Are dividends still the most tax-efficient way to extract profits from your company?
A key advantage of trading as a company is that the owners, who are generally both shareholders and directors, are only liable for tax and NIC on any profits extracted from the company, so any profits retained in the company are sheltered from personal tax rates. If funds are required to reinvest into the business or to repay debt, the only immediate tax hit is the corporation tax charge of 20%.
However, we all need funds for our personal outgoings and this is where careful tax planning comes into play. Dividends are often used in combination with remuneration to obtain the most tax-effective extraction of profits when the business is carried on through a company.
For many years, the common approach has been to pay a small salary to allow the tax-efficient use of the personal allowance, provide a corporation tax deduction for the company but not to pay NIC. A salary of £8,060 in 2015/16, would correspond to the primary NIC threshold and also provide a qualifying year entitlement to the state pension.
When the new tax regime for dividends is introduced on 6 April 2016 many director-shareholders will find that the tax bill on the dividends will be higher than for the 2015/16 tax year. So do the changes mark the end of the strategy of low salary and dividends?
We now have draft legislation for the new regime which explains the finer points of the proposals and how the new £5,000 Dividend Allowance interacts with other tax rates. The Dividend Allowance does not change the amount of income that is brought into the income tax computation. Instead it charges the first £5,000 of dividend income at 0% tax – the dividend nil rate. This means that:
• the payment of low salary below the personal allowance will allow some dividends to escape tax as they are covered by the personal allowance
• the £5,000 allowance effectively reduces the available basic rate band for the rest of the dividend.
The practical effect of this is that a strategy of low salary and the balance as dividends will still be a tax-efficient route for profit extraction for many director-shareholders although many will be paying more income tax.
What if the director-shareholder has savings income?
We now know how the receipt of savings income interacts with dividend income and it is potentially very complicated. Savings and dividend income are treated as the highest part of an individual’s income. Where an individual has both savings and dividend income, the dividend part is treated as the top slice.
There are two tax breaks which can apply to savings income. The Personal Savings Allowance (PSA), which is new for 2016/17, can provide a potential £200 tax saving for basic rate and higher rate taxpayers. As his is a fairly small amount, the PSA does not fundamentally change the approach to profit extraction.
The 0% starting rate of tax on savings income up to £5,000 has survived the changes made to the taxation of dividends. This tax break is potentially worth £1,000 as it taxes the income at 0% rather than 20%. These rates are not available if ‘taxable non-savings income’ (broadly earnings, pensions, trading profits and property income) exceeds the starting rate limit. But dividends are taxed after savings income and thus are not included in the individual’s ‘taxable non-savings income’.
So, if a director-shareholder only takes a salary of £8,060, any interest would first be allocated against the balance of the personal allowance (£11,000 for 2016/17) and then will be taxed at 0% up to the starting rate limit. The PSA may then give a further tax saving depending upon the total income of the director-shareholder.
Where does the interest come from? The director-shareholder may have interest from savings accounts, retail bonds or loans made via ‘peer to peer’ sites, or they may have provided loans to their company. Many have not charged interest on such loans but there is now an added incentive to do so.
In the new era of the taxation of dividends, please do talk to your RfM advisor about the best strategy for director-shareholders.