The July 2015 Budget announced changes to the tax rules on dividends that will inevitably affect most contractors and freelancers that trade using a limited company. It is important to understand the current contractor dividend tax system in detail, the changes that are on the horizon, as well as consider the options available that may help ease the new tax position.
How contractor dividend tax is calculated now
At present the means of taxing dividends is not straightforward. This is one of the reasons why the Government has prosed changes, to simplify the system. The new legislation, however, is not considered very “pro-business” as it will affect large numbers of tax-payers, including contractors and freelancers.
Before looking at the changes though, it helps to familiarise the details of the current dividend tax calculation, so it can be put into context.
Currently, dividends from shares held within a UK company have technically already had their tax paid, under the limited companies’ corporation tax, so the shareholder is isued with a 10% tax credit for each dividend.
A net dividend of say £1,000 can be divided by 90 and multiplied by 100 to give the gross dividend, in this case, £1,111.
For personal tax calculations the gross dividend is included in the personal tax return, and whilst basic rate tax payers will not be subject to further tax liability thereon, higher rate and top rate tax payers will.
The proposed new dividend tax system
The tax credit of 10% is soon to be abolished, from April 2016 and the new system will be similar to income tax, where income is received untaxed. Tax will then be calculated on the personal tax return.
A £5,000 tax-free allowance will be available to all dividend tax-payers, but tax will be applied to income earned in excess of this amount.
The amount of taxable income from other sources will dictate how much tax will be due on dividend income, however, it can broadly be calculated as 7.5% increase on all dividend income over £5,000.
Table representing increases for each tax band
|Tax band||Current dividend rate||Current effective dividend rate||Dividend tax rate after April 2016|
Tax on dividends under £5,000
Dividends received under the value of £5,000, will retain a neutral effect for basic rate tax-payers, with zero tax due. Higher-rate and top-rate tax-payers will in fact save on dividend tax with the new system.
A higher rate tax payer can expect to be £1,250 better off when taxing dividends under £5,000. For a top-rate tax payer they will save £1,530.
Share income on ISA’s and pensions
Dividend income can also be received on Stocks & Shares ISA’s, pensions, unit trusts or share investments.
ISA’s and private pensions are protected from tax, since 1997, so income received in these types of investment wrappers will be unaffected by the Reform.
Considerations for contractors and freelancers
Whilst, on the whole, it will still benefit to draw dividends rather than a salary, which is subject to income tax and NI contributions, many contractors and freelancers will feel the effects financially.
If you are thinking of setting up a limited company in the near future, speak to a professional accountant who can help shed light onto your personal situation and the tax implications of the decision.
There are a few things that can be taken into account for all contractors:
- With a few months left in this current tax year, it may be possible to maximise dividend drawings in this tax year before the changes come into force.
- Making company funded pension contributions is an avenue many contractors are exploring as a way to save for the future instead of drawing dividends and investing the money outside the company.
- If you are planning to draw dividends to invest in a buy-to-let property, this may be able to be executed under a limited company, avoiding tax implications of withdrawing extra dividends.
- Consider using ISA’s and other tax-free vehicles to avoid the additional tax
All of the above require bespoke advice as they require complex tax planning.