Comment: Warning on Osborne’s dividend tax reform

Amid the raucous cheering on the government benches on Budget day, my ears pricked up at the gentle tapping of a mallet working on the thin end of a new tax wedge: reforms to the tax treatment of dividends.
Bill Jamieson. Picture: Ian RutherfordBill Jamieson. Picture: Ian Rutherford
Bill Jamieson. Picture: Ian Rutherford

At first glance there seems little to worry about – but “first glances” on Budget measures can be dangerously unreliable. There is another caveat. Chancellor George Osborne said he wanted to simplify the tax rules around dividend income. Beware of claims to tax simplification. In fact, the present system is already fiendishly complicated – and the new regime is likely to make it more so.

First, some reassurance. Under the new system, to take affect from the 2016-17 tax year, everyone will receive a £5,000 tax-free allowance on their dividend income outside their pensions and Isa holdings (these remain unaffected). But they will be liable to higher taxes on dividend income beyond that. For the majority of those who hold shares outside those tax shelters, the changes should be benign. To be in receipt of dividend income of £5,000 and over, investors would need to be holding more than £140,000 in shares outside their pension schemes and Isas. Few private investors below retirement age are thus likely to be adversely affected.

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But “benign” is not how others would describe it. Treasury documents show the government expects to raise £2.5 billion through the measure next year, and £6.8bn over the next five years. As Dermot Callinan, head of private clients at KPMG, points out, “for the government to target almost £7bn in revenues from changes to the tax treatment of dividends, the announcement clearly represents a significant tax increase for people with high incomes” – adding that top-rate taxpayers would be paying at least 25 per cent more to Treasury coffers.

So what changes are envisaged? At present, those receiving dividends benefit from a 10 per cent tax credit. As the tax on dividends for basic-rate (20 per cent) taxpayers is 10 per cent, the result is that basic-rate taxpayers receive dividend income tax-free. For higher-rate taxpayers, the tax credit brings the 32.5 per cent notional charge on dividend income down to 25 per cent. For additional-rate taxpayers (those paying 45 per cent) the tax on dividend income falls to 30.6 per cent.

Under the new system, basic-rate taxpayers will pay 7.5 per cent tax on any additional dividend income over £5,000. Higher-rate taxpayers will pay 32.5 per cent (leaving them, according to Danny Cox, chartered financial planner at Hargreaves Lansdown, as much as 10 per cent worse off), and additional-rate taxpayers will pay 38.1 per cent. It might seem as if well-off savers have little to complain about. Substantial nest-eggs can be accumulated within existing tax-sheltered schemes, and the change cannot be described as crushing. But this, as I say, is the thin end of the wedge.

It extends the tax take on dividends. And, by effectively encouraging savers to take maximum advantage of pension and Isa tax-sheltered schemes, it means we are increasingly reliant on existing thresholds and tax breaks and on those schemes being maintained by future governments.

There are many reasons why investors may wish to hold equity investments outwith these. What of savings in excess of the current Isa maximum of £15,240 that investors may not wish to assign to a long-term pension plan? “Free-standing” investments provide greater access and flexibility.

Osborne said the reforms were targeted at those people who “self-incorporate and pay the lower rates of tax due on dividends”. That appears to refer to small- and medium-sized business owners who often pay themselves, at least in part, in dividends to reduce their tax liabilities.

What do income-conscious investors need to do? An early priority would be ensure as much as possible of equity savings are protected from tax. Take advantage of the maximum Isa allowance and if necessary transfer “free-standing” equity investments into Isas. Minimise pension drawdown where possible as savings here enjoy the most tax-sheltered environment available, drawing instead on savings outwith the pension shelter.

Investors could give further consideration to funds and trusts offering greater opportunities for capital gains rather than high-dividend distributions. But bear in mind dividend payments in the natural resource and commodity sectors may be hit by stock market turbulence in China and consequential falls in business investment and demand, further depressing commodity prices. Companies in this sector have featured strongly in income funds – so the market may well make an “adjustment” on your behalf.