The UK Government’s announcement earlier this month that National Insurance (NI) and dividend tax rates are both set to be hiked by 1.25 per cent in the 2022/3 tax year to fund health and social care costs has certainly proved controversial.
Most of the attention has focused on the NI hike, given this was a breach of a Tory manifesto pledge and its impact will be widely felt by both employees and businesses.
However, the increase in dividend tax rate will be painful too, especially for the millions of small business owners across the UK, many of whom take low salaries but pay themselves dividends. Small businesses are the backbone on the economy, but many owners will feel like they are increasingly in the Government’s crosshairs.
The hike in dividend tax rates looks specifically designed to prevent business owners from trying to mitigate the NI increase by potentially lowering the amount they take in salary, where National Insurance will apply, in favour of dividends, where it does not.
While some may see the Government’s move as a fair attempt to head off tax planning, it should not be forgotten that NI is paid by both the employee and the company. Self-employed workers paying themselves a salary are therefore effectively being asked to pay the new social care charge twice.
And while dividends are not subject to NI contributions, they are paid out of profits which attract corporation tax. Dividends as a source of income from small business owners are therefore effectively double taxed.
The hike, which will see tax on dividends rise next year from 7.5% to 8.75% for basic rate taxpayers, from 32.5% to 33.75% for those taxed at the higher rate and from 38.1% to 39.35% for additional rate taxpayers, is merely the latest raid on dividends.
In 2018 the UK Government slashed the annual allowance at which dividend income can be received without paying tax, from £5,000 per person to £2,000.
The combination of the cut in the allowance and the impending rise in dividend tax rates means that a basic rate taxpayer receiving £10,000 in dividends will have gone from paying £375 between 6 April 2016 and 5 April 2018 when the allowance was higher, to £700 from the next tax year.
Likewise, a higher rate taxpayer with £10,000 in dividends will end up paying £2,700 tax a year, compared with £1,625 prior to 5 April 2018. These represent effective an increase of 86.7% in the amount of tax paid on £10,000 of dividends for the basic rate taxpayer and 66.1% for the higher rate taxpayer in the space of four years.
While the squeeze will be acutely felt by the owners of small, private businesses, investors in publicly listed companies, whether through shares or equity funds, may be impacted too if they received more than £2,000 in dividend income. However, unlike owners of private company shares they have greater scope to act to mitigate the tightening of the noose.
Those who own stock market listed shares or equity funds in a taxable environment, should firstly consider migrating these into Individual Savings Accounts. This is a process known as “Bed and ISA” and involves selling the shares or funds and re-purchasing them with an ISA, where future dividends will escape tax entirely. This is not an option open to private business owners, as unquoted companies cannot be held in an ISA.
When doing this, care needs to be taken not incur a capital gains tax liability when selling the investment before re-purchasing it again. Up to £12,300 of profits can be crystallised each tax year, free from capital gains tax, and each adult can invest up to £20,000 in an ISA.
Another valuable option for married couples and civil partners, is to switch share and equity funds between each other to maximise tax efficiency.
These “interspousal transfers” do not trigger a taxable event. This can help married couples and civil partners make use of two sets of dividend allowances, two sets capital gains allowance and two ISA allowances to migrate dividend generating shares and investments out of the reach of the tax man.
Even where investments are still going to be remain in a potentially taxable environment because ISA allowances are already fully maximised, transferring them to whichever spouse might be subject to a lower rate of tax, can help reduce an overall tax liability.
Where a person is non-taxpayer, alongside using their £2,000 dividend allowance, dividends income can be set against their annual tax-free personal allowance of £12,570.
A careful bit of family financial planning can go a long way to helping shelter dividends from the grasp of HM Revenue & Customs.
Jason Hollands is a managing director at wealth manager Tilney Smith & Williamson.