How dividend income is taxed – what’s new

Important changes to the way dividend income is taxed

Shareholders in limited companies and some collective investment funds, such as unit trusts and open-ended investment companies (OEICs), receive dividends. Maybe you’re one of the relatively small number of investors who has a clear understanding of the way taxation currently applies to this income. Or perhaps, like so many of us, you’re not too sure. 

Either way, you may or may not be pleased to hear that everything is set to change when the new tax year begins on 6 April – so now would be a good time to get to grips with what’s changing and how the new rules will work. Let’s compare old and new: 

Current rules – until 5 April 2016

Currently, people who own shares are liable for tax on the dividend income they receive, but also benefit from a 10% tax credit.

  • To calculate the amount of tax due, dividends received must first be ‘grossed-up’ to calculate the gross dividend. This is done by dividing the amount received by 90 and multiplying by 100.

 Example: a dividend of £90 would have a gross taxable value of £100.

  • The 10% tax credit attaching to UK dividends is deemed to satisfy a basic rate taxpayer's income tax liability and so they have no further income tax to pay on the dividend.
  • Higher rate taxpayers (people with income between £42,385 and £150,000) pay tax on the gross dividend at 32.5% and also receive a 10% tax credit

Example: the tax due on a £100 gross dividend would be £32.50 minus £10 tax credit, leaving £22.50 to be paid in tax.

New rules – from 6 April 2016

The dividend tax credit will be abolished and instead, everyone will receive an annual Dividend Allowance of £5,000 a year.

From 6 April 2016, if dividend income received is less than £5,000 in a tax-year, then no tax will be due. This will apply to basic, higher and additional rate tax payers. 

On any excess over £5,000, tax will be paid on the excess at the following rates:

  • 7.5% for basic rate taxpayers;
  • 32.5% for higher rate taxpayers; and,
  • 38.1% for additional rate taxpayers.

What do these new rules mean for investors?

Shares, unit-trusts, OEICs and investment trusts produce investment returns in three ways:

1.Dividend income

2.Interest income (if the fund holds 60% or more of its assets in fixed income investments)

3.Capital growth

The new rules on dividends mean that you can hold quite a large amount of shares in limited companies or investment trusts, or units in unit trusts and OEICs, without breaching the £5,000 Dividend Allowance. Partners in a married couple or civil partnership could receive £10,000 in dividends each tax year without paying any tax on them. Whether this would work for you will depend on your own tax situation. If in doubt, consult a tax expert.  

Different shares and collective investments (unit trusts, OEICs and investment trusts) produce different levels of dividend income or ‘yields’. For example, the yield on the FTSE All Share Index, which covers the majority of shares traded on the London Stock Exchange, was 3.7% at the end of 2015.

To look at it another way:

  • £135,135 worth of shares held in the FTSE All Share Index would produce an annual dividend of £5,000 if the dividend yield was 3.7%. 
  • Or, if using two £5,000 allowances, a couple investing £270,270 in the FTSE All Share Index with a dividend yield of 3.7% would receive £10,000 of dividends.

The exact amount you can hold without paying tax on the dividends will depend on the yield produced by your chosen investments. The lower the yield, the higher the value you can hold without paying tax on dividends, and the higher the yield, the lower the value you can hold without paying tax on dividends.  

Tax on capital growth

Capital growth is taxed under the capital gains tax rules in the tax year an investment is cashed in (known as ‘disposal’). 

Each person can use their annual capital gains tax exemption to cover disposals, but the allowance cannot be carried forward, so if you don’t use it, it’s lost forever. In the 2016/17 tax year, the exempt amount will be £11,100 per person. 

A married couple or couple in a civil partnership could choose to split investments between each partner before realising a capital gain.  This means they would be using a joint allowance of £22,200 (2016/17) rather than a single allowance of £11,100. 

What the new dividend rules mean for investments in shares and share-based funds 

Some shares and funds deliberately aim to provide most of their return through dividends rather than capital growth. These are often referred to as ‘income stocks’ or ‘equity income funds’. 

  • Selecting equity income funds allows investors to utilise the new £5,000 annual dividend allowance and avoid paying tax on dividend income up to this amount.
  • Although the potential for capital growth in these funds is usually lower, capital growth and capital gains can still occur. 
  • But if the capital gain is less than the annual capital gains exempt amount of £11,100, then no tax would be paid on gains either.

By using these two tax allowances, investors can achieve ISA-like tax treatment of their share-based investments without using up their ISA allowance.

This article is not intended to give advice or a personal recommendation. If you need a personalised recommendation based on your personal circumstances, you should seek financial advice. You can find a financial adviser in your area at www.unbiased.co.uk

AR01605  02/2016

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