From 6 April 2016 the dividend tax credit system has been scrapped and replaced with a new dividend allowance of £5,000.
Over and above this £5,000, dividend income is taxed as follows:
- If you have any unused personal allowance (£11,000 for 2016/17) then that element is tax free.
- Dividends in the basic rate tax band (up to £43,000 for 2016/17) attract tax at 7.5%.
- Dividends above the basic rate tax band attract tax at 32.5%.
- Additional rates of tax will apply in the upper tax band (above £150,000 for 2016/17).
The usual approach to tax efficient profit extraction for a small owner managed incorporated business is to take a nominal salary and top up earnings by way of dividends up to the level of the higher rate income tax threshold.
If we assume:
- There is a sole director / shareholder who is entitled to the full tax free personal allowance and has no additional earnings.
- The employment allowance, which exempts an employer from paying the first £3,000 of their employer NI liability for 2016/17, may not be claimed as it is no longer available to companies where the only person on the payroll is a director.
Then the recommended approach would be:
- Take a salary equivalent to the NI primary threshold of £8,060. NI credit is received but no employer or employee NI liability arises. Similarly, as the salary is below the annual personal allowance, no income tax is payable and, as salaries are taken out of pre tax company profits, corporation tax of £1,612 will be saved (20% of £8,060).
- Take dividends of £34,940 so that total gross income is equivalent to the higher rate income tax threshold (£43,000 – £8,060).
- Tax on the dividends falling within the basic rate band is £2,025 (£34,940 less the unused personal allowance of £2,940 less the dividend allowance of £5,000 is £27,000 taxed at 7.5%).
- The effective income tax rate is 4.7% (income tax of £2,025 on total gross income of £43,000).