Dividend route to a smaller tax bill

NO writes: I am the owner-manager of a small limited company and want to minimise my tax bill. In a reply to a previous letter you recommended that it might be advantageous to take profits from a business as dividends rather than as a salary. But does this not result in paying more tax? For example, a business with a profit of £40,000 must pay corporation tax on the £40,000. The owner takes the rest as dividend and pays tax on the money. If the business pays the owner the £40,000 as salary, the business has zero profit and zero tax liability. However, would the owner now pay his income tax (as before) and somewhat higher national insurance contributions, but still less than the corporation tax avoided?

Answer

A shareholder receives any dividends with basic-rate income tax already paid. This means that you would only have to pay any further income tax if you were a higher-rate taxpayer. This tax credit is calculated at only 10%, but is not refundable in the hands of the individual taxpayer. In addition, the current tax rate for individuals in respect of dividend income is restricted to 32.5% rather than the normal higher rate of income tax of 40%. This rate of 32.5% is a derived rate of tax to make sure that shareholders do not pay any more tax than they did under the previous system of advance corporation tax, which was deducted from dividends at source. You are deemed to receive 90% of the gross dividend after the 10% tax credit is deducted. Therefore, with a rate of 32.5% on the gross dividend, the net liability is 22.5%. This tax is payable out of the 90% net dividend received and therefore the higher-rate liability represents a quarter of the net dividend actually received. This compares with the previous system of having 20% deducted at source and then having to pay a further 20% if you were a higher-rate taxpayer out of the 80% net dividend. Dividends are therefore a useful way of extracting profits from your company. However, recent legislation has stopped this practice for service companies, whereby if you had worked directly for a client you would have been classed as an employee. But for all non-service companies the dividend route can still be effective.