Rather than produce yet another summary of the changes announced by Philip Hammond this week, I would like to focus on the impact of the reduction in the tax free dividend allowance, in particular from the perspective of small business owners drawing salary and dividends.
In April 2016, the 10% dividend tax credit was abolished and instead only the first £5,000 of dividend income would be tax free. Rates of tax above this allowance were raised by 7.5% in each band as follows: 7.5% for Basic Rate, 32.5% for Higher Rate, and 38.1% for Additional Rate taxpayers.
Philip Hammond announced on Wednesday that the dividend allowance is to be reduced to £2,000 from 6th April 2018. The Treasury expects this to cost those in receipt of dividend income an average of £315 each (https://www.gov.uk/government/publications/income-tax-dividend-allowance-reduction/income-tax-dividend-allowance-reduction).
The Treasury state that “This measure will ensure that support for investors is more effectively targeted and that the total amount of income they can receive tax-free is fairer and more affordable, in light of increases to the tax-free personal allowance and the Individual Savings Accounts (ISA) allowance. It will also partially reduce the tax difference between the self-employed and those working through a company.”
It would have seemed fairer to directly target the self-employed contractors who have incorporated into single-person companies, as that is ultimately who the Government wants to clamp down on, but instead all shareholders have been affected.
The impact on those individuals who rely on dividend income generated by equity portfolios seems to be a by-product of the new rules. The Treasury feels that it will only affect a minority of investors, but bearing in mind dividends were effectively tax free up to the higher rate threshold until April 2016, it is a 7.5% hike for many. Not insignificant.
A Basic Rate taxpayer will be £225 worse off, assuming their dividend income was at least £5,000.
Based on the new £2,000 allowance, assuming a dividend yield of 3.5% per annum, an equity portfolio of over £57,143 will start to attract the 7.5% tax.
A Higher Rate taxpayer through other income sources, for example with a pension in payment over the Higher Rate threshold, will be £975 worse off and an Additional Rate taxpayer £1,143 worse off.
However, it needs to be considered that CGT on shares has reduced to 10% / 20% for shares and the ISA allowance is increasing to £20,000, both of which benefit private investors.
Shareholder / Directors
Small business owners typically use a combination of salary and dividends to remunerate themselves. The impact on each tax bracket will be as above, but drawing dividends is still more tax efficient than a salary over the Personal Allowance, due to the National Insurance both the employer and employee pay on salary payments.
I have read comments saying that this is the final nail in the coffin for small business owners, but I feel these fears are exaggerated. Putting this change into a broader context, there are two factors lessening the impact of this tax increase.
Firstly, Corporation Tax is reducing from 20% to 19% in April 2017, and then further to 17% in April 2020.
Secondly, Higher Rate tax will become payable on total income over £45,000 in 2017/18, an increase from £43,000 this year. A commitment has been made to increase the threshold to £50,000 by 2020, but we do not yet know what the threshold will be in 2018/19.
We do know that in 2018/19, when the dividend allowance reduces to £2,000, Corporation Tax will be 1% lower and there will be at least a further £2,000 of Basic Rate tax band to utilise compared to 2016/17.
If we look at an example Director / Shareholder drawing a salary of £11,000 and dividends of £34,000, in 2016/17, the income tax calculation on £45,000 will be as follows:
|£11,000 salary (0%)||£0|
|£5,000 dividends (0%)||£0|
|£27,000 dividends (7.5%)||£2,025|
|£2,000 dividends (32.5%)||£650|
The corporation tax payable after a £34,000 “net” dividend would be £8,500. Therefore, the total tax bill would be £11,175 in 2016/17.
In 2018/19, assuming the Personal Allowance remains at £11,500 and the Higher Rate tax threshold remains at £45,000 (2018/19 thresholds and allowances have not been announced yet), the income tax calculation will be as follows:
|£11,000 salary (0%)||£0|
|£500 dividends (0%)||£0|
|£2,000 dividends (0%)||£0|
|£31,500 dividends (7.5%)||£2,362.50|
In this example, the increase in the Higher Rate threshold saves more income tax than the reduction in the dividend allowance costs. In addition, Corporation Tax will be reduced to £7,975.
The total tax bill on the same remuneration would therefore reduce to £10,337.50 in 2018/19.
Clearly, comparing the figures to the pre April 2016 rates would show a significant tax increase has taken place, but the announced reduction in the allowance from £5,000 to £2,000 in 2018 is not as significant for small business owners as reported in some places, when taking into account the changes to both the Higher Rate tax threshold and rates of Corporation Tax.