The Budget announcement could hardly have been thinner on detail. It mentioned a £5,000 allowance and rates of tax on dividends falling within the basic, higher and additional rate bands. At the same time the tax credit would be abolished, meaning that from 2016/17 dividends will no longer need to be grossed up in the personal tax computation.
This information and a few examples are provided in a Dividend Allowance Factsheet.
£5,000 ‘allowance’ is really a nil-rate band
The key point is that the £5,000 allowance is not an additional allowance on top of personal allowances: when it applies it replaces the corresponding part of the individual’s basic, higher or additional rate band. Thus the dividend allowance applies regardless of the individual’s marginal rate of tax. Dividends received in excess of the £5,000 allowance will be taxed at 7.5% within the basic rate band; 32.5% within the higher rate band and 38.1% within the additional rate band.
The dividend allowance is not matched with income covered by allowances or deductions.
The way it works is best illustrated by a few examples.
Example 1 – Basic rate taxpayer
In 2016/17 Bert has pension income of £8,000, ISA income of £2,000 and dividends of £10,000.
The first thing to exclude is the ISA income which remains unaffected by the dividend tax changes; ISA income is still not taxable.
- Bert’s personal allowance (PA) of £11,000 is set first against his pension (£11,000 - £8,000) leaving unused PA of £3,000.
- The remaining £3,000 of his personal allowance is deducted from his dividend income (£10,000 - £3,000) leaving £7,000 of ‘taxable’ dividend income.
- Then the dividend allowance is deducted from the taxable dividend income (£7,000 - £5,000). In other words, £5,000 of Bert’s dividends have been subject to tax at 0%. This leaves £2,000 of dividend income subject to the dividend basic rate.
- Tax payable is £2,000 @ 7.5% = £150.
As a basic rate taxpayer, this means that Bert is actually worse off thanks to the dividend allowance, because previously there would have been no further tax to pay on his dividend income.
Tops and bottoms
The dividends a person receives will continue to be treated as forming the top part of their taxable income and so will be taxed at their highest marginal rate of tax.
But the £5,000 dividend allowance will be set against the bottom end of the dividend income i.e. the lowest rate of tax.
Example 2 – Higher rate taxpayer with income mainly salary
Ernie has the standard 2016/17 personal allowance of £11,000 and total income of £49,000: salary of £39,000 and dividends of £10,000.
- Ernie’s personal allowance is set first against his salary (£39,000 - £11,000) leaving taxable non-dividend income of £28,000 that falls within the basic rate band with £4,000 (£32,000 - £28,000) of his basic rate band unused.
- The first £4,000 of Ernie’s dividend income will:
- fall into the basic rate band; and
- use up the first slice of his dividend allowance (£5,000 - £4,000) leaving dividend allowance of £1,000.
- There is no tax to pay on the first £4,000 of dividend income.
- The remaining dividend allowance is deducted from the remaining taxable dividend income (£6,000 - £1,000) leaving £5,000 subject to the dividend higher rate.
- Tax payable on the dividends is £5,000 @ 32.5% = £1,625.
The dividend allowance is matched first with the £4,000 in the basic rate band and the remaining £1,000, not used up against basic rate dividend income is set against the dividend income that falls within the higher rate band. So the dividends that are taxable are all taxed at the dividends higher rate of 32.5%.
Example 3 – Higher rate taxpayer with income mainly dividends
In 2016/17 Jane has a salary of £7,000 pa but has significant investments giving her dividend income of £41,000, and she is entitled to the standard personal allowance of £11,000.
- Jane’s personal allowance (PA) of £11,000 is set first against her salary (£11,000 - £7,000) leaving unused PA of £4,000.
- The remaining £4,000 of her personal allowance is deducted from her dividend income (£41,000 - £4,000) leaving £37,000 of ‘taxable’ dividend income.
- The dividend allowance is applied so that £5,000 dividends are taxed at 0%, leaving a further £27,000 (£32,000 - £5,000) of dividend income subject to the dividend basic rate at 7.5%, and £5,000 (£37,000 - £5,000 - £27,000) subject to tax at the dividend higher rate of tax of 32.5% .
- Tax payable is £3,650 (£27,000 @ 7.5% = £2,025 + £5,000 @ 32.5% = £1,625).
Winners and losers
The new dividend allowance means that taxpayers with dividends of up to £5,000 will suffer no tax on that income. For basic rate taxpayers this is unchanged, but for higher rate taxpayers there is a tax saving as they would previously have had extra tax to pay.
However, where dividend income exceeds £5,000, basic rate taxpayers will actually be worse off, as they will be liable to tax at 7.5% on the ‘excess’ dividends. Thus basic rate taxpayers would save tax by using ISAs for investments in shares where their dividends would otherwise exceed £5,000 per annum.
In contrast, higher rate and additional rate taxpayers will be better off as a result of the changes up to certain levels of dividend income. These thresholds are dividends of £21,667 for higher rate taxpayers and £25,400 for additional rate taxpayers. So, for a taxpayer with non-dividend income taking him into the higher rate band, the dividend allowance will save them up to £1,625 (£5,000 @ 32.5%), as illustrated in Example 3 above. For additional rate taxpayers, the maximum potential saving rises to £1,905 (£5,000 @ 38.1%).
No news on trusts and estates
The information provided still only applies to individuals. For deceased estates it would appear logical for the £5,000 dividend allowance to apply as well but there is no guarantee that logic will be applied.
As regards trusts it will be interesting to see if the Government is gripped by anti-avoidance paranoia and decides that the dividend allowance must be shared among trusts with a common settlor in the same way that the CGT annual allowance is. The normal trust CGT annual exemption is half of the individual amount to start with (£5,550 in 2016/17) and is then further divided among the trusts of the same settlor, subject to a floor of one fifth of the full trust allowance, i.e. £1,110. Common sense says that even when set against the dividend additional rate of 38.1% the potential tax saving from splitting trusts (£5,000 @ 38.1% = £1,905) would be eaten up by additional costs of administration and compliance, so the complication of a further split in the dividend allowance should be unnecessary.
Pre year end planning
Although the end of the tax year is still some way off, it is worth not losing sight of the fact that it will be advantageous for some taxpayers to extract greater levels of dividends in 2015/16 than they normally would (if they will be disadvantaged by the new rules). However, bear in mind the normal formalities for dividends to be observed on the paperwork, and the requirement for the company to have sufficient distributable reserves.