A contractor’s guide to the April 6th legislation changes

By 6. April 2016News

The changes to dividend tax that begin on April 6th will have a big impact on contractors with limited companies. Until now, there has been no question that the most efficient way of paying yourself is to draw a small salary from your limited company, then draw down dividends for the rest of your income.

But the rules on dividend payments have been changed. While slightly simpler than the old rules, they mean that anyone accepting large payments in dividends will pay more tax than before.

What has changed?

Dividend payments will be subject to a dividend tax allowance of £5,000, replacing the old tax credit system. For dividend payments over £5,000, tax will be charged at the basic rate of 7.5 percent (up to £32,000), higher rate of 32.5 percent (up to £43,000) and additional rate of 38.1 percent beyond.

So the maximum a contractor can draw from their limited company without paying income or dividend tax is £16,000.

But the ‘tax-free’ dividend allowance is not quite tax-free – the £5,000 is still included in your total income when working out your taxpayer status. So if your total income tips into a higher band, you will pay more tax on that extra income.

What you can do to minimise the effects of the dividend tax changes

The most tax efficient method of paying yourself has been to draw a salary of £8,060, and use the payment of dividends for the rest. Although changes to dividend tax mean you will pay more, this remains the most efficient method under the new rules.

For example, someone earning a salary of £8,060 plus a gross dividend of £35,000 would be receive the first £5,000 dividends tax free, then pay 7.5 percent at the basic rate for from £5,000 to £32,000 (£2,025), then 32.5 percent on the remaining £3,000 (£975). Since no NICs would be due because the salary is below the NIC threshold, the total tax due would be £3,000.

That is still a significantly more tax efficient way of drawing income than by paying a straightforward salary, where both employer’s and employee’s NICs would be due, or by increasing the salary portion of pay at the expense of dividend payments. However, contractors earning higher salaries will be hit harder by the changes, so they may wish to explore other options including tax planning measures – speak to us to find out what your choices might be.

Leaving money in your company as retained profits

It will be tempting for many contractors to leave money in their limited company as retained profits. Corporation tax is still due on new profits for the 2016-17 Financial Year at 20 percent, although the Government has promised to reduce this to 19 percent from April 2017 and 18 percent from April 2020. But retained profits are not subject to tax so they can sit in your company for as long as you like.

That money does not need to simply sit there – it can be used for several things that previously you may have paid for from your net income.

The changes to pensions introduced in the 2014 Taxation of Pensions act mean you can now fund a very tax-efficient pension from your limited company. Pensions funded from within the limited company are made pre-tax so you will reduce your corporation tax bill. And when you come to draw down the pension, there are tax efficient ways of doing this too.

If you have a life insurance policy, it can be changed to a Relevant Life policy, which allows companies to provide life insurance cover for employees. This can reduce your corporation tax and dividend tax bills as the cost comes from pre-tax company profits.

Buy-to-lets may also be more attractive within a limited company, so you could consider setting up a wholly-owned subsidiary company to manage a property portfolio. While landlords are no longer able to claim tax relief on mortgage interest payments, this does not apply to limited companies. However, bear in mind that limited companies typically pay higher mortgage rates than individuals and there are of course the additional costs of running a limited company.

Find out more about your options for dividend payments

The tax changes today are complex, and the best way to discover how they might affect your and your contracting business is to get expert advice. Contact our team on 020 3642 8679 for a free consultation.

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