The retained profits generated by UK companies of all sizes can be distributed to shareholders. For professional workers (such as contractors, consultants, and freelancers), dividends make up the bulk of income drawn down from small limited companies.
This article has been updated to incorporate both the new dividend tax regime (post-April 6th 2016), and the old system (pre-April 6th 2016).
What are dividends?
If a limited company has made a profit, it is free to distribute these funds to its shareholders. This is the money the company has remaining after paying all business expenses and liabilities, plus any outstanding taxes (such as Corporation Tax and VAT).
This ‘retained profit’ may have been accumulated over a period of time, and any excess profits not distributed as dividends simply remain in the company’s bank account.
Working via a limited company is a tax efficient way to operate, as National Insurance Contributions (NICs) are not payable on company dividends, whereas they are payable on salaried income.
Dividends must be distributed according to the percentage of company shares owned by each shareholder, i.e. if you own half the company’s shares, you will receive 50% of each dividend distribution.
Dividends – getting the paperwork right
To comply with the law, all companies must hold a board meeting to agree the dividend declaration, and must record the meeting minutes in the company’s records. Of course, in practice, with many companies being run by sole directors, this is more of a paperwork exercise than anything.
Alongside the company paperwork, the directors must provide each shareholder with a dividend voucher. An electronic voucher (i.e. one attached via email, or automatically generated by an accounting software package) is perfectly acceptable these days, if previously agreed by shareholders. Otherwise, the company should post a paper voucher to each shareholder.
The voucher should detail:
- The date
- The company name
- The name and address of the recipient
- The total number of shares owned by the shareholder
- The net dividend being paid (for dividends pre-April 6th 2016)*
- The amount of the tax credit (for dividends pre-April 6th 2016)*
- The gross dividend being paid (for dividends pre-April 6th 2016)*
- The total dividend payable to the shareholder (for dividends 6th April 2016 onwards)
- Director’s signature
It is essential that you maintain the correct paperwork – including paper records of board meeting minutes, as you may need to produce them in the unlikely event that you are selected for an HMRC investigation.
* Tax credits no longer apply from the 2016/17 tax year onwards. Instead of net and gross dividends, and the tax credit, just the total dividend payable should be included on dividend vouchers from 6th April 2016.
View our example dividend paperwork templates.
How to calculate the tax payable on dividends
The dividend taxation system was changed on 6th April 2016. The old system, which involved ‘grossing up’ net dividends via tax credits has been replaced by a system of fixed tax rates for the 2016/17 tax year onwards.
You need to let HMRC know how much dividend income you have received via your annual self-assessment form.
a) 2016/17 tax year onwards
Dividend income is taxed as follows:
|Tax Band||2016/17 Income||Tax Rate|
|Basic||£0 – £32,000||7.5%|
|Higher||£32,001 – £150,000||32.5%|
A £5,000 so-called ‘dividend allowance’ is also provided, which means the first £5,000 of dividends is not taxable. However, this allowance does not reduce the total income figure upon which you are taxed.
Dividends are taxed after your other income sources have already been taxed, e.g. your salary and other relevant earnings (from savings or investments). So, your dividends will fall into one or more of the tax bands listed above, after your personal allowance and other income sources have been added together.
For examples and further information, read our in-depth article; how much will the April 2016 dividend tax changes cost you?
b) 2015/16 tax year
This section applies to dividends received prior to 6th April 2016.
As companies have already been taxed on their profits (Corporation Tax is levied at a rate of 20% for small companies), a notional 10% tax credit is applied to dividends received before 6th April 2016.
The ‘net dividend’ (the amount distributed to a shareholder) is multiplied by 10/9 to provide the ‘gross dividend’ amount, including the tax credit. This is the sum upon which income tax is payable.
For dividends which fall within the basic tax band (income up to £31,785, on top of the personal allowance for the 2015/16 tax year), there is no further tax to pay at all on dividends, as the 10% basic dividend tax rate is cancelled out by the 10% tax credit.
For dividends falling in the higher rate tax band (income between £31,786 and £150,000), a 32.5% tax rate applies. However, after taking into account the 10% tax credit, you only pay an effective 25% rate of tax on net dividends falling within the higher tax band.
Dividend tax is levied at 37.5% on all income falling in the additional tax band (over £150,000); 30.56% after the tax credit has been included.
|Tax Band||2015/16 Income||Dividend Tax|
|Basic||£0 – £31,785||10%|
|Higher||£31,786 – £150,000||32.5%|
2015/16 dividend tax example
If you pay yourself a salary of £8,000 per year, and draw down a further £60,000 in dividends, you first use up your £10,600 tax-free personal allowance when calculating your overall tax liability.
You pay no dividend tax at all on the dividends you receive within the ‘basic’ tax band – i.e. on the first £31,785 (2015/16) after taking into account the personal allowance.
So, there is no additional income tax to pay below £42,385.
You are taxed on the gross dividend amount (10/9 times the £60,000 dividend) = £66,667.
You must pay higher rate dividend tax on the income you have received between £42,385 and £74,667 (£32,282) – this is 22.5% of the gross dividend amount (32.5% higher tax rate – 10% tax credit) = £7263.45
Dividend tax – online calculators
Use our dividend tax calculators to calculate the additional tax you have to pay at self-assessment time.
There are no rules which determine how often you distribute dividends, however many accountants suggest processing dividend payments on a quarterly basis, for easier record keeping.
The most important thing you must remember is that all dividend distributions must be legal (i.e. there is sufficient retained profit in the company to cover them). Otherwise they will be classed as illegal, or ‘ultra vires’, and could result in HMRC penalties and further action in some cases.
Unlike traditional employees, limited company owners are in the fortunate position that they can determine the timing of dividend payments, as well as the amounts to be distributed.
This can help in tax planning. For example, if you are working hard during the current tax year, with a view to taking a ‘career break’ next year, you would be wise to delay distributing some of your profits until the year when you will be earning less – and pay less higher rate tax by splitting the distribution over two separate tax years.
You may also benefit by splitting ownership of your company with a spouse, particularly if they don’t have any other source of income (or modest earnings). As a couple, you can take advantage of the non-working partner’s tax allowance, and pay less higher rate tax.
What is a dividend waiver?
It is possible for one or more shareholders to waive their rights to receive a dividend, so a dividend is distributed to some, and not all shareholders. Care should be used when considering the use of a dividend waiver, as if this is not done for genuine commercial reasons (such as ensuring that the company retains sufficient capital after the distribution), you may attract the attention of HMRC. Read our guide to dividend waivers, and how they work.
IR35 and dividends
If you enter into contracts to provide professional services to clients via your limited company (typically as an IT contractor), you may be aware of a piece of tax legislation called IR35. If your contract work is caught by IR35, you will have to draw down the bulk of your company’s income in the form of a ‘deemed salary’, after allowing for a fixed 5% ‘administration allowance’ for the costs of running the company.
You will have to pay full PAYE income tax and NICs on this deemed salary – at the same rates paid by permanent employees.
So, if you do work as a limited company contractor, you should make IR35 compliance a key priority, as the financial consequences should you be caught are significant.
- We also recommend you sign up to receive email updates on any future limited company tax changes, via our in-house newsletter.
- Find out the most tax efficient way to pay yourself as a limited company owner, in terms of salary + dividends.
- Find out more about the different taxes a typical contractor has to pay (either as a limited company, or an umbrella employee).
- Please use this article as a guide only, and make sure you choose a specialist contractor accountant if you have any questions about how dividends work, dividend timing, and how best to set up your company’s share capital.