One of the announcements in the Chancellor’s July Budget statement was changes to the way in which dividends are to be taxed from April 2016.  This is likely to have a major impact, both for businesses which are thinking of incorporating and for existing companies where the director/shareholders take their rewards primarily by way of dividends.

It will still be much better to take the profits primarily by way of dividends rather than as remuneration.

The precise impact will vary enormously and will depend not only on the level of dividends taken but also on the amount, the nature, or any other income, for example rents, savings interest and pensions.  There is no “one size fits all” here.

There is nothing in the draft legislation which prevents one from bringing forward next years dividends into the current year and paying less tax overall as a result.

How will the new tax work?
The new tax-free Dividend Allowance takes effect on April 6, 2016. No tax will be deducted at source; taxpayers must use self-assessment to pay any tax due.

The Dividend Allowance means that you won’t have to pay tax on the first £5000 of your dividend income, no matter what non-dividend income you have.

The allowance is available to anyone who has dividend income.

Headline rates of dividend tax are also changing.

You’ll pay tax on any dividends you receive over £5000 at the following rates:

  • 7.5% on dividend income within the basic rate band
  • 32.5% on dividend income within the higher rate band
  • 38.1% on dividend income within the additional rate band

This simpler system will mean that only those with significant dividend income will pay more tax.

If you’re an investor with modest income from shares, you’ll see either a tax cut or no change in the amount of tax you owe.

Dividends received by pension funds that are currently exempt from tax, and dividends received on shares held in an Individual Savings Account (ISA), will continue to be tax free.

From April 2016 you have to apply the new headline rates on the amount of dividends you actually receive, where the income is over £5000 (excluding any dividend income paid within an ISA).

The Dividend Allowance will not reduce your total income for tax purposes.  However, it will mean that you don’t have any tax to pay on the first £5000 of dividend income you receive.

Dividends within your allowance will still count towards your basic or higher rate bands, and may therefore affect the rate of tax that you pay on dividends your receive in excess of the £5000 allowance.

How does this differ from before?
Under the current system, basic-rate taxpayers pay no tax on their dividend income, while higher-rate taxpayers pay an effective rate of 25 per cent and additional-rate taxpayers pay 30.56 per cent. So taxpayers in all bands pay less than they would on earned income. This is because dividends are paid out of company profits that have already suffered corporation tax.

Will everyone be worse off under the new regime?
No. While it’s true that many will pay more, such as basic-rate taxpayers who receive more than £5,000 in dividends, there are others, such as higher-rate taxpayers with £5,000 or less in dividend income, who will gain – currently they pay 25 per cent on the whole sum (or £1,250), while under the new regime there will be no tax to pay, thanks to the £5,000 allowance.

What if some of my dividend income is within the tax-free personal allowance?
Dividend income is still eligible for the personal allowance. So if next year you had £16,000 in dividend income, the first £11,000 would be covered by the personal allowance and the other £5,000 by the new dividend allowance. As a result, you would pay no tax.

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