Are dividends still a tax-efficient strategy?

5th June 2018

Corporation tax is levied on all companies but it also affects how much directors and shareholders can receive in the form of dividends. 

HMRC has had dividends in its sights in recent years, with the latest change seeing the dividend allowance reduced from £5,000 in 2017/18 to £2,000 from 6 April 2018.

Corporation tax is also on its radar, with the current rate of 19% – already one of the lowest in the developed world – set to reduce further to 17% for 2020/21. 

The following tax rates and bands for dividend income above the tax-free threshold of £2,000 remains in place, for now at least, at:

  • 7.5% - basic rate 
  • 32.5% - higher rate
  • 38.1% - additional rate.

But how do the 2 taxes affect each other and what’s the likely impact on directors and shareholders after corporation tax decreases 17% in less than 2 years’ time?

How does corporation tax affect dividends in 2018/19?

Lucy’s a basic rate taxpayer who owns a 10% share in a limited company. 

If the company was to make a profit of £50,000 in 2018/19 it can decide to pay out dividends of up to £40,500, which is what’s left of the profit after corporation tax of 19% has been deducted.

Lucy would receive £4,050 gross as her share is worth 10%. 

£2,000 of that is protected by the dividend allowance, and the rest of the dividend is liable for income tax at 7.5%, which means she stands to receive £3,896.25.

How will lower corporation tax impact on dividends in 2020/21?

The rate of corporation tax is poised to fall from 19% to 17% on 6 April 2020, and this looks like good news for shareholders on the face of it. 

Let’s assume the 2018/19 dividend allowance and tax bands remain unchanged and revisit Lucy and her 10% share in a limited company, which makes the same £50,000 profit in 2020/21. 

The company’s profit after the lower 17% rate of corporation tax is applied would be £41,500 – resulting in Lucy’s dividend being worth £4,150 before income tax. 

As she’s still a basic rate taxpayer, her dividend would be worth £3,988.75 – an increased dividend of £92.50 due to the 2% reduction in corporation tax. 

What if the dividend allowance changes again?

This is the joker in the pack. Any future changes to the dividend allowance, income tax rates or bands are likely to be announced in the chancellor’s Autumn Budget – and these are not set in stone.

Lucy stands to receive £3,896.25 after tax in 2018/19. 

However, if the company made the same profit in 2017/18, when the dividend allowance was at £5,000, she would’ve received the full £4,050 without having to pay income tax. 

And if the dividend allowance was to be abolished for 2020/21, Lucy’s entire dividend of £4,150 would be liable for tax, giving her £3,838.75 if she paid income tax of 7.5%. 

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