Contractors face tax hikes of 7.5% on all dividends in new dividend taxes from April 2016 following dividend tax reforms introduced by the Chancellor George Osborne in his Summer Budget. Anyone earning taxable dividend income up to the basic rate threshold of £32,000 per year will pay an extra £2400 in taxes on that part, an effective basic marginal rate of tax of 26%. Thereafter for higher rate tax payers, the extra 7.5% on taxable dividends equates to an effective marginal rate of income tax of 46% - more than employees pay. The new rates apply to anyone taking dividends, including small business owners.
According to the Treasury in section 1.184 (page 44) of its Summer Budget 2015 document: “The government has identified a number of areas of the tax system where imbalances have developed over time and where certain reliefs are disproportionately benefiting certain groups of individuals.”
Described by Osborne as “complex and archaic”, and designed over 40 years ago, the existing system of tax credits on dividends will be scrapped and replaced with a simple rate on net dividends of 7.5% for basic rate taxpayers, 32.5% for higher rate taxpayers and 38.1% for additional rate taxpayers. There will be a new £5,000 tax-free Dividend Allowance replacing the previous dividend tax credit.
“Cynical” new dividend tax replaces old dividend tax credits
“This is a cynical ploy by the government that enables it to tap contractors and all small business owners for extra tax without breaching any of its pre-election promises,” highlights ContractorCalculator CEO Dave Chaplin.
“That this measure, alongside a review of IR35 and a consultation on the future of umbrella and personal service company expenses, is announced days after the Prime Minister David Cameron promised to review the challenges facing the self-employed, demonstrates breathtaking duplicity.”
Previously, contractors and small business owners taking remuneration from their company via a dividend have enjoyed a dividend tax credit that removes the potential for double taxation as a result of the corporation tax their company already pays on its profits.
Under the old system, basic rate taxpayers have paid no additional income tax on dividends, and higher rate taxpayers have paid 25% on net dividends, bringing the tax paid on pre-taxed profits in line with the 40% higher rate income tax employees pay. Now, contractors who are basic rate taxpayers will pay 7.5% on their dividend income, and higher rate taxpayers 32.5%.
We need to crunch all the numbers and take into account the new Dividend Tax allowance, but it looks very much like an effective basic rate marginal tax of 26% and a higher rate marginal tax of 46% for contractors.
How to calculate dividend tax after the Summer Budget 2015
Using a fairly typical example of a contractor limited company with salary just over £11K and profits of £100,000, after corporation tax the distributable profits via dividends will be £80,000.
The new rules include a new Dividend Tax Allowance of £5000, so dividends eligible for taxation are £75,000.
For a contractor choosing to take all the dividends and incur taxes in the higher rate band, the dividend tax calculation just for the basic rate band would look like this:
- The basic rate is taxed on incomes between £11,000 to £43,000, so there is the full £32,000 of taxable income in the basic rate band
- The new dividend tax rate for basic rate taxpayers is 7.5%
- 7.5% of £32,000 is £2400, which is part of the new additional tax a contractor must pay from April 2016.
- On top of that, any dividends in the higher rate band are payable at 32.5%, and no longer 25%
For the higher rate tax band, the old rate was 25% of net dividends and the new rate is 32.5%, so has increased by 7.5%. Contractors used to pay 25% of the net dividend, the same as 32.5% of the grossed-up dividend. Under the old rule, higher rate taxpaying contractors effectively paid 40% of pre-corporation tax profits in tax.
The new dividend tax for higher rate taxpayers still requires 20% corporation tax, which on the example above is £20,000, plus an extra 7.5% on the net profit which is £6,000, equalling a 6% increase in overall taxation. Contractors in the higher rate band will pay a 46% marginal rate of tax on pre-corporation tax profit, and employees on these earnings are only paying an additional 2%, by way of NI.
There are other factors to consider, such as the Dividend Tax Allowance and end of the grossing up of dividends, which will bring the overall burden down from 7.5%, but on the whole contractors and small business will be paying lots more tax. In fact, we could now have a tax system where by small business owners will be paying higher marginal rates of tax than employees.
Chaplin concludes: “We are planning to release a new interactive online tax and salary calculator in the coming days that will enable contractors to calculate how much extra tax this tax-grab by the Chancellor will cost them.”
Update (14th July 2015) - calculator now published
The new Dividend Tax Changes Impact Calculator uses the new rules that take effect from April 2016. This calculator will show contractors and company owners how much extra tax they will pay as a result of the new rules.
Editors note (20th August 2015):
On 17th August 2015 HMRC published a Dividend Allowance Factsheet, which explained that the £5,000 Dividend Tax Allowance was to be implemented as a zero rate tax, contrary to what industry experts had agreed after the Summer Budget. Further, because it is now a zero rate tax (and not an allowance which would be taken off total income to arrive at taxable income) they confirmed that “Dividends within your allowance will still count towards your basic or higher rate bands”. For many contractors already paying higher rates of tax the consequence is an additional tax burden of £1,250 per year on top of the rises previously reported.
For more detail please see:
HMRC clarification of Dividend Tax changes will cost most contractors another £1250
To calculate the extra taxes you will be paying from April 2016, please use our Dividend Tax Changes Impact Calculator