To Tax Or Not To Tax?

In the summer budget the Chancellor announced that from 6^th April 2016 the tax credit on dividends would be replaced by a £5,000 tax free dividend allowance available to all. He went on to say that a dividend tax would also be introduced so that basic taxpayers would pay 7.5% tax, higher rate taxpayer would pay 32.5% tax, and additional rate taxpayers would pay 38.1% tax.

It was not at the time entirely clear what was meant by a “tax free dividend allowance”. Many quite understandably assumed that it would mean that the first £5,000 that a person received in dividends would be completely ignored for tax purposes. We now know that this is not what the Chancellor meant. The Treasury subsequently published a factsheet which you can find here: www.gov.uk/government/publications/dividend-allowance-factsheet/dividend-allowance-factsheet.

We see now what is meant by “tax free dividend allowance”. There is no exemption for the first £5,000 of dividends. Rather no dividend tax is charged on the first £5,000 of dividends. Those dividends remain as income for all other tax purposes. In many cases the effect is exactly the same as if the first £5,000 of dividends a person received was tax free, but in other cases additional tax is payable. The government publication gives 6 examples. We give 3 examples here where the results seem quite odd.

1. JEFF AND STEVE

Jeff and Steve are each employed by the same company and they each earn £50,000 per annum. Jeff’s wife works for the same company also earning £50,000 per annum white Steve’s wife works part-time earning £20,000 per annum. Jeff and Steve used to run a company together, but it has been non trading for 3 years and has £30,000 cash in its bank account. Jeff and Steve decide to take advantage of the tax free dividend allowance by each drawing a dividend of £5,000 per annum from the company starting in the 2016/17 year. Neither Jeff nor Steve have any other income and because their salaries are taxed under PAYE, neither expects to pay any tax. Jeff and Steve each have two children. Jeff’s children are 21 and 23 whilst Steve’s are 12 and 15.

Just to make sure their understanding is correct they consult accountant Edward Peters. Edward explains that Steve will have to pay £911.60 tax in the 2016/17 year. This is because Steve’s income has increased to £55,000 and as a result he must pay over 50% of the child benefit his wife receives. Happily Edward has a solution. He suggests that Steve gifts his shares to his wife so that she receives the dividend instead.

Jeff will have no tax to pay because his wife will clearly not be in receipt of child benefit.

2. SCARLETT AND HUW

Scarlett and Hum are both employed by financial institutions in London. Scarlett has a salary of £125,000 whilst Huw earns £100,000. Although neither have other income and they pay their taxes through PAYE, they each have non trading companies holding cash which goes back to the days when they were contractors. They each decide to take dividends of £5,000 per annum from their companies to take advantage of the tax free dividend allowance. Before doing so they check this out with Edward Peters. Edward confirms to Scarlett that she may take £5,000 in dividends and pay no further tax. But he has to caution Huw. He advises that Huw’s income will then be over £100,000 and that as a result, £2,500 of his personal allowance will be lost, resulting in an additional tax liability of £1,000.

3. CLIFF

Cliff is an Office Administrator with a salary of £20,000. 3 years ago he inherited a large portfolio of shares which yield £20,000 per annum in dividends. Until the end of the 2015/16 tax year Cliff will pay no tax on his dividends because he remains a basic rate taxpayer. Cliff’s wife, Lucy is a full time housewife with no income in her own right.

Cliff has thoroughly read up on the dividend tax and he decides to gift 75% of his portfolio to Lucy. He correctly calculates that from 2016/17 he will pay no tax on the £5,000 of dividends that he retains and sets to work out what Lucy will pay. Having spoken to Jeff, Steve, Scarlett and Huw, he arrives at the answer in the following logical way:

• The first £5,000 of dividend Lucy receives carries no dividend tax;
• that £5,000 is nevertheless part of Lucy’s income for tax purposes;
• she therefore has just £6,000 of her £11,000 personal allowance remaining;
• the tax rate on that £6,000 is 0% because that is part of her tax free personal allowance; and
• that leaves further dividends of £4,000 which represents basic rate income, taxable at 7.5% resulting in an annual bill of £300.

He nevertheless consults with Edward Peters and is delighted to find that tax and logic don’t always go together. Lucy has no tax to pay. That is because the first £11,000 of dividends are under the threshold for tax and are ignored. The remaining £4,000 of dividends are less than the tax free dividend allowance.