A new dawn for dividends

Many of the measures introduced by George Osborne in the Summer Budget were politically astute. The living wage, for example, was a potential vote-winner, while changes to inheritance tax and the increased personal allowance will undoubtedly curry political favour with savers.

However in what was a relatively unexpected move, the chancellor also introduced sweeping reforms to dividends tax which are due to come into effect in April 2016.

The existing system was introduced in the early 1970s, when corporation tax of over 50 per cent saw total tax on dividends reaching upwards of 80 per cent for some. In order to combat this, a nominal 10 per cent tax credit was applied to dividend income, meaning that basic rate taxpayers didn't face any additional charges. Essentially it prevented a company's profits being taxed twice.

In the 2014-15 tax year, there is a 10 per cent basic dividend tax rate, a 32.5 per cent higher rate, and a 42.6 per cent additional rate. These were offset by the nominally applied 'credit' to give effective tax rates of 0 per cent, 25 per cent and 30.6 per cent.

Corporation tax has been falling steadily since then to around 20 per cent (it is scheduled to fall to 18 per cent in 2020), and the notion of a 10 per cent 'credit' compensating for taxing companies twice was deemed an archaism by George Osborne. The Summer Budget therefore looked to streamline the dividend tax system and, importantly, bring it into line with the government's narrative concerning tax planning.

The grand scheme

Currently dividend income is not subject to national insurance contributions so, for entrepreneurs, incorporating and then taking payment through dividends in lieu of a salary was a legitimate and tax efficient way to draw income. This is just the sort of practice that is now being targeted by the government's £750m budget and additional £5bn revenue target for tax evasion and avoidance.

The changes to dividend taxation will contribute to this target by reducing 'the incentive to incorporate and remunerate through dividends rather than through wages to reduce tax liabilities.' The new system will, the government claims, reduce the costs to the exchequer associated with tax motivated incorporation (TMI) by £500m a year from 2019/20.

Rather than having a complex system which rewards profitability but, supposedly, encourages superfluous incorporation, the government hopes that more direct assistance (such as the cut to corporation tax) will provide a boost to UK businesses.

From April 2016, therefore, a new of set rules governing how shareholders are taxed on their dividend income will come into force. The top line of this is that, instead of basic rate taxpayers paying nothing on their dividends (due to the 10 per cent 'credit') they will now be faced with a 7.5 per cent basic rate tax, which is no longer offset by 10 per cent 'credit', a 32.5 per cent higher rate and a 38.1 per cent additional rate.

This looks, at first glance, to be gloomy reading but there is a glimpse of sunshine behind the clouds in the form of a £5,000 tax free dividend allowance. Taken in conjunction with the personal allowance, which increases to £11,000 in April 2016, individuals with a total income of £16,000 or less will pay no dividend tax at all.

Silver linings

This is good news for the majority of investors who will be drawing down less than £5,000 and will therefore be paying no additional tax. However this £5,000 allowance is only applicable to dividends and cannot, as many had hoped, be applied to overall income levels to reduce the income tax burden.

Entrepreneurs, on the other hand, could be faced with a potential tax hike. According to the chancellor, those who receive 'significant dividend income', i.e. as a form of remuneration, will pay more. Therefore planning future strategy before 5 April 2016 is essential, as business owners may wish to review their future remuneration strategy.

There still remain issues which need to be ironed out, despite the government clarifying how the reforms will work in practice in a document published last month; such as how the £5,000 allowance will work alongside the £1,000 savings income allowance announced earlier this year, and whether there will be any tapering system applied for high-earners.

Individuals who live off their savings incomes will have to carefully review their investment portfolios to discern how best to use the new £5,000 allowance, and maximise their tax savings; dividend income derived from tax-free 'wrappers' like ISAs and pension funds remain unaffected by these changes.

Likewise carefully pursuing a drip-feed strategy into a standard ISA, using the annual £15,240 allowance, may be a tax efficient way of managing additional dividend income - although advice should always be sought before embarking on a strategy of this kind.

Lucy Brennan is a partner at Saffery Champness

She writes a regular blog on tax and estate planning for Private Client Adviser