What is the dividend tax and how much is it increasing by?

On 6th April 2022, the rate of income tax payable on shareholder dividends will increase by 1.25 percentage points across all tax brackets in the UK. But what exactly is a dividend tax and how does it differ from other forms of income tax? Furthermore, how will this change affect individuals and businesses around the UK?

What is a dividend tax?

Put simply, a dividend tax is a form of income tax levied on income received via a shareholder dividend, which is a payment made by a limited company to its shareholders if it makes a profit.

Shareholders come in many forms and might be investors who have bought stock in a publicly traded company, or directors or employees of a small business who are paid via a mixture of a salary and share dividends.

The way in which income from a dividend is taxed is a little different to the way a salary is taxed and the rates at which these dividends are taxed is changing in 2022.

What is increasing?

Similar to the way in which National Insurance contributions are increasing in April 2022, dividend taxes are also going up by the same amount, 1.25 percentage points.

Because dividends are not subject to National Insurance Contributions (NICs), the increase in dividend tax is being put in place to ensure that everyone shares the burden of the tax rises roughly equally, whatever the form of their primary income, be it a PAYE salary (with National Insurance contributions) or through share dividends.

Who does this affect?

The increase in dividend tax rates may affect anyone who owns shares in a company and receives a dividend, one or more times in a financial year, which the government estimates to be over 2.5 million people in the UK. They might be investors who own and trade in company stock, or employees and directors of businesses who benefit from share option schemes.

Just as with income tax on a salary, however, there are different tax brackets that are taxed at different rates. This means that while the increase in dividend tax rates of 1.25 percentage points applies to the tax rate in each tax bracket. It will affect those in the basic rate band the most (this includes the average UK full-time salary of £31,825)

Where will the extra money go?

The increase in both dividend tax and National Insurance contributions in the 2022/23 financial year will go directly to funding the NHS following the Covid-19 pandemic. From the 2023/24 financial year onwards, the NIC increase will be replaced by a Health and Social Care levy, while the funds raised through the 1.25% dividend tax increase will be ring-fenced for health and social care organisations.

According to projections by the Office for Budget Responsibility, the increase in dividend tax rates will deliver an additional £1.34 bn to the exchequer for the 2022/23 tax year.

Is there a tax free dividend allowance?

Every individual has a £2,000 per year tax free dividend allowance, meaning that you will not have to start paying any income tax on your shareholder dividends unless you receive more than £2,000 worth in a single financial year. At that point, you’ll pay tax on your dividend according to the income tax bracket that you are in (see above).

For example, in the 2022/23 tax year:

• You earn a PAYE salary of £35,000
• You are paid shareholder dividends of £4,500
• Your total income is therefore £39,000

This places you in the basic-rate income tax bracket. Your personal allowance is £12,570. This means:

• Your taxable salary is £35,000 minus £12,570, or £22,430
• You will pay income tax at 20% on this amount, equalling £4,486

Then:

• Your taxable dividend income is £4,500 minus your £2,000 allowance, or £2,500
• You will pay dividend tax at basic rate (8.75%), equalling £218.75

What does this mean for businesses?

According to the government’s own analysis and impact assessment, the increase in shareholder dividend tax is “expected to have no impact on businesses…as it relates only to individuals who are shareholders”. However, this may have an impact on how small business owners and directors choose to draw income from their business.

There are pros and cons to business owners and directors paying themselves by either a salary or through dividends. Payment through dividend will generally incur a lower tax burden and is exempt from National Insurance contributions, while a salary will help you build up entitlement to a state pension and maternity benefits, as well as lowering your business’ corporation tax bill.

While a lower rate of income tax is a great benefit of payment by dividend, the tax increase may force some small business owners to reassess how they choose to use salaries and dividends to extract money from their business ventures. With research commissioned by Superscript indicating that over a quarter of owners and directors of businesses (27% of 1500 respondents) were paid entirely or primarily through dividends, this is not an issue that only affects a small number of companies.

Should small businesses pay owners and directors through dividends?

The answer to this question is, simply, that it depends on the size, industry and makeup of the company. A large number of directors and owners of businesses in the UK are paid largely or entirely through dividends as opposed to a salary and there are pros and cons of each approach.

In light of the dividend tax increase in 2022, let’s briefly look at the benefits and drawbacks of each approach so you can make the most informed decisions for your business.