TECHTALK. Pension contributions should not be overlooked as they are often the most tax-efficient. THOMAS COUGHLAN THE POST APRIL 2016 DIVIDEND RULES

Transcription

1 TECHTALK This article originally appeared in JAN 18 edition of techtalk. Please visit for the latest issue. LOWERING THE BAR: THE REDUCED DIVIDEND ALLOWANCE From 6th April 2018, the recently introduced dividend allowance will reduce from 5,000 to 2,000. The implications for business owners and investors are looked at in detail. THOMAS COUGHLAN Tom has spent over 15 years in technical roles. He has wide experience including the provision of technical support to financial advisers covering life, pensions and investment compliance. He currently specialises in pension planning. Owners of small companies are in the enviable position of being able to choose the most taxefficient method of remunerating themselves from salary, dividends and employer pension contributions. The right mix depends on a variety of factors including profit level, other income, age and the state of existing retirement funds. Recent changes to dividends have reframed this debate, but no black and white answer has emerged. Salary and dividends usually form the backbone of the remuneration strategy and with good reason but pension contributions should not be overlooked as they are often the most tax-efficient. Before looking at different remuneration strategies, I will recap on recent changes to the dividend tax rules. THE POST APRIL 2016 DIVIDEND RULES The headline change to dividends in April 2016 was the introduction of the 5,000 dividend allowance, which currently exempts the first 5,000 of dividends from income tax. It is an allowance rather than an exemption, which means it still uses up part of the tax band that it falls in. The other change was an increase in the effective rates of tax. The previous dividend tax rates were 10%, 32.5% and 37.5% for Pension contributions should not be overlooked as they are often the most tax-efficient.

2 From 6th April 2018, the dividend allowance will reduce to 2,000 2,000 basic, higher and additional rate taxpayers, respectively, however because dividends were paid net of a 10% non-reclaimable tax credit, it was the effective rates of tax that were important. The equivalent effective rates were 0%, 25% and 30.6% in each case. The new rates of tax that apply to dividends from April 2016 onwards are 7.5%, 32.5% and 38.1% a 7.5% increase in each band over the old effective rate. This change also removed the tax credit, taking with it any distinction between net and gross dividends. THE POST APRIL 2018 REDUCED DIVIDEND ALLOWANCE From 6th April 2018, the dividend allowance will reduce to 2,000. Whilst this is a reduction to the current allowance, it is perhaps best viewed as a comparison alongside the original rules which were in force less than two years ago. When the 2016 reformed dividend rules came in, it was noted that higher rate taxpayers receiving less than 21,667 in dividends would be better off. The equivalent critical threshold for additional rate taxpayers was 25,400. The reason for a critical threshold was that low levels of dividends became tax free, but above the allowance dividends were taxed at a higher rate. The reduction in the dividend allowance from April 2018 will, therefore, change the critical thresholds, which will become 8,667 for higher rate taxpayers, and 10,100 for additional rate taxpayers. WHAT ARE THE IMPLICATIONS FOR INVESTORS AND OWNER MANAGED BUSINESSES? In the main, investors benefitted significantly from the original tax-free dividend allowance of 5,000. No tax on dividends up to this amount took many out of dividend taxation altogether. From April 2018 when the allowance reduces to 2,000, investors with dividends between that level and 5,000 will become liable to tax, but in many cases that will be less than what they would have paid before April The reformed rules won t matter very much for those with dividends less than the allowance that fall within the basic rate income tax band, because their liability was previously covered by the tax credit. Basic rate taxpayers with dividends in excess of the allowance will be worse off, but few taxpayers fall into this category. Higher and additional rate taxpayers with dividends within the allowance benefit significantly as previously they would have been taxable on all dividends received. And even those with dividends above the allowance but below the critical thresholds will benefit but to a smaller extent compared to their pre-april 2016 position. Anyone receiving dividends in excess of the critical thresholds will be worse off. Director shareholders paying themselves dividends as part of their remuneration strategy would in many cases be receiving dividends well above 5,000 / 2,000 so fewer in this category will be happy with the reforms and soon to be reduced dividend allowance. As these critical thresholds from 2016/2017 and 2018/2019 were/are relatively low, it is straightforward to conclude that many director shareholders would suffer an increased dividend tax liability as a result of the new rules. The amount of extra tax depends on the actual level of dividend and non-dividend income received in the tax year, so relies on a personal tax calculation. But despite this increase in tax against higher levels of dividends, many will still be better off compared with a remuneration strategy based wholly on salary. And many will benefit significantly by adding some pension contributions to their remuneration mix. COMPARING REMUNERATION STRATEGIES Whilst it is helpful to consider the changes to dividends in recent years, a more meaningful comparison for director shareholders is between their current remuneration strategy and the alternatives available to them in the same tax year. As the owners of small private companies can exercise control over the type of remuneration they receive, they will want to ensure they have the most tax-efficient mix of salary, dividend and employer pension contributions. This will involve a discussion with their accountant to establish: how much salary they should pay themselves, ensuring entitlement to valuable social security benefits; the level of dividends available to them, within the constraints imposed by HM Revenue & Customs and the amount of distributable profit within the company; their ability to fund their personal pension within the available annual allowance plus carry forward.

3 Let s look at an example for the 2018/2019 tax year, taking into account that the personal allowance and basic rate income tax band will have increased to 11,850 and 34,500 by then. EXAMPLE Walter is aged 54, runs his own limited company, remunerates himself using salary and dividends, and has his full annual allowance available in this tax year plus 35,000 carry forward. In 2018/2019 he wants to distribute 100,000 out of his company to remunerate himself. After a discussion with his accountant around the level of dividends he can receive, he decides to pay himself a salary of 8,424 (the national insurance primary threshold) and the rest in dividends. As there will be no employer national insurance liability in relation to the payment of salary, the remainder - 91,576 - can be paid as a dividend. The remuneration package is, therefore: Salary: 8,424 Dividend: 91,576 The total tax liability is as follows: 2018/2019 Dividends 91,576 Total income 100,000 Full personal allowance available: 11,850 Earned Income: Deduct PA ( 8,424) Taxable 0 Dividends: Dividend 91,576 Deduct PA ( 3,426) Taxable 88,150 Dividend allowance: 2,000 x 0% = 0 Basic rate tax: 32,500 x 7.5% = 2, Higher rate tax: 53,650 x 32.5% = 17, Total tax 19, What is important here is the overall extraction rate. As the dividend itself is a distribution of post-tax profits, the corporation tax bill has to be accounted for. The profit before tax was 113,056.79, which is found by grossing up the dividend by 100%/81%. The extraction rate, then, is the monetary amount received by the shareholder director as a percentage of the total cost to the company: Amount received after all taxes: 100,000-19, = 65.96% Cost to the company: 113, ,424

4 WHAT ALTERNATIVE REMUNERATION STRATEGY IS AVAILABLE? Following a discussion with his financial adviser, Walter is aware that he is able to swap some of his remuneration for an employer pension contribution to improve his overall tax position. As he is close to his 55th birthday he knows that he will be able to access these funds very shortly under the Freedom & Choice regime. Walter looks at swapping some of his dividend for the maximum contribution he can make to a personal pension. EXAMPLE Walter considers his potential tax bill if he swaps 75,000 of the dividend for an employer pension contribution, thereby maximising his annual allowance plus carry forward in 2018/2019. To compare the overall tax position it is necessary to take all tax liabilities into account. The remuneration package would, therefore, be: Salary: 8,424 Dividend: 30,826 Employer pension contribution: 75,000 The total tax liability is as follows: 2018/2019 Dividends 30,826 Total income 39,250 Full personal allowance available: 11,850 Salary: Deduct PA ( 8,424) Taxable 0 Dividends: Dividend 30,826 Deduct PA ( 3,426) Taxable 27,400 Pensions: Pension 75,000 Deduct provision for retirement tax (assume basic rate taxpayer): Dividend allowance: 2,000 x 0% = 0 Basic rate tax: 25,400 x 7.5% = 1,905 Tax-free cash: 18,750 x 0 = 0 Taxable pension: 56,250 x 20% = 11,250 Total tax 13,155 Again, as the dividend itself is a distribution of post-tax profits, the corporation tax bill has to be accounted for. The profit before tax was: 38, ( 30,826 x 100%/81%). The extraction rate is: Amount received after all taxes: 101,095 = 83.22% Cost to the company: 121,480.79

5 Director shareholders will be able to improve their overall tax position by considering whether they are receiving the right mix of salary, dividends and pension contributions. Walter should be motivated by this to change his remuneration strategy. Switching some of the dividends to an employer pension contribution can save a significant amount of tax in 2018/2019. There is no need to have salary of a certain level to be able to receive employer pension contributions, and as Walter is the driving force that generates the company s profits there should be no issue deducting the employer pension contribution from profit. In other words, it is likely to be incurred wholly and exclusively for the purposes of trade and is, therefore, a deductible expense. Looking further forward, Walter will not be able to utilise this strategy each year (he would have exhausted all of his carry forward), so he will have to revert to a higher level of salary and/or dividends in later years. He can, however, pay up to a maximum of 40,000 in employer pension contributions depending on the annual allowance available to him and any other contributions he makes to registered pension schemes. Many director shareholders will be able to improve their overall tax position by considering whether they are receiving the right mix of salary, dividends and pension contributions. Any such discussion will involve the client s accountant, but ensuring pension contributions which are sometimes overlooked by director shareholders are maximised within the annual allowance can help to better the extraction of profits, in addition to the usual retirement benefits that are available. To carry out your own comparisons please use Salary, Dividend and Pension calculator. This can be found in the Tools section of the Scottish Widows Adviser Extranet. Note: Scottish resident taxpayers will have their own income tax rates and bands from 2018/2019 which may affect the tax outcomes in our examples. Every care has been taken to ensure that this information is correct and in accordance with our understanding of the law and HM Revenue & Customs practice, which may change. However, independent confirmation should be obtained before acting or refraining from acting in reliance upon the information given. Scottish Widows Limited. Registered in England and Wales No Registered office in the United Kingdom at 25 Gresham Street, London EC2V 7HN. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. Financial Services Register number