Proﬁt extraction issues and the new regime
A key advantage of trading as a company is that the owners, who are generally both shareholders and directors, only suffer tax and NIC on any profits extracted from the company, so any profits retained in the company are sheltered from personal tax rates. If funds are required to reinvest into the business or to repay debt, the only immediate tax hit is the corporation tax charge of 20%.
However we all need funds for our personal outgoings so there will be another level of taxation when the profits are extracted won’t there? This is where planning comes into play. Dividends are often used in combination with remuneration to obtain the most tax effective extraction of profits when the business is carried on through a company. For many years it has been attractive to pay a small salary to allow the tax efficient use of the personal allowance, to provide a corporation tax deduction for the company but not to pay NIC. This means a salary of £8,060 in 2015/16, corresponding to the primary NIC threshold (and 2016/17 as the threshold has not changed). The payment of this level of salary also provides a qualifying year entitlement to the state pension.
When the new tax regime for dividends is introduced on 6 April 2016 many director-shareholders will find that the tax bill on the dividends will be higher than is the case for the 2015/16 tax year. So does this change the strategy of low salary and the balance as dividends?
We now have draft legislation for the new regime which explains the finer points of the proposals and how the new £5,000 Dividend Allowance interacts with other tax rates. The Dividend Allowance does not change the amount of income that is brought into the income tax computation. Instead it charges the first £5,000 of dividend income at 0% tax – the dividend nil rate. This means that:
- the payment of low salary below the personal allowance will allow some dividends to escape tax as they are covered by the personal allowance
- the £5,000 allowance effectively reduces the available basic rate band for the rest of the income.
The practical effect of the new regime is that a strategy of low salary and the balance of income requirements taken as dividends will still be a tax efficient route for profit extraction for many director- shareholders. However many will be paying more income tax.
What if the director-shareholder has savings income?
The main category of savings income is interest received. We now know how the receipt of savings income interacts with dividend income. Unfortunately the interaction is potentially very complicated. Savings and dividend income are treated as the highest part of an individual’s income. Where an individual has both savings and dividend income, the dividend income is treated as the top slice.
There are two tax breaks which can apply to savings income. One is new for 2016/17 – the Personal Savings Allowance (PSA). The practical effect of the PSA is to provide a potential £200 tax saving for basic rate and higher rate taxpayers. As this is a fairly small amount the PSA does not fundamentally change the approach to profit extraction.
The other tax break on savings income – the 0% starting rate of tax on savings income up to £5,000 – has survived the changes being made to the taxation of dividends and the PSA. This tax break is potentially worth £1,000 as it taxes the income at 0% rather than 20%. These rates are not available if ‘taxable non-savings income’ (broadly earnings, pensions, trading profits and property income) exceeds the starting rate limit. But dividends are taxed after savings income and thus are not included in the individual’s ‘taxable non- savings income’.
So if a director-shareholder only takes a salary of £8,060, any interest would first be allocated against the balance of the personal allowance (which is £11,000 for 2016/17) and then will be taxed at 0% up to the starting rate limit. The PSA may then give a further tax saving depending upon the total income of the director-shareholder.
Where does the interest come from? The director-shareholder may have interest from savings accounts, retail bonds quoted on the London Stock Exchange or loans made via ‘peer to peer’ sites. Or they may have provided loans to their company. Many have not charged interest on such loans but there is now an added incentive to do so.