"We have inherited a very complex and archaic system. So I am undertaking a major and long overdue reform to simplify the taxation of dividends."
This was the rationale given by the Chancellor, George Osborne, in his summer Budget as he announced a significant overhaul of the way that UK investors' dividends are taxed, taking effect in the 2016/17 tax year. In essence the current 10% dividend tax credit is to be replaced with an annual tax-free dividend allowance of £5,000. Any dividends above this amount which are not held in a tax-free wrapper such as an ISA will be taxable at rates shown in the table below. The tax due will not be deducted at source therefore dividends that are liable to tax will need to be declared on a tax return as at present.
The table below shows the effect of the changes on investors in different tax bands who receive dividends of £10,000 outside a tax-free wrapper:
So is the new system any more straightforward than previously?
Currently, tax is chargeable on a dividend plus its accompanying tax credit. This tax credit is a notional figure only, involving no movement of cash, and cannot be reclaimed even by non- taxpayers. The total dividend plus tax credit (as shown in col C) is calculated by dividing the dividend payment actually received (Col A) by 0.9. Any tax due to HMRC* is calculated at the rate in Col E which is the rate in Col D less the 10% tax credit. The table shows the effective tax rate payable on dividends received (Col F) in order to illustrate the changes more clearly.
From 2016/17, all dividends in excess of £5,000, excluding those in tax-free wrappers such as ISAs and pensions, will be taxed at 7.5% for basic rate taxpayers, 32.5% for higher rate taxpayers and 38.1% for additional rate taxpayers, as shown in the Col F of the table. The rate chargeable will depend on the relevant income tax band of the investor.
The new rules therefore do away with the outdated tax credit, a legacy of the days when companies paid Advance Corporation Tax on dividends, and simplify the calculation of additional tax due.
Who are the winners and losers?
currently pay no tax on a dividend and this will still be the case.
Basic rate taxpayers
also now pay no tax on dividends but from April 2016, they will pay tax of 7.5% on any dividends received above the tax-free allowance. Therefore, a basic rate taxpayer with dividends of more than £5,000 will be potentially worse off.
currently pay tax on all their dividends but will no longer have to because of the new allowance. Under the existing system they are subject to an effective tax rate of 25% and from April 2016, on dividends over £5,000, will pay an additional 7.5% tax, making a total of 32.5%. As a result they will only be worse off if their dividends exceed £21,667.
Additional rate taxpayers
currently pay an effective tax rate of 30.6% but next year they will pay an extra 7.5%, equating to a rate of 38.1% on dividends exceeding £5,000. Consequently, they will only be worse off if their dividends exceed £25,401.
The Chancellor maintains that around 85% of investors – or over a million people – will see their dividend taxes unchanged or reduced as a result of the reforms. However, the 15% of investors who receive significant dividend income on shareholdings (or business owners who pay themselves large sums in dividends) will pay more.
Will the changes affect me and should I take any action?
One outcome that may occur following these changes, according to the research firm Markit, is an acceleration of dividend payments before April 2016, predominantly from small and mid-cap companies where investors and management are more likely to have large shareholdings. Analysts at Markit believe that house builders, insurers and investment trusts are particularly likely to pay special dividends due to their strong balance sheets and cash flow.
So what action, if any, should investors take to ensure they are not negatively impacted by these changes? If you have funds or shares held outside of tax wrappers and have not yet fully utilised your ISA allowance of £15,240 for the current year, it may be worth considering transferring assets to make the most of this allowance. Although, £5,000 of tax free dividends outside a tax wrapper sounds very generous, if you are thinking of using savings to generate an income in retirement do be aware that a pot of £143,000 yielding 3.5% would provide around £5,000 of gross dividend income. Portfolios of a larger size would therefore be subject to income tax at your marginal rate.
There has been speculation that the new rules may deter investors from selecting equity income funds which invest in high yielding Blue Chip companies. For example, some investors might consider increasing exposure to growth funds with lower dividend payouts and generate income by selling units to make use of their capital gains allowance (currently £11,100 per annum).
When setting up an ISA you could think about putting assets which generate the highest yields in it and keeping those with lower yields outside to minimise the income tax due. Another strategy for married couples or civil partners to adopt would be to ensure that assets outside tax wrappers are allocated so that both partners make use of the £5,000 tax free dividend allowance.
Business owners could consider spreading share-holdings among family members who each have their own allowance and perhaps increase dividend payments before the new regime is implemented.
A summary of the tax breaks for savers:
Mr Osborne pointed out that that everyone will now be able to receive up to £17,000 in income a year tax free from April 2016. This comprises the new £5,000 dividend allowance, the increased personal taxation allowance of £11,000 p.a. and the new Personal Savings Allowance of £1,000 per annum (£500 p.a. for higher rate tax-payers) on interest income, including that from corporate bonds, which was announced in the Spring Budget.
In conclusion, it is clear that some income seeking investors may be right to be concerned about the possibility of paying more tax on their dividends. However, as it will not affect pensions and ISA investors there is all the more reason to consider these wrappers as the first port of call for your investments. The ISA allowance and an annual contribution limit of £40,000 into a pension give plenty of capacity to save tax-free for all but the wealthiest investors. In reality, relatively few investors receive dividends in excess of the tax free limit and the new allowance could actually encourage additional investment. The new regime is most likely to have a negative impact on business owners who draw significant dividends from their companies in lieu of salaries and/or bonuses.
*Her Majesty’s Revenue and Customs
We do not give investment advice so you will need to decide if an investment is suitable for you. If you are unsure whether to invest, you should contact a financial adviser.