In the Summer Budget 2015, George Osborne, Chancellor of the Exchequer, announced comprehensive changes to the income tax treatment of dividends. This article explains the current system and contrasts this with the proposed changes, before considering the impact the new rules will have for investors.

What are Dividend Tax Credits?

Dividends are paid from the taxed profits of companies (i.e. corporation tax has already been applied to the distributed funds). The tax credit accounts for the tax already applied, to ensure that dividends are not subject to dual taxation. Dividend tax credits are available to the shareholder to offset against any Income Tax that may be due on their dividend income.

How are dividends taxed currently?

Currently all UK dividends are paid with a notional 10% tax credit, so for every £1,000 of dividend income received it is assumed that £111 of tax has already been paid (the total gross dividend is therefore deemed to be £1,111). Under the current system, basic-rate taxpayers pay no further tax on their dividend income, while higher rate taxpayers pay an effective rate of 25% and additional rate taxpayers pay 30.56%. So taxpayers in all bands pay less tax on dividend income than they would on earned income.

What are the changes?

Under the Chancellor’s proposals the system of dividend taxation will be fundamentally changed. The dividend tax credit mechanism will be completely abolished, and will be replaced with a “simpler” system.

After the personal allowance has been taken into account (£11,000 from April 2016), the first £5,000 of dividend income in each tax year will be tax free. Therefore, if your total income is £16,000 or less, you will pay no income tax on dividends received. Dividends above the tax free allowance (£5,000) and personal allowance (£11,000) will be taxed at 7.5% for basic rate taxpayers, 32.5% for higher rate taxpayers and 38.1% for additional rate taxpayers. The table below outlines the current and proposed rates of dividend tax.

Click here to view the table.

t is important to note that the rates shown for 2016/17 will only apply to dividends over the £5,000 allowance, and only where an investor’s combined dividend and non-dividend income exceeds £16,000. It should also be noted that dividends paid from investments within an ISA wrapper will be free of any income tax. 

What is the impact for “ordinary investors”?

When the Chancellor introduced his reforms he promised a saving for “ordinary investors”. The majority of savers may well see a reduction in the tax payable on their dividends in the coming years, however there are important exceptions. Basic rate taxpayers with combined income in excess of £16,000 (and dividends exceeding £5,000) will effectively pay tax on their dividends for the first time. Further, higher rate and additional rate taxpayers may see an increase to their tax bill.

The following two examples provide a worked demonstration of the changes.

Example One – Tom

Tom has income as follows:

Click here to view the table.

As noted above, all dividends received from investments held within an ISA wrapper are free of tax, and as such no tax is levied on that portion of the income.

Tom has a personal allowance for Income Tax purposes of £11,000, which will apply to his non-dividend income. The remaining £7,000 of Tom’s non-dividend income will be taxed at the basic rate (20%), so the tax to pay on Tom’s non-dividend income will be £1,400.

Tom also benefits from the Dividend Allowance, meaning the first £5,000 of dividends received are paid free of Income Tax. The remaining £17,000 is charged at the basic rate applied to dividends (7.5%), as Tom’s total taxable income is below the higher rate threshold (£43,000). The tax payable on Tom’s non-ISA dividends is therefore £1,275.

Tom’s total Income Tax liability is £2,675 on a total income of £50,000, representing an effective income tax rate of 5.35%. 

Example Two – Harry

Harry has income as follows:

Click here to view the table.

Once again, the dividends received within the ISA wrapper are free of tax.

£11,000 of Harry’s non-dividend income is covered by the personal allowance, with the remaining £29,000 taxed at the 20% rate as this falls below the higher rate threshold. The tax payable on Harry’s non-dividend income is £5,800.

The first £5,000 of Harry’s non-ISA dividends are tax-free, as they are covered by the Dividend Allowance. The remaining £10,000 is taxed at the 32.5% rate, as the dividend income falls above the higher rate threshold. As such, the tax payable on Harry’s non-ISA dividends is £3,250.

Harry’s Income Tax liability is £9,050 on total income of £75,000, representing an effective tax rate of 12.1%. 

How can I manage my liabilities?

It is clear that the proposed reforms will force many investors to reconsider the tax position of their portfolios. Some basic rate taxpayers will have to pay tax on their dividends for the first time, but the new £5,000 allowance will effectively reduce dividend tax for many higher and additional rate investors.

The importance of using tax-efficient wrappers for savings is highlighted by the examples above. The most effective means of avoiding the new dividend tax may be to ensure that dividend generating investments are moved into ISAs or other tax-wrappers where possible.  

Bond Dickinson Wealth can provide a full review of your portfolio, to highlight any potential changes to the tax payable and to advise on means of mitigating tax. Should you wish to discuss this further please do not hesitate to contact your usual adviser, or any member of the Bond Dickinson Wealth team.