Possible effects of the tax treatment of dividends from April 2016

The Telegraph online declared ‘Budget 2015 – Investors face tax raid on dividends’. Whilst this is true for those with large income portfolios, not everybody loses out and in fact those who do not currently invest in stocks and shares, there is now a tax incentive to do so.

Very importantly, Dividends in tax wrappers such as SIPPS and ISA’s are not affected.

Under the existing system a dividend of £100 is grossed up to a notional £111 and that amount is taxed at 10% for basic rate taxpayers, 32.5% for higher rate taxpayers and 37.5% for additional rate taxpayers. The tax credit of £11 is then subtracted giving the tax percentage as in the table below:

This system of grossing up the dividend will now end and be replaced by a new system that will give all taxpayers a ‘personal allowance’ of £5000. So in the table below:

And

And

So for Basic rate taxpayers, they are worse off when their dividend income exceeds £5000. For higher rate taxpayers they are worse off when their dividend income exceeds approximately £20,400 and better off below that. For additional rate taxpayers they are worse off when their dividend income exceeds approximately £25,000 and better off below that.

See below for some illustrations:

Overall the effect is bad for those with existing large income portfolios but is actually beneficial to individuals who currently do not invest in stocks and shares or have a relatively small income from dividends. (less than approx. £20,400 for higher rate taxpayers and less than approx. £25,000 for additional rate taxpayers)

The biggest effect of the changes falls upon self employed people using limited companies as a tax efficient / avoidance scheme by choosing to operate a limited company for the purposes of their work, such as IT contractors who can potentially avoid National Insurance and pay lower tax rates by paying themselves in the form of dividends as opposed to using PAYE.

However, entrepreneurs will be similarly hit and that cannot be good as there are very good tax incentives for the entrepreneur to sell their business. Entrepreneurs relief allows the entrepreneur to sell their business with a capital gains tax rate of just 10%.

Is there a strategy for dealing with the changes? Investors may with to mitigate the ex-dividend effect by selling shares for capital gain in the days before a stock goes ex-dividend thereby locking in the gain and foregoing the income. This is unlikely to work very well for large portfolios as there is only a limited amount of tax free capital gains (£11,100) in any one year. However the top rate of capital gains is only 28% compared to 32.5% for the higher rate taxpayer and 38.1% on income for the additional rate taxpayer.

The other tool in the investor’s armoury is to go for growth stocks with lower yields, thereby reducing the overall income level in the portfolio and again pushing the portfolio towards gains tax rather than dividend income tax.

Another possible outcome of the changes is that companies will consider moving away from cash dividends and more into share buybacks. This may happen, but on a relatively small scale. It will have the effect of moving investors away from taxation of income and more into capital gain, but it is not something that will become widespread in the sense of companies scrapping their cash dividends. There will be some companies that move to do both. The main consideration is how is the company doing. Are the profits growing? Is cash flow strong? How they choose to distribute to shareholders will be in the interests of shareholders especially as almost all directors of PLC’s are shareholders in the companies themselves.