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Extraction of profits for owner-managed businesses - part 2

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20th May 2016
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Taxation of dividends - prior to 6 April 2016

Dividends paid prior to 6 April 2016 carry a deemed tax credit of 10% which is available to offset in the individual's income tax computation. Any unused tax credit is wasted.

For individuals who are basic rate taxpayers there is no further liability to income tax on dividends.

For taxpayers with income in excess of the higher rate band (£31,785 in 2015/16), additional tax will be due at 32.5% up to the additional rate band limit of £150,000 and 37.5% for income in excess of the limit. The deemed 10% tax credit is available for offset against the tax liability on the dividend, which gives effective tax rates of 25% for higher rate taxpayers, and 30.56% for additional rate taxpayers.

Timing of payment of tax on dividends

Generally, where additional tax is due on dividends for higher / additional rate taxpayers, this is collected via the self assessment system. The tax is due for payment by 31 January following the tax year of the dividend.

Where the amount of tax not satisfied at source represents more than 80% of the total tax liability, or is more than £1,000, then payments on account will be due for the following year. Payments on account are due on 31 January in the tax year and 31 July following the tax year. So in most cases, the tax payment due on 31 January each year will be for the full amount of the tax liability for the previous tax year plus a payment on account in respect of the following tax year.

It is possible for the taxpayer to claim reduced payments on account if the level of dividends varies from year to year.

The Personal Tax Module contains detailed guidance on the taxation of dividend income, self assessment and payment of income tax.

Timing of taxation of salary

Generally, salary is treated as received by individuals when received or, if earlier, when the person becomes entitled to receive it. There are some additional dates which need to be considered for directors. For directors, remuneration is treated as received on the earliest of all the following dates:

  • when received
  • when the director is entitled to receive it
  • when amounts on account of the earnings are credited in the company's accounts or books
  • at the end of the accounting period, if the amount of earnings for that period are determined by the end of it
  • when the amount of earnings is determined, if that is after the end of the period

Tax relief for remuneration for the employing company

Remuneration is generally deductible from trading profits as long as it is paid wholly and exclusively for the purpose of the trade. Whilst it is almost unheard of for HMRC to challenge the level of director's salary, there may be more focus on remuneration paid to family members. For more information on this see Husband and wife / civil partners and Employing the children guidance notes.

Tax relief for remuneration is generally given when it is accrued in the accounts, as long as the amounts accrued are paid within 9 months of the year end. For more information on this see the Employee related guidance note.

In order for amounts accrued at the year end to be allowable, as a general rule they must be in accordance with FRS 12/FRS 102. For more information on this see the and Tax relief for provisions guidance notes.

Impact on company's taxable profits

The impact of the payment of salary on the company's taxable profits should not be ignored. For periods prior to 1 April 2015, where a company is paying tax at the marginal rate, it may be appropriate to pay sufficient salary to bring the level of profits down to the small profits' rate. For periods post 1 April 2015, this mechanism could also be used to avoid falling within the quarterly instalments regime by reducing augmented profits to below the £1.5m limit.

Due regard should also be given to utilising losses generated by payment of salary. In particular, it may be desirable to generate a repayment of corporation tax by carrying back losses to the previous 12 months, or for three years under the extended carry back provisions. For more information on this see the Current year relief and carry back losses guidance note.

National Minimum Wage

Guidance published by the Tax Faculty of ICAEW, and approved by both the DTI and HMRC, indicates that there is no need to pay the National Minimum wage to directors, provided they do not have a specific written contract of employment with the company. Should there be a contract of employment in place when a director is appointed, this should be terminated on appointment if it is desired to exclude the provisions of the National Minimum Wage.

Note that employment of the spouse, when not a director or other officer of the company, is affected by National Minimum Wage. A record of hours worked and wages paid is advisable.

Balancing remuneration between salary and dividends - optimum tax position

Generally, prior to 6 April 2016, the most tax-efficient way of extracting profits is to extract a salary to the level of the NICs earnings threshold and take the remainder of distributable profits as a dividend. Remuneration in the form of salary is taxed as earned income and so has the advantage of dividends of being qualifying remuneration for pensions purposes. Similarly, an adequate level of salary can fulfil the requirements of the National Minimum Wage Act 1999 (more on this below) as opposed to dividends.

From 6 April 2016, the tax advantage of taking dividends as opposed to salary is reduced or even eliminated. However, there remain differences between dividends and salary in terms of timing of payment of tax, statutory framework, impact on company reserves and many other factors. It is important when advising clients not to lose sight of the overall picture.

Read the first part of Extraction of profits for owner-managed businesses

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