Limited company contractors can implement a range of strategies that could enable them to mitigate the impact of the Dividend Tax changes announced in the Chancellor George Osborne’s Summer Budget.
“All contractors will be paying an additional 6% marginal rate of tax from 6 April 2016 when the changes come into force,” explains James Abbott, founder and head of tax at contractor accountant Abbott Moore. “Contractors can take some choices before the deadline and once the rules come into effect that can mitigate the impact of the tax.”
But Abbott highlights that whatever strategy they adopt, the Dividend Tax changes have been structured in such a way that all contractors continuing to pay dividends will be paying more tax from 6 April 2016.
“We won’t know for sure exactly how the Dividend Tax changes will work in practice, and therefore what tax planning options are available, until the legislation is published in next year’s Finance Bill and we see HMRC’s guidance,” he adds.
How to approach mitigating the impact of the Dividend Tax changes
According to Abbott, the existing income tax rules alongside the proposed Dividend Tax changes make working out the best option a highly complex process: “With the reducing rate bands for those receiving child allowance and earning over £100,000, income tax is complex enough.
“When you add the Dividend Allowance, which is not in fact an allowance as we would normally understand it but a reducing rate band, then working out whether you will be better off is not easy.”
Abbott recommends that each contractor considers their own personal situation and asks: “If I take £1 today, before 16 April 2016, what would the tax be? If I took that same pound in a year’s time, what would the tax be? And then compare the two.”
“This can produce some surprising results. For example, those contractors who have never paid higher rate tax (HRT) and are thinking of declaring a large dividend before the changes take effect will discover that in virtually all cases paying HRT under the existing regime is worse than paying the 7.5% basic rate Dividend Tax under the new regime.”
What action can contractors take before 6 April 2016?
One measure HRT- and top rate tax-paying contractors can take by 5 April is to accelerate the dividends they take, potentially up to £150,000 total annual earnings for 2015/16. The HRT and top rate tax on dividends pre-April 2016 will be lower than under the new rules.
However, contractors should beware when approaching the changing allows thresholds for child allowance at £50,000 and the withdrawal of the personal allowance from £100,000. “The tax between £100,000 and £121,200 is horrendous,” adds Abbott.
But Abbott warns that with accelerated dividend income earlier is not necessarily better: “Firstly, the objective of an early dividend is to save on personal tax, but by taking money out sooner, a contractor is bringing forward that liability.
“Contractors should also consider that taking a higher income does not just affect income tax. It will also impact on processes such as university funding applications and child benefit.
“There is also the fact that there is less cash available after paying personal tax compared to if the money is left in the business. This factor is less relevant to mainstream contractors, but those growing their business or considering business investments will have less cash to do this.”
Accelerated dividends must have the correct paperwork
“If there was ever a time to make sure you get the paperwork right, it is now,” highlights Abbott. “HMRC is not daft. The taxman knows that dividends around 5 April 2016 are worth checking to ensure they fall into the correct period.
“Contractors should get the paperwork signed and have some independent method of verifying the signature. It may be worth contractors completing and signing their board minute and dividend counterfoils, scanning them and emailing the documents to their accountant, who can then confirm timing if required.”
This is particularly important if the cash does not physically move at the same time as the dividend is declared. Money leaving the bank account reinforces the legitimacy of the dividend, but if the money can’t be moved for some reason then contractors need to be rigorous.
“Contractors must also ensure that there are sufficient profits in the business to declare an accelerated dividend,” continues Abbott, “otherwise the dividend will be illegal.”
Timing of additional actions before 6 April 2016
In addition to accelerated dividends, contractors can also mitigate the impact of the Dividend Tax changes by carefully planning other actions, which could include pension contributions, training, time away from work and the timing of big projects.
Abbott explains: “Let’s say a contractor was planning to go on a course in January 2016 and make a lump sum pension contribution in February. Both of these represent sizeable costs which, if incurred during the 2015/16 tax year, will reduce the amount of profit for the year and potentially the level of dividend. They will also represent a cashflow out of the business.
“But let’s say the contractor decided to defer the training until May and the pension payment until after 6 April 2016. All other things being equal, this would result in higher profits and leave more cash in the business for 2015/16. The contractor could then declare a larger dividend in the lower tax regime and a smaller dividend in the 2016/17 higher tax regime.”
The same principal could apply to a contractor deciding to take a break from contracting, or investing in a project, which could be piece of equipment, which would result in lower profits in the tax year that the costs were incurred.
On the subject of pensions, Abbott adds one more point: “Shifting pension contributions between tax years should be considered in the context of the contractor’s wider retirement strategy..
“If they wish to max out their pension allowances, then shifting contributions from 2015/16 to 2016/17 may not be the best option. Contractors should talk to their financial adviser before taking these decisions.”
Why can’t the company close on 5 April 2016 and restart anew?
Abbott notes that what contractors can’t do it shift their business into a new company to benefit from the 10% Entrepreneur’s Relief (ER) tax rate via a member’s voluntary liquidation (MVL) – HMRC has rules preventing this.
“But a contractor with a lot of cash in the business could close the company, extract the cash tax efficiently and so something completely different for a couple of years. IT contractors have been known to try plumbing as a career change, or go back to university for three years.”
Contractor Dividend Tax changes strategies post-6 April 2016
Abbott acknowledges that there is little contractors can do to avoid the impact of the Dividend Tax changes when they come into force on 6 April 2016, and the strategies they can adopt are similar to those that can be employed pre-6 April that will mitigate them.
“It is worth restating that salary above the National Insurance threshold is still beaten by dividends because of the difference in National Insurance Contributions (NICs) and because contractors no longer gross-up the dividend and so don’t hit the HRT and top rate tax bands as quickly.
“Furthermore, the benefit in kind (BIK) rules and NICs at 13.8% have not changed. So, because accessing money via dividends is more expensive it might be worth contractors looking at taking more benefits in kind, particularly HRT taxpayers.”
Taking a company car may still be borderline, but it could be more tax efficient to consider benefits such as private medical insurance and gym membership. “If a contractor has dismissed these in the past, they should consider working with their accountant to run the numbers again and perhaps put these costs through the business.”
Most contractors are aware of the benefits of pension contributions: a contractor’s limited company pays into the contractor’s pension scheme, and gains both corporation tax relief and income tax relief on the contribution.
“Pensions will become even more attractive for contractors because they remain a tax effective method of diverting up to £40,000 each year tax-free into a pension fund,” explains Abbott.
“Plus the taxes on pension income when it does pay out are the ‘old’ income tax rates of 20%, 40% and so on. For contractors approaching 55, after which the pension freedoms introduced in 2015 become available, they may wish to consider maxing out their allowance, although a conversation with their financial adviser is essential.”
Income splitting and salaries for spouses
Contractors not taking advantage of their spouse or civil partner’s lower rate can transfer shares to their spouse so that a proportion of dividend income is paid to them, and they may also be paid a salary. Salary without NICs will beat dividends following the Dividend Tax changes, so if a spouse or civil partner’s role in the company justifies it, they can be paid a salary.
“Income splitting is a misnomer, because the spouse is being granted the rights over the income but also the rights and responsibilities of owning the shares. As long as the shares are in the same class and dividend waivers are not used, a contractor can transfer shares over to their spouse without fear of the settlements legislation.”
Abbott reminds contractors that spouses and civil partners receiving more than £5,000 of dividends each year and who currently do not have to do a tax return will now have a tax liability, and the only way this can be collected is through self-assessment (SA) tax return.
“The accountant can help the spouse of course, but this is another administration burden and cost.”
Director’s loans and business investments
According to Abbott, there have been no changes to the rules regarding director’s loans, and they do become more advantageous when tax rates on dividends go up.
“A word of caution about director’s loans: contractors should ensure they understand the tax implications of drawing money out, they need to make it clear that the cash is a loan and not a dividend, and there are some new rules that avoid recycling director’s loans and obtaining a tax advantage from recycling them.”
Many contractors will also be thinking about business investments such as buy-to-let properties owned by their company. Proposed changed to the tax reliefs that private buy-to-let landlords being phased in over several years from 2015 could make personal ownership more untenable going forward.
“This could mean building a portfolio within the company could become more attractive, as currently companies will not be subject to the same tax relief restrictions that are being implemented for individuals. Again – professional advice must be sought to properly evaluate options and provide the information needed to make a decision.”
Expenses and gift aid
There are also some expenses that contractors pay out of their own pocket and may not claim because they don’t think it is worth their time and completing the paperwork. Abbott urges contractors to look at these expenses as every pound claimed could be worth 46p of a contractor’s tax bill, 10% more than under the old rules.
“In addition to expenses, are there assets a contractor can sell to their company and so draw down tax free, such as furniture or IT equipment from when the contractor started their business?
“Gift Aid may also become a useful tax strategy, as the way it works is to expand basic rate bands. Contractors making regular charitable donations should think about whether their company should be paying, or if it is more tax efficient for them to make contributions personally.”
Abbott concludes: “There is no ‘silver bullet’ to make the Dividend Tax changes go away. But, after seeking professional advice from an accountant and financial adviser, contractors can adopt strategies that can mitigate its impact.”