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 2019/20 and 2020/21 tax years, for a small company owner earning £12,500 salary and £40,000 in dividends, you calculate your dividend tax liability as follows:
- Your £12,500 salary is equal to the personal allowance, so no tax is payable.
- The dividend allowance covers the first £2,000 of dividends, but uses up £2,000 of the basic rate tax band.
- The next £35,500 of dividends are taxed at the basic rate (7.5%) = £2,662.50.
- The remaining £2,500 of dividends are taxed at the higher rate (32.5%) = £812.50
- The total dividend tax bill for the year is £3,475
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 our partner site, ITContracting.com.