6th April: Major changes to the way dividends are taxed

The existing system of grossing-up dividends will be abolished and replaced with a simple rate of tax on net dividends. The tax bands will be 7.5% for basic rate taxpayers, 32.5% for higher rate taxpayers and 38.1% for additional rate taxpayers. The current Dividend Tax Credit will be replaced by a new tax-free Dividend Allowance of £5,000.

The way that dividends are taxed will completely change. Using the existing rules, a contractor declares a dividend and then grosses-up that net dividend by ten ninths to arrive at a gross dividend, including tax credit of 10%.

So currently, for every £100 of profit earned, a contractor’s company pays 20%, or £20, in corporation tax, leaving £80 to be paid as a dividend. That is then grossed up to £88.89 to find out which personal tax band the dividend falls into. Basic rate taxpayers pay no additional income tax on dividends, while higher rate taxpayers pay 25% of the £80 and additional rate taxpayers pay 30.55% of the £80.

From April that will change. The new Dividend Tax rates will be applied to all net dividends after deducting an individual’s personal allowance not used by salary or other income. The new rates are 0% for the first £5,000 (called the Dividend Allowance), 7.5% for a basic rate taxpayer, 32.5% for a higher rate taxpayer and 38.1% for an additional rate taxpayer.

On a positive note, the new rules say that for every £100 profit, 20% or £20 of corporation tax is deducted and then the Dividend Tax applies to the remaining £80. What this does is actually delay the point when a contractor starts to pay higher rate tax, because the net dividends are no longer grossed up.

There is little that can be done for contractors to avoid the new tax on dividends, however with good advice from Cogent and careful planning, such as diverting profits into a pension scheme, much can be done to mitigate the increase.