MONTHLY FOCUS: DIVIDEND TAX AND PROFIT EXTRACTION FOR 2021/22

Dividend tax in 2021/22

What are the rules?

Since April 2018 all taxpayers, regardless of the rate they pay tax at, are entitled to receive up to £2,000 (called the dividend allowance by HMRC) of dividends completely free of tax for the year. If they receive dividends above this level, the excess will be included as the top slice of the individual’s income, and is taxable at the appropriate rate(s).

Note. Prior to April 2018 the allowance was £5,000. This will be relevant when looking at returns for the 2016/17 or 2017/18 tax years, for example in the event of dealing with an ongoing enquiry.

Given this higher tax cost, higher and additional rate taxpayers with substantial dividend income who are looking for long-term growth could benefit from moving investments into ISAs or pensions, which will continue to enjoy exemption from tax on dividends.

 

What are the appropriate tax rates?

For 2021/22, the rates are:

• basic rate - 7.5%
• higher rate - 32.5%
• additional rate - 38.1%.

The old concept of net and gross dividends is obsolete, and the dividend simply equals the cash received.

 

How does the dividend allowance interact with the tax bands?

The tax bands themselves are not reduced by the allowance; however, when adding up the income to determine which tax band an individual falls to be taxed in, any dividends covered by the allowance have to be included. The allowance is then applied within the relevant band(s) as appropriate. The allowance is really a 0% tax band applied specifically to dividend income.

Example

Arnold receives £43,570 as earned gross income in 2021/22. He also receives £7,500 in dividends. The personal allowance for 2021/22 is £12,570 reduces the taxable earned income to £31,000. The basic rate band for 2021/22 is £37,700, and so all the earned income falls within this, leaving £6,700 of the basic rate band.

Regarding the dividends, you might be forgiven for assuming that you simply need to deduct £2,000 from the total dividends, leaving £5,500 taxable. In fact, the full £7,500 is taxable. The first £2,000 falls into the basic rate band, but is covered by the dividend allowance and taxed at 0%. The next £4,700 uses the remainder of the basic rate band and is taxed at 7.5%. The final £800 falls into the higher rate band, and is taxed at 32.5%.

Because dividends count as income even if they are covered by the allowance, they must be included in full when considering whether the higher income child benefit charge applies. They are also included when considering liability to personal allowance abatement (for income in excess of £100,000).

Example

Wendy earns £90,000 in salary in 2021/22, as well as receiving £16,500 in dividends. Her total income when considering how much of her personal allowance she can use is £106,500 - so it includes the £2,000 of dividends which are taxable at 0%. Wendy’s remaining personal allowance is £12,570 – (£6,500/2) = £9,320.

 

Are companies able to deduct dividend payments from taxable profits?

No, unfortunately extracting profits as dividends leads to double taxation, unless the total receipts in the tax year are below the £2,000 allowance. The government is looking to increase the overall tax take from dividend payments.

The allowance is available to all individuals, and so married couples and civil partners can look at transferring investments between each other to ensure they both make maximum use of the allowance each year.

 

Does the dividend allowance include the savings allowance?

No, the two are distinct from one another. Therefore, shareholders can potentially take advantage of both, as well as the personal allowance.

 

How does the savings allowance work?

Since April 2016 the personal savings allowance (PSA) allows all basic rate taxpayers to receive up to £1,000 in savings income before tax is due. Higher rate taxpayers get a £500 band, whilst additional rate taxpayers have nothing.

The allowance is additional to the existing 0% “starting rate” for savings income, which is dependent on the level of other income received. However, the PSA is available for all basic and higher rate taxpayers, regardless of how much other income they have.

How does the PSA interact with the dividend allowance?

As mentioned, the PSA and the dividend allowance (which HMRC refers to as the dividend nil rate band) are entirely separate. Whilst dividends are a form of investment income they do not qualify for the PSA and, similarly, other investment income, such as bank interest, does not qualify or affect the amount of dividend allowance available.

Where an individual uses some or all of their PSA, or the dividend allowance, the relevant tax band available will be correspondingly reduced.

Example

Jill runs a small company from which she draws a salary and dividends. She also receives interest from various bank and building society accounts. In 2021/22 her income is:

Salary: £19,570  
Dividends: £38,000
Bank etc. interest: £800

Jill’s tax is calculated as follows:

Type of income	Amount (£)	Tax band or allowance	Tax-free allowances (£)	Taxable at 0%	Taxable at basic or higher rates (£)	Tax rate
Salary	19,570	Personal allowance	12,570		7,000	20%
Bank etc. interest	800	PSA		500**	300	20%
Dividends *	38,000	Dividend allowance		2,000*	36,000
		Lower dividend rate			27,900	7.50%
		Higher dividend rate			8,100	32.50%

 

* Dividends are taxed as the uppermost part of  income, i.e. the top slice

** Because Jill’s taxable income exceeds the basic rate band for 2021/22 of £37,700, the PSA is allowed at the lower rate, i.e. £500 instead of £1,000.

 

Profit extraction for 2021/22

Sole traders may be better off continuing to operate as they are following the changes that came into force from April 2016, as opposed to considering incorporation. But what about director shareholders who already trade through a limited company?

The first point to note is that there are other reasons (besides income tax) for using a limited company as the trading vehicle of choice, and these should be considered carefully before any decision is taken as to whether to continue trading through the company or not.

 

What other reasons to use a company are there?

Briefly, non-tax reasons for using a limited company include:

• a company can appear more prestigious to potential clients
• the protection of limited liability in most circumstances
• potentially greater borrowing power - companies can secure debt on their current assets
• family succession planning - by bringing in new generations gradually.

As well as offering a one-man band solution, a company can also be an ideal way of introducing family members to the business and securing its future, without necessarily giving up too much (or indeed any) control.

 

What if none of these reasons is enough?

If a director shareholder of a smaller company feels that it is no longer beneficial to operate through a company, they can consider reverting to being a sole trader. This used to be done in a tax-efficient way by taking advantage of disincorporation relief (before 31 March 2018), but now disincorporation can lead to tax charges on the transfer of the company assets. These charges will also need to be considered when weighing up the costs and benefits of continuing the company.

 

What if the company is to continue?

In this case profit extraction will need to be considered very carefully to ensure it is as efficient as possible. If the company is a one-man band, it is possible that the director has been taking a salary equivalent to the personal allowance, rather than the secondary NI threshold to take advantage of the employment allowance which was allowed for tax year 2015/16. The allowance is no longer available to one-man companies, so which is the most efficient salary level?

Let’s compare the position of a company with £50,000 profits and look at the respective positions for full profit extraction by a sole director shareholder with no other taxable income with salaries of £12,570 and £8,840, i.e. the personal allowance and secondary threshold levels:

2021/22
Salary £12,570	£	Salary £8,840	£
Gross profit	50,000	Gross profit	50,000
Salary taken	12,570	Salary taken	8,840
Employers’ NI	-515	Employers’ NI	0
Net profit	36,915	Net profit	41,160
CT	-7,014	CT	-7,820
Available to distribute	29,901	Available to distribute	33,340
Tax	-2,093	Tax	-2,071
Employees’ NI	-360	Employees’ NI	0
Total tax/NI	9,982	Total tax/NI	9,891

 

So a one-man company looking to extract all the profit will be slightly better off opting for a salary equal to the secondary NI threshold rather than the personal allowance, though the difference is modest - just £91.

 

Salary or dividends?

Despite the increases to the dividend tax rates since April 2016, it is still cheaper to take the remaining profit as dividends rather than a director’s salary or bonus.

Company with £60,000 profit

2021/22
Salary £8,840 + dividend	£	Full salary	£
Gross profit	60,000	Gross profit	60,000
Salary taken	8,840	Salary taken	53,796
Employers’ NI	0	Employers’ NI	-6,203
Net profit	51,160	Net profit	0
CT	-9,720	CT	0
Available to distribute	41,440	Available to distribute	0
Tax	-2,681	Tax	-8,950
Employees’ NI	0	Employees’ NI	-4,956
Total tax/NI	12,401	Total tax/NI	20,111

 

What if the profits are higher?

The dividend option is still cheaper than salary or bonus at a higher level of profit:

Company with £175,000 profit

There is little point taking a small salary here because no personal allowance is available. We’ve assumed therefore no salary is taken with the dividend in the rest of the examples where no personal allowance is available.

2021/22
Full dividend	£	Full salary	£
Gross profit	175,000	Gross profit	175,000
Salary taken	0	Salary taken	-154,851
Employers’ NI	0	Employers’ NI	-20,149
Net profit	175,000	Net profit	0
CT	-33,250	CT	0
Available to distribute	141,750	Available to distribute	0
Tax	-36,494	Tax	-54,643
Employees’ NI	0	Employees’ NI	-6,977
Total tax/NI	69,744	Total tax/NI	81,769

 

So certainly where the option is available, a dividend is cheaper than taking additional salary over and above the relevant secondary threshold or personal allowance amount.

 

So what is the optimum salary/dividend mix for one-man companies?

This is no longer a straightforward question (if it ever was), and unfortunately there is no silver bullet answer. The increased dividend rates actually make a sole trader the most tax-efficient option at higher profit levels, and so matters are complicated by the option of disincorporation.

 

What tax-efficient alternatives to dividends are there?

It’s easy to fall into the trap of assuming that small company owners will want to extract every last penny. Often this is not the case, and there may be leftover profits which can be put to good use, and in some cases in a tax-efficient way.

An obvious answer is to simply leave the excess cash in the company until it is needed; however, this will still incur CT. A possible alternative is to make employer pension contributions which are generally deductible from CT and are not considered a taxable benefit.

To illustrate how this could work and improve the overall position, let’s consider a one-man company with profits of £80,000. If all the profits were extracted, the position would look like this:

80,000 profit	£
Gross profit	80,000
Salary taken	-8,840
Employers’ NI	0
Net profit	71,160
CT	-13,520
Available to distribute	57,640
Tax	-7,946
Employees’ NI	0
Total tax/NI	21,466

 

The take home cash here is £58,454, but what if our director only needs around £45,000 a year? Let’s see what happens if we make a company pension contribution of £20,000.

	£
Gross profit	80,000
Salary taken	-8,840
Employers’ NI	0
Employer pension	-20,000
Net profit	51,160
CT	-9,720
Available to distribute	41,440
Tax	-2,681

 

Obviously, the overall tax is lower due to the lower corporate profits and dividend but we have achieved a result for our director. The take-home position is £47,599 - meeting their needs - and their pension plan has also increased by £20,000. Of the total £80,000 profit, £67,599 has been retained for the benefit of our director, albeit £20,000 is locked away until retirement. That is around £9,000 more than would be achieved by taking the surplus profit as a dividend.

The obvious downside to this is that the money cannot be accessed until at least age 55 so it is not available for sudden emergencies, or to get the director through years with smaller profit levels.

 

Proactive planning

Having a good awareness of the tax position that will apply to the business and its shareholders at various levels of profit will allow for proactive steps to be taken to mitigate it.

 

Overall, what are the potential planning points?

One man companies

The savings that are likely to have influenced the decision to incorporate have been eroded since 6 April 2016. This does not necessarily mean that operating through companies is no longer worthwhile. However, profit extraction should be carefully planned even in the most basic cases.

The possibility of making employer pension contributions (which are deductible for CT purposes) should be explored in circumstances where the maximum possible profit does not need to be extracted from the company.

Where the company has profits in excess of £150,000, all tax benefits of incorporation relating to profit extraction are removed if the profits are extracted in full. For companies likely to maintain profits above this level, thought should be given to delaying dividend payments (potentially using a dividend waiver), making pension contributions, or bringing in a second director shareholder to take advantage of multiple personal allowances, basic and higher rate bands, and dividend allowances.

 

Use other allowances

It is also possible to increase the amount of tax-free income taken from the company by taking advantage of the two savings income allowances - the savings starting rate and the personal savings allowance - by loaning the company money and charging it interest. This has the added bonus of the interest being deductible for the company, provided it is paid at no more than a commercial rate.

Example

Ursula takes a salary of £12,570 and dividends of £40,000 from her company, which has her and her PA as employees. In 2021/22 the income tax on this mix is £3,425. If she were to inject some cash into the company such that she could, for example, charge the company £6,000 interest, and only take £34,000 dividends, this tax would fall to £3,075. The company would also enjoy a saving of £1,140 because the interest would be deductible for CT purposes - provided it’s paid at a commercial rate.

Getting cash into the company by way of a loan is one option to take advantage of this; however, interest can be charged on a director’s loan account that is in credit. When considering what rate to charge, keep in mind that a small private company will be viewed as a risky investment by most banks, and so it would probably be offered finance at a higher rate than a personal loan - if indeed it would be eligible at all. It may be worth getting some quotes as evidence to HMRC that the company has been charged no more than a commercial rate.

The planning becomes more valuable if a spouse or civil partner can be brought into the business - this could lead to £41,140 of tax-free income in the right circumstances. Then there is always the possibility of using the tax savings to make employer pension contributions for even more efficiency.

Company investments

An alternative to using excess profits to make pension contributions could be for the company to purchase and hold investments in its own right. Given the changes that individual landlords are currently suffering, using companies to hold buy-to-let properties may become particularly attractive. This could be undertaken as an alternative to a pension, and reinvestment of profits could avoid any issues with built up cash reserves jeopardising business asset disposal or business property relief.

With careful planning, however, new generations can be brought into the business by setting up a family investment company structure. This can be done in a way that protects against inheritance tax, whilst providing the existing shareholders with a means to meet living costs going forwards.

Companies can claim relief of up to 25% of the amount invested (spread over five years) if they invest in certain community development schemes.

 

School/university fee planning

On a related theme, shares could be given to grandchildren via a nominee arrangement (usually with the parents as bare trustees). Profits can then be retained and paid out as dividends (taking advantage of the grandchildren’s personal and dividend allowances) when fees become due. This can prevent the necessity of accumulating student debt.

Note. Parents can’t give shares directly to their own children because the settlements legislation would be invoked - meaning that any income arising on the shares would be taxed upon them directly, not on the children.

 

Use income tax reducers

Where shareholders wish to withdraw the maximum profit, even though there is no need to do so, there are still some ways the exposure to tax might be mitigated. If pension contributions are not attractive, perhaps because of the bad press received by the pensions annuity market in recent years, thought could be given to making a qualifying investment via one of the venture capital schemes.

There are currently four venture capital schemes, which operate in broadly similar ways. All four give an income tax reduction equivalent to a percentage of the amount invested. Qualifying investments into these schemes also have other benefits, such as CGT exemption on a disposal.

The current schemes are:

• the enterprise investment scheme;
• venture capital trusts; 
• seed enterprise investment scheme; and
• social investment tax relief

HMRC has some straightforward guidance on the schemes which serve as a useful introduction. However, specialist advice should be sought before any decision is made.

 

Links: Income Tax Calculator Dividend Checklist