Dividend allowance to sit inside contractors' tax bands

Two paragraphs from HMRC have undone the understanding about the new dividend tax allowance, as they reveal it will sit inside -- not outside -- the basic and any higher rate bands.

In fact, the £5,000 allowance will “not reduce a taxpayer’s total income for tax purposes,” meaning dividends within it will “still count towards your basic or higher rate bands.”   

“[It] may therefore affect the rate of tax that you pay on dividends you receive in excess of the £5,000 allowance,” added HMRC, playing down what is a big, widely unforeseen change.

The Association of Taxation Technicians called it a tax rise “by the back door.” Indeed, some contractors on the basic rate face having their dividends taxed at the higher rate if they also take salary.

“This is likely to come as a huge surprise to taxpayers with dividend income who had been under the impression that the allowance was significantly more generous,” said the ATT.

“Announced in the Summer Budget, [the allowance] is in fact not a complete exemption to tax. It will instead sit within the normal basic and any higher rate tax bands of the taxpayer.”

In a factsheet on the allowance, HMRC gives six examples of how the £5,000 voucher will interact with tax bands, rates and allowances, but only one of them reflects the radical upshot.

So on £9k dividends and £40k salary (- “non-dividend income”), £11k of the salary is covered by the personal allowance, leaving £29k of salary to be taxed at basic rate (which applies up to £32k).

The £5k dividend allowance goes on the £3k left within the basic rate, and the leftover £2k goes in the higher rate band. The remaining £4k dividends are all taxed at 32.5% --  the higher rate.

The ATT reflected: “As this measure was announced…as…a tax-free allowance, it is understandable that taxpayers believed the dividend allowance would operate outside of an individual’s tax rate bands.

“To now discover that the allowance is in fact restricting the amount of dividends that a basic rate taxpayer can currently receive without a tax liability is a fairly big shock. It also raises questions as to the real policy intention behind this measure.”

Those policy intentions may be spelt out in a “detailed consultation,” which the association is calling for ahead of the drafting of the relevant legislation, due to come into force from April 2016.

The tax charity also appealed: “[HMRC needs to] address the major impact that this [proposal] will have for example on company directors who receive both salary and dividends.

“The limited examples provided in the factsheet suggest that some basic rate taxpayers may well have to pay more tax than under the current system whilst some higher rate taxpayers may actually pay less than at present.”

So the dividend allowance has not “been thought through thoroughly,” said ATT’s president Michael Steel, seemingly evidenced by the “simplistic” examples on it from HMRC.

He also condemned: “The chancellor announced the dividend allowance as a positive measure for taxpayers but underneath it all it now appears to be designed as a tax raising measure.”

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