The Chancellor, George Osborne, delivered his first Budget a few weeks after the General Election and since then most of the attention has focused on the cuts to Tax Credits.
Unfortunately, this has meant a new tax, which will affect many small business owners, as well as well as investors, has passed by almost unnoticed.
Leading up to the election the Chancellor committed to not increasing National Insurance or Income Tax during the next Parliament. This left him with few revenue raising options, which probably explains the changes to the way dividends are taxed.
The new rules, which will come into effect from 6th April 2016, will change the way dividends are taxed and will hit many business owners particularly hard.
Some people, when they think of business owners, entrepreneurs and shareholders think about fat cats earning huge amounts of money. But that often isn’t the case. The new rules will affect anyone who owns or runs a limited company, that could include you, your window cleaner, electrician or plumber, as well as the executives of FTSE 100 companies.
How will the new tax work?
The changes are complex, so please bear with us as we try to explain by using the example of a small business owner called John (the name is made up for the purposes of this article) who runs a small consultancy business.
The turnover of John’s business is around £60,000 each year, with a net profit of £50,000 after expenses, which is of course subject to Corporation Tax at a rate of 20%.
When John withdraws money from his business he takes a salary of £10,600 per year, which is equal to the Personal Allowance (the amount of money you can earn before you start to pay tax) and is therefore tax free.
He then takes another £25,000 in dividends, on which he pays Income Tax on due to something called the dividend tax credit. Remember though his business has already paid Corporation Tax at a rate of 20%, on this money.
From 6th April 2016 the tax on John’s dividends will change.
The first £5,000 of the £25,000 he takes in dividends will still be tax free. However, as he is a basic rate taxpayer, the additional £20,000 in dividends will be subject to a further tax of 7.5%. So John will have paid tax twice on the majority of the money which makes up his dividends; 20% Corporation Tax on the profits and 7.5% of the dividends above £5,000.
That will cost him an extra £1,500 each year in tax.
Most small business owners who trade through a limited company will structure their pay in this way i.e. salary equal to the Personal Allowance and the balance of their income in dividends, they will therefore all be hit by the new tax.
The new dividend tax will not be deducted at source, but through the Self-Assessment system.
Higher rate tax payers will be hit even harder
Those people who pay higher or additional rate tax will be hit even harder.
Higher rate taxpayers will pay 32.5% tax on their dividends, whereas additional rate taxpayers will pay 38.1%.
Will anyone be better off?
The first thing to make clear is that dividends received by Pensions and ISAs (Individual Savings Accounts) will not be affected.
Higher rate taxpayers, perhaps investors rather than business owners, who receive less than £5,000 per year in dividends will be better off, as this will be covered by the new tax-free allowance.
How can you reduce the effect of the new dividend tax?
To start with make sure your business is set up as tax-efficiently as possible. For example, if your spouse or partner doesn’t work, or is a basic rate taxpayer, consider making them a shareholder so you can pay them dividends.
If you are an investor and affected by the new rules, consider moving your investments into more tax-efficient vehicles such as ISAs.
You could also reduce your income, which of course will reduce the amount of tax paid.
You could consider making additional pension contributions in lieu of dividend income. Of course the money you contribute to a pension will not be accessible until 55 at the earliest.
Finally, you could just pay the extra tax!
Make your voice heard
If you believe the new dividend tax is unfair a petition has been set up on the official Government website.
The petition has already received more than 30,000 signatures and can be found here: https://petition.parliament.uk/petitions/106525
We are here to help
Before you decide on your strategy we would always recommend you seek professional advice, ideally from your accountant in conjunction with an Independent Financial Adviser.
We are here to help, if you would like to know more about how these changes will affect you please call Bev or Sarah today on 0115 933 8433 or email firstname.lastname@example.org