From April 2016, the old system of issuing a tax credit on dividends will be abolished and dividend tax rate will be increased to 7.5% for basic rate taxpayers after an allowance of £5000. For higher rate taxpayers, the rate will be 32.5% (the current rate is 25%) and for additional rate taxpayers, the number is 38.1% (the current rate is 30.56%).
Actually despite a system that most business directors rely on, Osborne seems to think it is not going to affect 85% of businesses
These changes will affect the operating of practically every small business as a limited company. Many owners of small limited companies choose to be paid through a combination of minimum wages and dividends to minimize both income tax and national insurance contributions. Also many UK limited owner directors that currently live in the EU take advantage of the reciprocal tax agreements that gives a credit on the dividends that can be offset in their country of residents.
The Budget changes mean that the current dividend/wages strategy of many businesses may no longer be the most efficient way of extracting money from the business and it will most likely force them to look to other ways to save tax.
Furthermore, from April 2016, if the director is the sole employee of the company, he will no longer be able to claim the NIC employment allowance.
Personal service companies will no longer be an attractive one-person business model. Some business owners, especially those who pay at the top 45% income tax rate are likely to dispose of their business before the rules are implemented.
One expert commented that trading through a company medium is now less attractive and business owners may want to consider taking accelerated dividends before the change comes.
Scraping the dividend tax credit was perhaps for some a change waiting to happen. The “imaginary” credit which is neither paid or rein-burst is a confusing system.
The existing dividend tax credit is to be replaced with a tax-free dividend allowance of GBP5,000/year for all taxpayers. The new dividend tax model is simpler and taxing dividends will be much more transparent.
This move is expected to raise an extra GBP6.8 billion for the Exchequer, coming mostly from top-rate taxpayers’ contributions. If you are an investor with a modest portfolio, you will not pay any extra tax.
According to Chancellor George Osborne, this change is intended to deter small businesses from incorporating for tax reasons. This is a prerequisite for a planned further corporation tax reduction to 19% in 2017 and 18% in 2020.
Pay yourself in dividends
Let’s talk about the new dividend policy further. This new policy would really affect the amount of cash entrepreneurs take home. The Dividend Tax Credit will no longer be in effect starting April 2016. It will be replaced with a new tax-free Dividend Allowance of £5,000 a year for all taxpayers as stated above.
Some entrepreneurs may pay less tax but top rate taxpayers, who currently have the option of growing their company and paying themselves dividend income at a 30.6pc tax rate will find that the top rate of dividend income tax will rise to 38pc.
This could encourage small business owners to sell their existing business to take advantage of the much lower capital gains tax which remains at 28 pc.
This may be a good change but for sure, it will involve a big adjustment for some founders. As we all know, tax planning is a very complicated subject and with this change, the financial advisers will profit the most.
Many people incorporated their businesses at the time of the 0% corporation tax band. The new changes are intended to discourage individuals from incorporating purely to obtain tax advantages.
The computations for this setup is not yet clear as we do not yet know what the National Insurance bands are for next year.
Let’s take this as an example. The advantage of incorporation is much of the income could be received as a tax-free dividend. If a business earns £30,000, about £20,000 could be taken as dividend. Next year, the £20,000 will create an additional tax of £1,125 making it a significant increase. On the other hand, the self-employed will see little change. Additional tax at that level makes incorporation less attractive.
Winners and losers
So who wins in this new scheme? Those people whose dividend income is below £5,000 will not pay any tax at all on their dividend income, but they didn’t on the previous scheme either.
If you are a professional with no additional income and you currently receive around £38,000 of tax-free dividend income, you face a tax bill of £1,700 starting April 2016.
The new rules create the very real possibility of discouraging entrepreneurism and will make sole traders think twice about making their company into a limited one. Many people are preparing for the negative effect these new rules bring.
There is a decision to withdraw the employment allowance for one-person companies. Another review of the IR35 provisions is also on the agenda that aims to find a solution that improves fairness in the system and protects the Exchequer.
Many business owners say that these changes on the design of the tax system are for different purposes that are all crashing together on the small businesses which are the lifeblood of the economy. This results to complexity and administrative burdens.
If you are a small business owner or entrepreneur and are still unsure of your tax position following the Summer Budget 2015, seek professional advice from an accountant on finding the best tax plan for your company to ensure your tax affairs are structured to suit your needs in the most efficient way. Your accountant will be able to give you a rough idea on the impact of the dividend taxation reform on your bill.