Salary or Dividend?

The impact of new tax legislation relating to dividend income on owners of SMEs.

Until now the most business efficient way of extracting company profits by its director-shareholder was to draw a minimal salary and have the cashflow flexibility to draw dividends (assuming availability of reserves).

For most owner managed businesses this meant that salary was set at the level of personal allowance of £10,600 (2015/16) or up to the NI threshold of £8,059 (2015/16). Most tax conscious directors reluctant to go into the 40% tax rate typically paid themselves a dividend up to the basic rate tax rate, thus drawing total cash of £35,060 without incurring any personal tax or NIC.

From 6 April 2016 tax rates applied to dividend income will change significantly. In summary:

  • the effect of the change is that any distribution of profits over £5k will now be taxed
  • an equivalent scenario of a salary at below tax and NIC thresholds and a dividend up to the basic tax rate, will now cost £1,429 in dividend tax
  • tax free income is reduced from £35,060 in 2015/16 (min salary of 8,060 plus net tax free dividend of £27,000) to only 16,000 in 2016/17 (personal allowance + dividend tax free allowance).

The legislation changes effectively mean that from 2016/17 the following will apply in an income tax computation:

  • a 0% band of 5,000 applied to dividend income. This allowance reduces the basic tax rate band, rather than being applied in addition to it
  • up to basic rate band: 7.5%
  • higher rate: 32.5%
  • additional rate: 38.1%
  • dividend tax credit will no longer apply
  • dividend income in the tax computation will not be grossed up.

Two examples will illustrate the differences between the current and 2016/17 tax computations relating to remuneration drawn as a combination of salary and dividend.

These examples aim to provide only a very simple illustration of the mechanics of a personal tax calculation, the tax cost and net funds available to an owner of a small business. The illustrations do not address the issue of the cost of extracting profits at the respective levels mentioned in the scenarios to the company, as this aspect remains unaffected by the new legislation.

Overall the impact of the changes is negative – the new legislation increases tax due on dividends, reduces post tax funds available to the individual, and reduces a tax free amount available by some £19,000.

Whilst even with the introduction of these dividend tax rates from 2016/17, drawing a dividend is still significantly more beneficial than drawing a salary at the same level and the recent change is likely to discourage some tax driven incorporations.

Whether this marks the beginning of the Chancellor’s transition towards a philosophy of one ‘business tax’ applied to business profits, rather than different legal structures the business is able to assume, remains to be seen.

Next month we will use these illustrative examples to highlight the company taxation position.

Source: ACCA InPractice