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You may receive dividend income if you have invested in shares. You may also receive dividends if you have a family or owner-managed company and extract profits in the form of dividends.
For tax purposes, dividends have their own allowance and rates of tax. They can also benefit from the personal allowance if it is not used elsewhere.
No tax is payable on dividends held in a tax-free wrapper, such as a stocks and shares ISA.
Top slice of income
Dividends are treated as the top slice of income.
Consequently, the rate at which you pay tax on your dividend income depends on what other taxable income you have in the year, and whether you have used up your personal allowance and dividend allowance.
Dividends have their own tax-free allowance – the dividend allowance.
All taxpayers are entitled to a dividend allowance, regardless of the rate at which they pay tax. The dividend allowance is available in addition to the personal allowance. It is set at £2,000 for 2022/23.
Although termed the ‘dividend allowance’, it is actually a zero-rate band rather than an allowance, with dividends sheltered by the allowance being taxed at a zero rate. However, the allowance uses up part of the tax band in which it falls.
The fact that the allowance is available to all individuals regardless of the rate at which they pay tax is useful from a tax planning perspective in a family company situation, and it provides the opportunity to extract profits without triggering further tax liabilities.
Dividend tax rates
There are three dividend tax rates: the dividend ordinary rate, the dividend upper rate and the dividend additional rate.
The dividend ordinary rate applies where dividends (treated as the top slice of income) fall in the basic rate band; the dividend upper rate applies to the extent that the dividend falls in the higher rate band, and the dividend additional rate applies to dividends falling in the additional rate band.
Dividends are not liable for National Insurance contributions (NICs), so where profits in a family or personal company are extracted predominantly in the form of dividends, there will be no NICs to pay. If the salary level is at or below the primary threshold, there will be no primary Class 1 NICs to pay on the salary either.
From 6 April 2023, a new Health and Social Care Levy is introduced to provide ring-fenced funds for health and adult social care. Payment of the levy (at a rate of 1.25%) is linked to earnings on which NICs are payable. The rates of Class 1, 1A, 2 and 4 NICs are increased by 1.25% for 2022/23 only, pending the introduction of the levy.
In parallel with the NICs rises and the introduction of the Health and Social Care Levy, the dividend tax rates were increased by 1.25% from 6 April 2022; the increase providing funding for health and adult social care costs and ensuring that those who receive income predominantly in the form of dividends and pay little or no NICs also contribute towards these costs.
Consequently, the dividend tax rates for 2022/23 are as follows:
- Dividend ordinary rate: 8.75%.
- Dividend upper rate: 33.75%.
Dividend additional rate: 39.35%.
Example 1: No tax to pay
Milly is a student. She earns £3,000 in 2022/23 from part-time work. She also holds shares in her family’s company, in respect of which she receives a dividend of £5,000.
As Milly’s total income for 2022/23 is less than her personal allowance of £12,570, she has no tax to pay on her dividend income of £5,000.
Example 2: Covered by allowances
Ben receives a salary of £11,000. He also has a small personal company and is able to pay himself a dividend of £3,500 for 2022/23.
Ben’s salary uses up £11,000 of his personal allowance for 2022/23 of £12,570, leaving £1,570 available. This is set against his dividend, reducing it to £1,930. This is covered by the dividend allowance of £2,000, meaning Ben has no tax to pay on his dividend of £3,500 as it is fully sheltered by his remaining personal allowance and the dividend allowance.
Example 3: Basic rate taxpayer
Norman has a pension of £20,000 in 2022/23. He has a share portfolio from which he receives dividends of £15,000 in 2022/23.
Norman’s salary uses up his personal allowance (£12,570) and the first £7,430 of his basic rate band, leaving £30,270 of his basic rate band available (£37,700 - £7,430).
The first £2,000 of his dividends are sheltered by the dividend allowance and are tax-free. However, the dividend allowance uses up £2,000 of his basic rate band leaving £28,2370 available.
The remaining dividends of £13,000 fall wholly within the basic rate band and are taxed at the dividend ordinary rate, which for 2022/23 is 8.75%. Consequently, Norman must pay tax of £1,137.50 (£13,000 @ 8.75%) on his dividends.
Example 4: Partly taxable at dividend higher rate
Bella has a salary of £47,000 for 2022/23. She also receives dividends of £10,000 from her family company.
Her salary uses up her personal allowance of £12,570 and £34,430 of her basic rate band, leaving £3,270 of her basic rate band available (£37,700 - £30,430).
The first £2,000 of her dividends are sheltered by the dividend allowance and are tax-free. The dividend allowance uses up a further £2,000 of her basic rate band, leaving £1,270 available.
Of the remaining dividends of £8,000 not covered by the dividend allowance, the first £1,270 falls within the basic rate band and is taxed at the dividend ordinary rate of 8.75%. The balance of £6,730 falls within the higher rate band and is taxed at the dividend upper rate of 33.75%.
Consequently, Bella pays tax of £2,382.50 ((£1,270 @ 8.75%) + (£6,730 @ 33.75%)) on her dividends of £10,000.
Example 5: Taxed at dividend additional rate
Jacob has a salary of £120,000 and income from property of £60,000 in 2022/23. He also receives dividends of £30,000 from his family company and further dividends of £20,000 from his share portfolio.
His total dividend income for 2022/23 is £50,000. He has other income of £180,000. Consequently, his dividend income, treated as the top slice, falls in the additional rate band.
The first £2,000 of his dividend income is sheltered by the dividend allowance. The remaining £48,000 is taxed at the dividend additional rate of 39.35%. Consequently, he pays tax of £18,888 on his 2022/23 dividends of £50,000.
Extracting profits as dividends
The lack of NICs on dividends, the availability of the separate dividend allowance and the lower tax rates that apply to dividends mean that it can be attractive to extract profits from a personal or family company in the form of dividends.
A popular profit extraction policy is to extract a small salary equal either to the NICs primary threshold (£11,908 for 2022/23) or the personal allowance (£12,570) depending on whether the National Insurance employment allowance is available, and to extract further profits as dividends.
However, when taking dividends, there are company law rules that must be met. Failure to adhere to these rules will mean that the dividends are illegal.
Dividends are paid out of retained profits. These are profits that have already suffered corporation tax at 19% and which have yet to be distributed. Consequently, a dividend can only be paid if the company has sufficient retained profits from which to pay the dividend. A further limitation is the requirement that dividends must be paid in proportion to shareholdings. Where there is only one class of share, this removes the flexibility to tailor dividends to the circumstances of the recipient (although dividend waivers can be used in certain circumstances).
This limitation can be overcome by having an alphabet share structure whereby each shareholder has their own class of share (e.g., ‘A’ shares, ‘B’ shares, etc.). This allows different dividends to be declared for different classes of share (and consequently for different shareholders), allowing the dividends to be tailored to the circumstances of the shareholder. This is useful from a tax planning perspective, and allows profits to be extracted tax-free where shareholders’ personal and dividend allowances remain available.
The impact of the increase in dividend tax rates that applies from 6 April 2023 should be taken into account when formulating profit extraction strategies.