24/08/15
One of the most fundamental changes announced in the Summer Budget was to the taxation of dividends. HMRC has clarified the way in which it expects this to operate and so we wanted to share an update as we believe that many people will be affected.

What is changing?

We are all used to seeing dividend vouchers showing the net dividend that we receive together with a tax credit, and we understand that tax will be charged on the gross figure, with relief for the tax credit. From April 2016 this system is being fundamentally changed in a way that is likely to mean higher taxes for anyone with significant dividend income outside the shelter of an ISA or pension fund.

From April 2016:
  • The tax credit attaching to dividends will be abolished so you will be taxed on what you receive, with no grossing up.
  • There will be a £5,000 dividend tax allowance so that dividends below this level will be tax free, regardless of your other income.
  • Tax rates on dividends will be changed to 7.5%, 32.5% and 38.1% for basic, higher and additional rate taxpayers respectively, a rise at each tax level of 7.5% in the effective rate.

Who will be affected?

For investors with modest dividend income the changes will be limited in their impact. Basic rate taxpayers, used to having their tax liability covered by the tax credit, will be worse off if their dividends exceed £5,000 as they will pay 7.5% on the excess. Higher rate taxpayers will be better off under the new rules until their dividend income exceeds £21,667 as the availability of the £5,000 dividend allowance outweighs the loss of tax credit until this point. The break even point for additional rate taxpayers is £25,400.

However, those most likely to feel the impact of the new regime are director / shareholders of small companies. For them, it has been tax efficient to extract funds from a company using a combination of modest salary and the balance in dividends; the effective rate on dividends extracted is currently 0%/25%/30.56% for basic, higher and additional rate taxpayers respectively. Each of these income bandings is likely to experience higher levels of tax on their business income.

Illustration

HMRC has provided clarification about the operation of the dividend allowance; in particular, rather than reducing taxable income (as an additional personal allowance would, for example), it will form a nil tax band for dividend. Crucially it will also reduce the value of any basic rate band that would otherwise be available for dividend income. By way of illustration:

Mr Smith runs a business through a small company, taking a salary of £8,000 and dividends of £40,000.

For 2015/16 the aggregate of his gross dividend and salary is £52,444. The first £10,600 of his income (which will include his salary) is covered by the personal allowance.  The next £31,785 is within the basic rate band; for dividend income in this level the tax credit covers the tax liability. The top slice of Mr Smith's dividend income, the excess over the personal allowance and nil rate band, is £10,059. Tax is levied at 32.5% = £3,269 and is then reduced by the 10% tax credit, making a final tax liability on his personal income of £2,263.

For 2016/17 the new regime applies so that:
  • Mr Smith's salary of £8,000 will still be within the personal allowance
  • The dividend income will no longer be grossed up, and so will go into his tax return at £40,000 rather than the £44,444 which included the tax credit in 2015/16
  • The first £3,000 of dividend income will be within the 2016/17 personal allowance of £11,000
  • The next £5,000 of dividend income will be taxed at 0%
  • The next £27,000 of dividend income (the rest of the basic rate band) will be taxed at 7.5%
  • The final slice of £5,000 dividend will be taxed at 32.5%.

The calculations contrast as follows:

The result is a 2016/17 tax liability of £3,650, £1,387 more than he will pay for 2015/16. On the plus side, however, Mr Smith's taxable income no longer exceeds £50,000 which means that his family will be able to claim child benefit in full.

How can we plan for this?

There is no ‘one size fits all’ planning technique. Salary payments still carry employers' national insurance contributions at 13.8% and so, for many, the appropriate way forward may well still be to use the sort of dividend and salary combination illustrated above. Much will depend on the level of other income of the proprietor. For companies with significant reserves it may be sensible to extract dividends in the current tax year, before the new rules take effect. This may be neither possible nor appropriate for some.

If you would like to discuss how these changes affect your own situation please do get in touch by writing to advice@rdhaccountants.co.uk
10/08/15
In the Summer Budget 2015, the government announced that the level of rent-a-room relief will be increased from the current level of £4,250 to £7,500 from April 2016. This means that from 6 April 2016, an individual will be able to receive up to £7,500 tax-free income from renting out a room or rooms in their only or main residential property. The relief also covers bed and breakfast receipts as long as the rooms are in the landlord's main residence.

To qualify under the rent-a-room scheme, the accommodation has to be furnished and a lodger can occupy a single room or an entire floor of the house. However, the scheme doesn't apply if the house is converted into separate flats that are rented out. Nor does the scheme apply to let unfurnished accommodation in the individual's home.

The rent-a-room tax break does not apply where part of a home is let as an office or other business premises. The relief only covers the circumstance where payments are made for the use of living accommodation.

If additional services are provided (cleaning and laundry etc.), the payments must be added to the rent to work out the total receipts. If income exceeds £4,250 a year in total, a liability to tax will arise, even if the rent is less than that.

There are two options if the individual is receiving more than the annual limit a year:
  • The first £4,250 is counted as the tax-free allowance and income tax is paid on the remaining income.
  • Renting the room is treated as a normal rental business, working out a profit and loss account using the normal income and expenditure rules.

In most cases, the first option will be more advantageous.

The principal point to bear in mind is that those using the rent-a-room scheme cannot claim any expenses relating to the letting (e.g. insurance, repairs, heating).

To work out whether it is preferable to join the scheme or declare all of the letting income and claiming expenses via self-assessment, the following methods of calculation need to be compared:
  • Method A: paying tax on the profit they make from letting worked out in the normal way for a rental business (i.e. rents received less expenses).
  • Method B: paying tax on the gross amount of their receipts (including receipts for any related services they provide) less the £4,250 exemption limit.

Method A applies automatically unless the taxpayer tells their tax office within the time limit that they want method B.

Once a taxpayer has elected for method B, it continues to apply in the future until they tell HMRC they want method A. The taxpayer may want to switch methods where the taxable profit is less under method A, or where expenses are more than the rents (so there is a loss).

The individual has up to one year after the end of the tax year when their income from lodgers went over £4,250 to decide the best option to take, so it is worth taking a bit of time to work out which route produces the lowest tax bill, we can help you with this.