The Real Cost of Ambition

In his second budget of 2015, Chancellor George Osborne announced plans to introduce a new controversial taxation on dividends.

From April 2016, the way dividends are taxed will change. Currently basic rate taxpayers don’t pay a tax on dividends, whereas higher rate taxpayers pay 25% and additional rate taxpayers pay 30.56%.

Under the new rules laid out in the budget, only the first £5,000 a year will be exempt from tax across all rates, with anything over being taxed at 7.5% for basic rate, 32.5% for higher rate and 38.1% for those who pay the additional rate of tax.

While those on the basic rate of tax will be worse off under the changes, those on the higher and additional rates of tax could be better off.

The Chancellor then went on to say that 85% of people currently receiving dividends would be no better or worse off under the new changes. What the Chancellor failed to explain is how the remaining 15% would be affected by the new regime.

We decided to dissect the new changes to see how the remaining 15% would be affected.

It’s all about percentages

Business owners currently taking advantage of dividends, as their sole income, will be hit hard by the new tax. At a time when the Government is championing new businesses, it’s interesting to see such a controversial change to the system, effectively stifling entrepreneurship. Where is the incentive for people to start up their own business?

Running a business is about risk and reward

The risk of going out on your own and creating something from scratch. Many owners go years without taking a full wage from their business, instead choosing to reinvest the money to help the company grow.

Employees receive holidays, standard hours and sick pay, whereas owners face job uncertainty with little to no holidays and long hours.

The reward comes in the form of dividends. The ability to pay dividends is an attractive proposition for investors looking to supplement their income. Dividends also provide certainty about a company as they are only paid out of profit, meaning that any company that is able to pay them is surely performing well.

Let’s have a look at the current contributions of a standard employee compared to an owner of a limited company.

A standard company employee usually pays a tax of around 32% on their earnings (basic rate income tax of 20% and 12% in national insurance)

Compare that with someone who owns a limited company who pays themselves purely in dividends. They would pay 0% income tax as a basic rate taxpayer and 20% corporation tax. This would give them a saving of 12% on tax over the standard company employee.

Even if the limited company owner were in the higher tax brand they would still come out better off. This is where the risk / reward factor comes into play. The limited company owner is rewarded for the risk he is taking.

Currently, an individual who receives no other income can claim £38,000 tax-free. From April 2016 the same person would have a tax liability of £1,700.

The government claims this new regime will reduce the incentive to remunerate through dividends rather than wages to reduce tax liabilities.

With this in mind here are a few suggestions on how to avoid being stung by the changes.

Get an ISA 

You can shelter taxable investments of up to £15,240 into an ISA each year, which can be withdrawn tax-free. As there is no capital gains tax to pay on this amount it could be a way to ease the cost.

Diversify your portfolio

Spread your portfolio around to make the best use of it. Your dividend allowance is £5,000 per year, therefore be aware of the yield your portfolio will generate. £500,000 at a 1% yield is better than £100,000 with a yield of 5%.

Take an interest

From April 2016, the first £1,000 of fixed rate interest income (£500 for higher rate taxpayers) will be free from income tax. Therefore it may be useful to think about this when offsetting the income from bonds and cash.

It pays to have a pension

Why not take advantage of the tax relief on pension contributions. This helps when stretching your limit on basic rate tax. Essentially any contributions paid will increase your limit, for example:

This will give you access to the lower rate of tax on the additional amount. For example:

Earn less

From April next year your personal allowance will rise to £11,000. Add this to your dividend allowance and interests income and you’re entitled to £17,000 tax-free. If you reduce your incomings, such as deferring withdrawals from a drawdown pension for a year, you could reduce the amount of tax paid on dividends.

Invest in VCTs

For those investors happy to take a higher risk, Venture Capital Trusts produce tax free dividends that are payable in addition to the new dividend allowance.

Share and share alike

Another option is to reduce your dividend payments and increase share buybacks. You could gift shares to yourself and then sell them back to the company.

Rewriting the headlines

For a Government intent on using SMEs to boost the economy, this tax will only discourage entrepreneurship. The chancellor has been clever in managing the headline.

Up to £5,000 dividends tax-free each year

In reality they have just added a 7.5% tax on dividends and increased the higher rate tax from 25% to 32.5%. In truth the headline is:

Hardworking entrepreneurs expected to fund slow economy

If owning your own company is about risk and reward why is it the owners face the risk while the Government reaps the reward?

If you’re unsure about how to adapt to this new regime we can help. Just give us a call on 0161 974 0735.