of getting cash out of a company and in just a few weeks they’re going to change.

What is a Dividend?

Dividends are distributions of profit from a company to its shareholders.

When a company operates it should hopefully create profits. These profits are liable to corporation tax at 20% (basically, on which more here) after which we are left with the distributable profits. A company can hold onto these profits to do with whatever it likes, or it can pass them along to its shareholders.

Thousands of people investing in publicly listed companies receive a dividend when their company does well. Some companies are particularly good investments because they give a dividend which is consistent or often high, thereby forming a predictable source of income. In the unpredictable financial world in which we now find ourselves, news stories are made of companies failing to deliver the dividend investors expected, such as BMW and Rolls Royce within the first few months of 2016.

Most smaller companies also have shareholders of course. Typically this will be one or two people, the founder and their partner. Sometimes there are a few owner managers. It is these small companies, not publicly listed, which are to be most affected by upcoming changes to dividend tax.

Why use a Dividend?

As a method of extracting cash from a company the dividend has been tax efficient for a few major reasons:

  1. No National Insurance Contributions – 12% saved for the employee, 13.8% for the employer.
  2. Lower tax rates compared to employment income – Where PAYE takes 20%, 40%, or 45% depending on levels of income, dividends are taxed at 10%, 32.5%, and 37.5% at the same thresholds. This is further supplemented by…
  3. The 10% tax credit – Net dividends distributed by a company are currently grossed up by a 10% notional tax credit. The notional part means you can never actually receive 10% extra, although you are taxed as if you do. This means effective tax rates for net dividends are actually 0%, 25%, and 30.6% with respect to the aforementioned thresholds.

What are the Changes?

In the Summer Budget of 2015 Chancellor George Osborne announced a raft of changes which will significantly change how owner managed companies are taxed. These are:

  1. Scrapping the tax credit – Dividends are distributed gross, what the company gives, the shareholder receives. No tax credit, notional or otherwise.
  2. Changing rates – 7.5% at the basic rate band, 32.5% at higher rates, and 38.1% for additional rate income.
  3. Introduction of a Dividend Allowance – Analogously to how all income has a personal allowance, the first £5,000 of dividends will be taxed at 0%. Technically the income is included for rate band calculations, but nothing is payable until more than £5,000 of dividends are received.

Many investors will not be affected by these changes, higher rate taxpayers with a small amount of dividend income may actually benefit from the allowance and the higher rates. For some however the changes are very significant.

From some estimate calculations imagine an owner manager receiving around £80,000 in dividends in both the 2014/15 and 2015/16 tax years, (and no other income for simplicity’s sake). They will pay £9,377 in 2014/15, rising over 60% to £15,729 in 2015/16.

This is only if things stay the same, planning can help. The simplest step is for companies to declare dividends before the changes take place. There are three weeks left in the 2015/16 tax year, I predict they will be very busy for company secretaries.

For share certificates, tax advice, or if you just found this interesting and wish to receive further advice from Wisteria’s team then get in contact with us. We are trained in a variety of financial disciplines, and are happy to help.