On the one hand dividends represent a reward for investment and, by extension, saving which is perceived to be a good thing and a behaviour to be positively reinforced by a favoured tax treatment. On the other hand, dividends are used by many small and medium sized companies to extract profits tax efficiently for their owners, avoiding the National Insurance cost that would otherwise result were the dividends taxed as earnings – which in many cases is their true economic form.
Of course, if certain dividends represent a bonus then, logically, the solution lies in taxing these dividends as earnings. However, a “dividend as bonus” is easily recognised but more difficult to describe, at least in statutory terms (although it is understood that efforts continue to draft such a rule). As a result the “earnings” problem has been addressed by the simple expedient of removing the tax credit and introducing new rate bands specifically targeted to dividend income: in other words a rise in the effective tax rates charged on dividends.
Looking forward (post-5 April), what results is a narrowing of the differential in tax rates as between earnings and dividends although the balance of advantage remains with dividends, and as such the dividend as bonus planning will continue!
More significantly, in the immediate term the rate of tax applied to dividends will be increased by 7.5 per cent across all rate bands from midnight on 5 April. Currently dividends carry no income tax charge when taxed at the basic rate and give an effective rate of 25 per cent and 30.55 per cent at the higher and additional rates. The corresponding rates under the new regime will be 7.5 per cent, 32.5 per cent and 38.1 per cent. An opportunity to accelerate dividends (or bonuses) arises to pre-empt these higher rates. The legislation carries no anti-forestalling provisions; it seems clear that the Government is happy to take the benefit of the accelerated tax receipts should taxpayers choose to take the benefit of these “old” rates.
Dividends are taxed when “paid”. As might be expected “paid” carries a meaning beyond that found in the OED. At its simplest, if a company has available distributable reserves (profits) and has the available cash then a transfer of the cash (by way of cheque of bank transfer) to the director/shareholder, evidenced by a resolution of the directors, is all that is required. Simple but rarely the case in practice.
There may be insufficient cash to support the dividend. Even if the cash is available it is likely to be required in the business. The “solution” often found is to credit the dividend to a director’s loan account to be drawn upon as available cash or circumstances permit. In normal times this might be enough. Whether a dividend credited to a loan account represents a dividend “paid” (and therefore the tax point) is generally a matter of no great concern for HMRC who will happily tax the dividends “volunteered” if payment for tax purposes has not, technically, been achieved. However this is a practice not to be relied upon when a 7.5 per cent rate advantage is lost to HMRC.
The “loan account” planning has a number of weaknesses in fixing the “paid” date. The crediting of a dividend in accounting terms is unlikely to represent payment until those accounts are approved by the members, probably long after the date the loan account is physically credited. Moreover, the declaration of a dividend by the directors does not, somewhat surprisingly, bind the company to actually pay the dividend, or indeed, create any debt due or right to the shareholder. The declaration simply authorises the payment of the dividend and until actual payment the shareholder has received nothing…and quite correctly you should not be taxed on nothing.
The solution is simple: declare the dividend in general meeting approved by the shareholders. The directors’ resolution declaring the dividend should still occur but should then be followed by approval by the shareholders (the directors wearing a different hat in most cases) in general meeting. This simple expedient of approving the dividend by the members in general meeting fixes the payment of the dividend to the date of the meeting (or, if required, the date specified in the resolution declaring the dividend). The dividend is “paid” for tax purposes when the declaration is approved and it is entirely irrelevant when the cash is transferred or when the credit to the director’s loan account is made.
The approval of dividends by the members is arguably a good practice in normal times, but where, as here, certainty of the payment date is required it is essential. Dividends to be paid before 5 April, in order to lock into current rates, should be declared and approved in general meeting – finding the cash to pay the dividend is then a problem for the future.
By Neil Simpson, Tax Partner at haysmacintyre