Why is dividend tax so complicated and how does it work?

If you run a limited company you will have the option of taking payment through dividends rather than from a traditional salary, this is often the best choice for directors as dividends can significantly reduce the amount of national insurance you would otherwise pay by taking a salary. For many directors dividends are used in conjunction with salaries to ensure their personal tax allowance is used up.

The issue of a dividend is more formal than taking a salary or drawings as a sole trader, certain conditions have to be met or HMRC can reclassify the dividend as a salary and demand additional national insurance payments and fines, these are:

The company must be profitable and have paid off any losses carried forward from previous years.

A dividend voucher must be issued showing the application of the dividend tax credit.

A board meeting must be held with minutes taken to approve the dividend, yes even if you are the only director!

The dividend tax rates are:

10% for basic rate payers

32.5% for higher rate tax payers.

However when a dividend is issued it is assumed 10% tax is deducted by the company in the same way they would deduct PAYE taxes at source and that a 10% tax credit has been applied to the tax the company owes HMRC on behalf of the shareholder.

This means that there is no tax overall for the company to pay to HMRC as the 10% tax credit cancels out the 10% tax rate, it also means however that the dividend received by the shareholder is only 90% of the total dividend value. At this stage 20% corporation tax has already been taken into account so dividends are not by any means tax free.

When dividend earnings start falling within the higher tax band then the 32.5% rate applies, the first 10% of this is dealt in the same way as above, the remaining 22.5% needs to be disclosed via a directors self-assessment tax return.

The 22.5% is also applied to the entire 100% of the dividend that was issued when in reality only 90% of that was actually paid out to the shareholder, this means that the actual tax to be paid on the dividend is:

22.5% / 90% = 25%

As 20% corporation tax has already been deducted at this point then the 25% only applies to 80% of the total profit so taking this into account the dividend rate is actually:

25% x 80% = 20%

of your total profits, added to the 20% corporation tax already deducted this means that you will pay 40% tax on your total company profits.

Overall at the basic rate you will save 9% in class 4 NIC’s and 2% in the higher rate by being a limited company rather than a sole trader.

Please contact us with any questions relating to this article.

Nishi Patel

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