Contracting through a limited company: how the Budget makes dividends less efficient, but preferable for most than salary

Changes to dividend taxation

The government believes the way that dividends are currently taxed is arcane and complex and is going to overhaul the current ‘tax credit’ regime. This will lead, in most cases to an increase in tax liability, but the strategy of extracting funds from the business via a dividend rather than a salary continues to be the most tax efficient.

Limited company shareholders must pay tax at their marginal rate on any dividends they receive. However, as companies have already paid Corporation Tax on their profits a notional 10% ‘tax credit’ is applied to the net dividend to “gross-up”. For example, if you chose to pay yourself a £100 net dividend, the gross dividend of (£100/90%) £111 will go on your self assessment tax return. It’s important to realise that the tax credit, the difference between the net dividend received and the gross dividend that goes on the tax return, (£11 in the example above), is notional and not actually payable.

Under the current system a basic rate taxpayer pays Income Tax at a rate of 10% on the gross dividend, but this simply wipes out the tax credit, so the effective tax rate is zero.

From April 2016 the tax credit is to be abolished and replaced by a dividend personal allowance of £5,000, although new higher rates of tax will apply to all dividend income above this allowance. The effective tax rates that apply under the current system and the new one can be summarised as:

Consider the position for a contractor operating through a limited ‘personal service’ company. Assume a net profit of £100,000, which includes paying a salary equal to the personal allowance (£10,600 in the current tax year). All other income is therefore taxable and drawn as a dividend.

Under the present system no additional tax would be due on the first £31,785 (since corporation tax is deducted at source), and a tax rate of 25% would apply to the next slice of £68,215, which is £17,054. Total tax due is therefore £17,054.

Under the new system the first £5,000 of dividend income would be tax paid (not tax-free as the Chancellor said as 20% corporation tax is paid in most cases), but the next slice of £31,900 (the new basic rate tax band for 2016/17) would attract a tax rate of 7.5%, which is £2,393. The remaining £63,100 would fall into the higher rate tax band and a tax rate of 32.5% would apply, which is £20,508. The total tax due would therefore be £22,900, which is £5,856 or 34% more tax.

Whilst this increase in effective tax rate seems staggering, contractors are still going to pay less tax than if they were to draw profits as income, where even higher rates of Income Tax as well as employer and employee National Insurance (at rates of 13.8% and 2% respectively) would apply.

Review of IR35

IR35 is to undergo an HMRC review with the objective of increasing its effectiveness and increasing its tax yield as the exchequer aims to “improve fairness in the system”.

In the summer budget 2015 document, it states that “IR35 is not effective enough” and that they will “engage with stakeholders this year” on how improvements can be made.

A discussion document is due to be published soon that HMRC is expected to use “to start a dialogue with business on how to improve the effectiveness of existing IR35 legislation”.

Consultation on the future of personal service company expenses

The Chancellor confirmed plans to change the rules to restrict travel and subsistence relief for workers engaged through an employment intermediary, such as an umbrella or personal service company, and under the supervision, direction and control of the end-user.

The new regulations are to take effect from April 2016 following a consultation on the changes.

Reduction in corporation tax

The corporation tax rate, which is currently 20% is to fall to 19% in 2017 and to 18% by 2020.