Last year’s budget announced changes to the way dividends are taxed with effect from April 2016. Although most investors won’t pay additional tax as a result, small business owners often will because the changes are aimed specifically at them.

Many contractors operate within a limited company and receive most income as dividends to minimise tax and NI costs. The new system will reduce these benefits and is expected to generate an additional £6.8 billion in tax revenue by 2020-21.

Changes to the System

Under the old system, dividend payments had applied to them a dividend tax credit of 10%. This can be confusing since cash dividends paid have to be grossed up (by dividing the payment by 0.9) to achieve the amount for tax purposes. However, since the credit is then deducted, no tax is payable within the lower tax band (up to £42,385 for 2015-16) and then 25% of the cash dividend within the higher band and 30.61% for Dividends_Changes_For_UK_Contractors_Image_Of_Cashadditional rate taxpayers.

From April 2016, all that changes. The dividend tax credit is abolished and replaced by a £5,000 tax free dividend allowance. Dividend payments above that level are taxed at a new 7.5% rate for earnings within the basic rate band (up to £43,000 total earnings for 2016-17), 32.5% at the higher rate and 38.1% for the additional rate. That, of course, is in addition to corporation tax paid on profits.

The Effect

Basic rate taxpayers could previously receive just over £38,000 in dividends tax free but this is now reduced to the £5,000 allowance, with increasing rates of tax levied above that level. Even contractors receiving relatively modest amounts of dividend income rather than salary will pay additional tax.

If you receive a large proportion of your income as dividends, the additional payment will be significant. A £50,000 dividend, for example, can result in more than £2,000 extra tax. For married couples running a family business, the additional burden can be twice that level.

What You Can Do

The changes will have a significant effect on net income for limited company contractors so you may feel you need to take action to limit the impact.

One thing you may consider is bringing forward dividend payments before the new changes take effect. It’s estimated that an additional rate taxpayer could save almost £55,000 in tax by taking £750,000 out of the business before the end of the 2015-16 tax year.

Such payment will seriously deplete your business cash reserves and need to be considered carefully. Longer term, you should be looking at the overall position and determining again the benefits of limited company operation against self-employment.

This can be a complex calculation, taking into account corporation tax and the additional cost of running a limited company. High earners with relatively modest dividend income, for example, may be better off under the new system while others may not. Professional advice is invariably cost-effective and Phoenix Cloud Accounting can help you make an informed choice.

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