We’ve produced helpful information for investors on the tax treatment of dividends and set out some of the potential planning options for shareholders to consider, to both help minimise their impact and maximise the benefit of the reduced rates of capital gains tax (CGT) on the disposal of investments (with the exception of residential property).
As dividend income is not subject to the Scottish income tax, the rules apply across the UK.
What is the tax treatment of dividends?
The dividend allowance was reduced from £5,000 to £2,000 for all taxpayers with effect from 6 April 2018. The £2,000 allowance is effectively a 0% rate band for dividend income and reduces the taxpayer’s available basic rate or higher rate bands.
Dividends in excess of the tax-free allowance are subject to dividend tax rates based upon whether they fall into the taxpayer’s basic rate, higher rate or additional higher rate bands, with the rates being 7.5%, 32.5% and 38.1% respectively.
Ken and Barbie are married with two grown-up children. Ken owns and runs the family hairdressing business, Curl Up Limited. Ken also owns a personal investment portfolio worth around £0.5 million.
Ken has so far in the 2020/21 tax year received net dividends of £30,000 from Curl Up Limited and £20,000 from his investment portfolio.
Ken is a higher rate taxpayer. Ken’s dividend income tax liability will therefore be £15,600 (£50,000 - £2,000 = £48,000 @ 32.5%) in the 2020/21 tax year. This will be payable by 31 January 2022.
It should be noted that dividends arising in discretionary trusts will be subject to income tax at the additional higher rate of 38.1% and will not benefit from the £2,000 dividend allowance.
What is the impact for you?
The Government’s stated purpose behind the introduction of the new dividend tax regime from 6 April 2016 was to deter taxpayers incorporating their businesses purely for tax purposes by increasing the effective tax rates for extracting company profits by way of dividends. It should come as no surprise, however, that the impact of these measures have extended well beyond this intended target.
Taxpayers who rely on their personal investment portfolios to provide them with a regular annual income stream could be facing larger tax liabilities under the current dividend regime. All basic rate taxpayers with annual dividend income in excess of £2,000 are worse-off. Basic rate taxpayers who receive dividend income may also now find themselves having to file self-assessment tax returns each year.
Higher rate and additional higher rate taxpayers with only modest levels of investment income (e.g. employees with small investment portfolios) will potentially pay less income tax as a result of the availability of the dividend allowance.
What can be done to minimise the impact?
The effective tax rate of dividends will continue to make dividends more attractive than receiving salary, bonuses, or pension income. There may, however, still be options available to help minimise the impact of the changes depending upon your circumstances:
Dividend policy and timing of payment
Family companies can determine the timing and amount of dividends paid.
It may be more commercially viable and tax-efficient for profits to be retained in the family company for a longer period of time. The aim would be to defer and potentially reduce the dividend tax liability by spreading dividends over a number of tax years, or paying dividends in a year when the rate of tax payable by the recipient will be less.
In certain circumstances company owners may consider retaining profits in the company until it is wound-up in order for the ultimate distribution to benefit from potentially lower CGT rates. In certain situations the availability of CGT entrepreneurs’ relief could reduce the effective CGT rate on the entire chargeable gain to 10%.
Transfer of shares to other family members
A shareholder can transfer shares to their spouse or civil partner and/or other family members. This would enable a number of dividend allowances to be utilised and for dividends to potentially be taxed at lower rates. There would be no CGT charge on the transfer of shares between spouses or civil partners. A capital gain arising on the transfer of shares to other family members will potentially be subject to CGT at up to 20%. There are, however, CGT reliefs available for the transfer of shares in unquoted trading companies.
This type of planning requires a great deal of care when the shares being transferred are in a family company. Any dividends paid to other family members require to be justifiable and genuine in practice in order not to be caught by any tax avoidance legislation. This will not be an issue for shares being transferred from a personal investment portfolio. Be aware also that income arising following the transfer of investments from a parent to a child will remain taxable on the parent until the child reaches age 18.
Case study - Ken could transfer sufficient shares in either Curl Up Limited and/or his personal investment portfolio to Barbie in order for, say £20,000 of dividends to be taxed in Barbie’s hands.
If, for example, Barbie is a basic rate taxpayer, then she would only be subject to £1,350 of income tax (£20,000 - £2,000 = £18,000 @ 7.5%). This would result in a substantial annual tax saving on the basis that Ken would be subject to £6,500 of income tax (£20,000 @ 32.5%) if the shares remained in his name.
There are a number of investment options available, which either favour capital growth with a lower income yield, shelter dividend income tax-free or offer tax incentives for saving over longer terms. These include:
- ISAs provide a tax-free environment for capital growth and income. The 2020/21 ISA allowance is £20,000.
- Pension contributions for you and your spouse or civil partner can be highly tax-efficient.
- Investment in shares under the Enterprise Investment Scheme or through a Venture Capital Trust (VCT) qualifies for income tax relief.
- Capital investment bonds enable you to make annual 5% tax-free withdrawals of your original capital while deferring any income tax on the capital growth within the bond until a point when you (or an assignee) are in a position to benefit from lower tax rates.
- Investment in commercial woodlands can provide income tax-free returns.
- Investment in the family business which attracts several forms of tax benefits.
- Dividends received by ISAs, VCTs and pension funds will be exempt from income tax.
This demonstrates that minimising your income tax exposure does not need to be complicated. It can simply involve pro-active asset structuring and cash-flow management.
You should always seek, where appropriate, financial planning and investment advice before taking any investment decisions.
We’re here to help with your tax planning and we would strongly recommend that you establish the tax, legal and financial implications, and seek specialist advice tailored to your own circumstances before taking any action.
Our Private Client Services offers a full portfolio of advisory services in tax planning, private property and family advice. It is a full-service solution that is always tailored to meet individual and family needs.