Since the Chancellor announced his overhaul of the current tax system in his Summer Budget, many contractors will be counting down to April 2016 when their tax liabilities could increase substantially. This article is designed to provide all the information you need about how the changes will affect you.

Upcoming changes

The current way of taxing dividends is one of the areas where the ongoing review of the tax system has focussed their attention. The government intends to simplify the tax system, and because the current system was originally designed when corporation tax was much higher, they are concerned that an update is required. This has been led by fears that self employed individuals are incorporating in order to take advantage of the tax benefits of operating as limited companies.

The planned changes are estimated to be worth around £5 billion to the exchequer in the first year, but this will be at a direct cost to limited company contractors who may find that the benefits of incorporating are reduced somewhat.

The current dividend taxation system

When you extract dividends from your limited company, the gross sum is calculated by multiplying 10/9 in order to take into account the fact that corporation tax has already been paid on the money.

The gross figure is then taxed at the following rates:

  • Basic rate - 10%
  • Higher rate - 32.5%
  • Additional rate - 37.5%

However, because of the ‘tax credit’, this means that you effectively pay no tax on dividends at the basic rate, 25 per cent on those at the higher rate and 30.56 per cent at the additional tax rate.

Currently, you can earn £31,785 in dividends, which combined with the £10,600 personal tax-free allowance has allowed contractors to take home £39,206.50 without paying any income tax.

 

The system as of April 2016

The planned changes will abolish the current system and replace it with one that is designed to be simpler. The new personal allowance will be £11,000, for those who are entitled to the entire amount, and there will be a dividend income allowance of £5,000, which will be available without any tax liability.

Anyone with an income of less than £16,000 will pay no tax at all on dividends. However, there will be three new dividend tax bands that will apply to all dividend income over the £5,000 per year allowance:

  • Basic rate - 7.5%
  • Higher rate - 32.5%
  • Additional rate - 38.1%

An individual who earns £43,000 will still be in the basic rate tax band (£11,000 tax-free allowance and £32,000 basic rate allowance).

A taxpayer whose income is more than £43,000 and takes them into the higher rate tax band will be liable for dividend tax at 32.5 per cent, as opposed to the 25 per cent they would have paid under the old rules. This means that someone who takes £10,000 in dividends on top of their £43,000 will have to pay an extra £3,250 in dividend tax (32.5 per cent of the extra £10,000) compared to the £2,500 they would have had to pay in previous years.

For advice and information on the best way to plan for the future, speaking to a specialist accountant will help you to be prepared. Call our friendly team today on 01253 362062 or email newbusiness@nixonwilliams.com.

You may also find our page on April 2016 - changes to travel and subsistence expenses useful.