The New Dividend Rules

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1 The New Dividend Rules Introduction This is an in-depth look at the reforms announced by the Chancellor in the Budget of 8 July In Section One we look at the background to dividend taxation and how the new regime will operate from 2016/17. The next two Sections will look at the impact on investors and then on business owners. All three Sections are based on material published to date by HMRC/Treasury, which is sadly thin on detail - the necessary legislation is not due to emerge until Finance Bill Section One Background Dividend taxation is an awkward area for revenue authorities throughout the world. The major issue is whether and how to allow for the fact that the dividend payers companies generally pay corporation tax on their profits before making any distribution. In the USA, which has a much higher corporation tax rate than the UK, Uncle Sam does not bother and simply levies an additional 15% withholding tax on dividends. In the UK, since 1973 we have had an 'imputation' system, which has attempted to give credit for some of the tax paid at the corporate level. Before Norman Lamont started messing around with this in 1993, UK dividends were treated as basic (standard) rate tax paid and came with a reclaimable tax credit equal to that basic/standard rate amount. So, for example, in 1992/93 a 75 net dividend would have come with an attaching tax credit of 25 which pension funds and other tax-exempt investors could reclaim. To make sure that tax was actually paid at the corporate level, there was advance corporation tax (ACT). This matched the dividend tax credit and had to be paid by the company even if it exceeded the corporation tax ultimately due. In the 1993 Budget Norman Lamont took the first step towards breaking the system by reducing the tax credit to 20% (when basic rate was 25%) and creating a new dividend basic rate of 20%. This tweak had two benefits for the Exchequer: higher rate taxpayers paid more tax because of the smaller credit and, more significantly, the tax reclaim amount was reduced. ACT was cut to 20%, but the total corporation tax take did not change. Wind forward to 1997 and Gordon Brown's first Budget took Norman Lamont's tweaking to the next level by reducing the tax credit and basic rate for dividends to 10%, with the ability to reclaim the credit withdrawn for pension funds immediately and from 1999/2000 for individuals (and PEPs/ISAs to come). For higher rate (40%) taxpayers dividends became taxable at 32.5% of the grossed up amount, ie. an extra 22.5% was payable after allowance for the 10% tax credit. ACT

2 continued at 20% for a couple of years, but was scrapped from April The demise of ACT effectively removed the last remnants of a direct link between the dividend tax credit and corporation tax paid. It could be argued that in the July 2015 Budget, Mr. Osborne brought the actions of his predecessors to a logical conclusion by scrapping the non-reclaimable 10% tax credit. In effect he has abandoned the imputation system and moved towards the US model. The Chancellor could have stopped it at that, adjusting tax rates for higher and additional tax payers to 25% and 30.56% of the dividend payable to produce the same tax income in 2016/17 as in 2015/16. However, instead he announced: A new dividend allowance from 2016/17 of 5,000 for all individual taxpayers; and New tax rates above the allowance of 7.5% for basic rate taxpayers, 32.5% for higher rate taxpayers and 38.1% for additional rate taxpayers as the Chancellor said, a rise in all effective rates (based on dividend paid with no grossing up) of 7.5% The net result is that 85% of taxpayers will be better off or at least no worse off, according to the Chancellor. For those above the new allowance a comparison of this and next tax year is shown below: Basic Rate Higher Rate Additional Rate 2015/ / / / / /17 Dividend Tax Credit Taxable Tax liability Tax Credit Tax to pay Section Two The impact on Investors In his Budget speech, the Chancellor said '85% of those who receive dividends will see no change or be better off. Over a million people will see their tax cut.' Are the changes really that good? From the viewpoint of an investor whose marginal rate of tax is above basic, the 5,000 dividend allowance is very generous: For a higher rate taxpayer, the allowance represents a saving of up to 1,250 [22.5%/0.9]). To end up with a bigger overall tax bill on their dividends, the 40% taxpayer would need to receive total net dividends (i.e. not grossed up) of over 21,667. For an additional rate taxpayer, the corresponding figures are 1,528 and 25,250. The investor s worst affected although there will be few are basic rate taxpayers with dividend income above 5,000. At present they pay no tax until they hit the higher rate threshold whereas from 2016/17 they will pay 7.5% tax. In other words, the dividend tax change is regressive, at least as far as most investors are concerned. In his speech Mr. Osborne also said 'Those who have large shareholdings worth typically over 140,000 will pay more tax'. That figure was a crude stab based on the fact that the FTSE All- Share Index yields about 3.5% 3.5% = 4,900). In practice, for most investors the value threshold will be higher because:

3 (i) most collective investments will have charges deducted from income before dividends are paid, so the actual yield will be lower than the market figure; and (ii) The UK is a relatively high yielding market. The S&P 500 yields just under 2% and the MSCI World Index (admittedly 57.6% USA) yields about 2.5% (implying a portfolio threshold of 200,000). So what are the consequences of these changes? At present there are some imponderables as the Treasury/HMRC has provided only limited information. With that in mind, the following list must be regarded as somewhat provisional in nature: An end to grossing up makes dividends the most attractive form of income for those worried by thresholds based on total gross income (e.g. personal allowance phasing out, child benefit tax and next year's annual allowance cutback). 100 of dividend is 100 of gross income, too and is worth the same as 125 of gross interest/earnings (ignoring NICs) to a basic rate taxpayer. For higher and additional rate taxpayers with dividend allowance to spare, the corresponding figures are and Once the 5,000 allowance is breached then the equivalent gross interest/earnings amount drops to about Just as next year's personal savings allowance has raised issues about the value of cash ISAs, so the dividend allowance poses a similar question for stocks and shares ISAs. Until the dividend allowance is exhausted, the main advantage is CGT, which few investors pay anyway. The higher rates of tax on dividends above the dividend allowance make collectives where charges are deducted from income more attractive than externally managed portfolios, where the investor meets costs from the income they receive. This has always been the case for higher and additional rate taxpayers, but it becomes more so with the higher rates and will now also catch basic rate taxpayers. The result may be more managed portfolios within a single collective wrapper. UK investment bonds may have become more attractive. Once the dividend allowance is exceeded, tax rates of 7.5%, 32.5% and 38.1% will apply to the net dividend. By contrast the tax rate applicable via an onshore bond on gains will be 0%, 20% and 25%. Usually this would be countered by the more favourable capital gains treatment on a personal basis, but the chances are that once the dividend allowance is exceeded, there may be little or no annual exemption available. At that point overall tax on capital gains via a bond does not look too bad, particularly once the internal indexation relief is taken into account. HOWEVER and it is a big however we do not know whether there will be any revision to the rate of tax levied dividends received in policyholders' funds. s102(2) Finance Act 2012 sets the policyholders' rate of tax on income as 'the rate at which basic rate tax is charged'. Will that become 7.5% for dividends from 2016/17 or remain at an effective 0%? If it is 7.5%, then there will be a much smaller marginal advantage for higher and additional rate taxpayers. The dividend allowance (along with the personal savings allowance) could mean fewer selfassessment returns issued, because there will be no extra tax to collect if earnings/pension are covered by PAYE. This fits in with the Chancellor's pledge greeted with much skepticism to do away with tax returns. A corollary is that for 2016/17 some investors will need to claim a reduction in their payments on account (using from SA303) because they will no longer have as much if any extra tax to pay on their dividend income.

4 COMMENT This gives a flavour of how the investor's world will change, but doubtless more will emerge in the weeks ahead as further thought is given to the consequences of the Chancellor's actions. In his Budget speech, the Chancellor said 'Those who either pay themselves in dividends or have large shareholdings worth typically over 140,000 will pay more tax'. This was the only clue to why Mr. Osborne had undertaken such a radical reform of dividends, seemingly giving away money to 85% of dividend recipients. Section Three The Impact on Business Owners As we noted above, the 5,000 dividend allowance will mean: Basic rate taxpayers are only worse off when their dividend income exceeds 5,000; Higher rate taxpayers are better off until their dividend income exceeds 21,667; and Additional rate taxpayers are better off until their dividend income exceeds 25,250. The main groups who will be hit by the reforms will thus be those people with substantial investment portfolios or, more likely, who operate via private companies and draw large dividends. Such dividends will often be in lieu of salary, but they may also represent withdrawal of corporately-sheltered investment income, e.g. by individuals who use companies to hold buy-to-let portfolios (coincidentally also side stepping the new interest relief rules). The impact of the changes on those who use dividends instead of salary or bonus (and are not caught by IR35) can be seen in the following examples. Example 1 The Typical Contractor Peter is a contractor who operates via PeterCon Ltd. He takes just enough income to avoid reaching higher rate. He has a salary of 8,000 just enough to avoid NICs and draws net dividends of 30,946. Ignoring the personal allowance and tax band changes, this is what the Budget has done to Peter: 2015/ /17 Earnings 8,000 8,000 Dividend (net) 30,946 30,946 Tax credit on dividend 3,438 Nil Total income 42,384 38,946 Personal allowance 10,600 10,600 Taxable income 31,784 28,346 Tax on earnings Nil Nil Tax on dividends Nil 1,751* Total tax Nil 1,751 * As Peter has 2,600 of unused personal allowance once he has taken his salary, he does not start paying 7.5% tax on his dividends until they exceed 7,600.

5 The absence of grossing up of the dividends means that in 2016/17 Peter could draw another 3,439 of net dividends before hitting the higher rate threshold (in 2015/16 terms the threshold will actually be 43,000 in 2016/17). If he does so he would pay another 258 in tax 7.5%). If he drew the same 3,439 extra in 2015/16 he would have a tax bill of %). Once Peter hits higher rate, every 100 of dividends is worth 75 after higher rate tax in 2015/16, but only in 2016/17, reflecting the effective 7.5% tax rate increase. Example 2: Bonus or Dividend? Sally has earnings of 50,000 and 7,500 of dividends from SallyCo, and is wondering how to withdraw 25,000 of gross profit from her company. She is a higher rate taxpayer. 2015/ /17 Bonus Dividend Bonus Dividend Marginal gross profit 25,000 25,000 25,000 25,000 Corporation 20% N/A (5,000) N/A (5,000) Dividend N/A 20,000 N/A 20,000 Employer's National Insurance (3,032) (3,032) Contributions 13.8% N/A N/A Gross bonus 21,968 N/A 21,968 N/A Director's NICs 21,968@ 2% (439) N/A (439) N/A Income tax (8,787) (5,000) (8,787) (6,500) Net benefit to director 12,742 15,000 12,742 13,500 Whereas under the 2015/16 regime Sally suffers no tax 'leakage' she receives a 60% of the gross profit of 25,000 as a benefit, in 2016/17 there is 1,500 'leakage' as the effective tax on gross profits is 46%. There are a variety of points that stem from the changes for business owners: There is an obvious incentive to bring forward dividend payments into 2015/16, just as there was in 2009/10 ahead of the introduction of additional rate tax. The OBR recognises this in its Summer Budget forecasts by projecting an 2.54bn increases in tax receipts for 2016/17 over March's projection. This represents the extra higher and additional rate tax payable on 2015/16 dividends, which falls due in January In 2017/18 there is an 0.89bn drop as the process unwinds. However, by 2019/20 the additional flow to the Exchequer has settled down at around 2bn. The higher tax paid by via the corporate route is expected to reduce what the Treasury calls 'Tax Motivated Incorporation'. This is estimated to be worth additional revenue of 190m in 2016/17, rising to 565m in 2020/21. The need to reduce the motivation to incorporate could well be related to the reform of NICs. The Government's much-touted 'tax lock' only applies to employees' and employers' NIC rates, which leaves the self-employed exposed. Class 2 NICs are due to be scrapped and replaced with a revised Class 4 and at about the same time the self-employed will benefit from the new single tier pension. It is not impossible to imagine that the main Class 4 rate will thus soon rise from 9% to match the Class 1 employee rate of 12%.

6 In 2017 and again in 2020 corporation tax will be reduced by 1%, taking it ultimately to 2% below basic rate tax. Without the dividend measures this move would have further encouraged incorporation. COMMENT The days of incorporation for businesses are by no means over, but the benefits will be reduced in the short term. This is based on our current interpretation of legislation and various industry comments. It is a broad summary and cannot cover every nuance. You should not take, or refrain from taking any action based on this information. Tax treatment can change and depends on your circumstances. This information does not constitute advice and is purely for information purposes. The views noted may differ significantly from the final version of the legislation.