In April 2016, as part of a fundamental overhaul in dividend taxation, a new ‘dividend allowance’ was created – a nil-rate tax band on the first £5,000 of dividend income. This allowance threshold was short-lived, however, and was cut to £2,000 from April 2018.
April 2016 changes to dividend taxation
Although the allowance itself may appear to be a tax giveaway, it was announced as part of much wider changes to the way dividends are taxed. Prior to April 2016, dividends were paid ‘net’ to shareholders, who also received a tax voucher to account for the fact that company income had already been subject to Corporation Tax. These net dividends were then multiplied by 10/9 to produce the ‘gross’ dividend upon which income tax was payable.
A much less complicated, but far more punitive dividend tax regime was introduced in April 2016. All dividend income on top of the £5,000 dividend allowance is taxed at a fixed rate, according to the tax band the income falls within. The rates are 7.5% (basic), 32.5% (higher) and 38.1% (additional). You pay any tax you owe at Self Assessment time.
As a result of the reforms, almost all company owners pay significantly more tax on dividend income than they did before.
Changes to the dividend allowance from April 2018
Chancellor Philip Hammond first announced the allowance reduction from £5,000 to £2,000 during the Spring 2017 Budget, however the measure was dropped from the first Finance Bill 2017 due to the General Election. Despite wishful thinking from shareholders all over the UK, the measure was re-introduced in the second Finance Bill 2017 and became law on 16th November 2017.
How does the dividend allowance actually work?
Put simply, you don’t pay any tax on the first £2,000 of dividends you draw down during the tax year.
However, importantly – the allowance does not reduce your total income for tax purposes. Many people don’t take this point into account when working out their potential tax liability.
For example, during the 2022/23 tax year, for a small company owner earning a £9,100 salary and £41,170 in dividends (using the entire basic rate tax band), you calculate your dividend tax liability as follows:
- Your £9,100 salary is less than the £12,570 personal allowance, so no tax is payable.
- The first £3,470 of dividends use up the rest of the £12,570 tax-free personal allowance.
- The dividend allowance covers the next £2,000 of dividends but uses up £2,000 of the basic rate tax band.
- The next £35,700 of dividends are taxed at the basic rate (8.75%) = £3,123.75.
- The total dividend tax bill for the year is £3,123.75
Find out more
For the official description of this tax measure, together with examples, click here.
There are a number of popular dividend tax calculators out there – try this one from ITContracting.com.