New rules for the taxation of dividends - what does it mean for income protection claims?

The old rules

Prior to April 2016, dividend income was taxed with reference to the ‘Dividend Tax Credit’. However, the ‘Dividend Tax Credit’ often caused confusion as it implied that some tax had already been deducted from dividend payments at source, which could be claimed back through the Dividend Tax Credit – this was not actually the case. 

The history of the ‘Dividend Tax Credit’ stems from the days when companies had to pay Advanced Corporation Tax (ACT) on dividends paid. Individuals were then able to reclaim this tax paid as a credit against their total tax liability. However, when ACT was abolished in 1999, the tax credit remained, albeit at a reduced 10% rate, and since this time the ‘Dividend Tax Credit’ has been a purely notional amount – it does not reflect any actual tax payment and no money is physically repaid by HMRC.

Prior to April 2016, the mechanics of calculating an individual’s tax liability on dividend payments involved the “grossing up” of dividends received by 10%, then taking into consideration an individual’s Personal Allowance and other incomes before applying the appropriate dividend tax rates. The notional ‘Dividend Tax Credit’ was then offset from the total tax liability, reducing the tax payable. 

This was always a rather convoluted way of calculating the tax payable on dividends, and so the short-cut approach was to consider whether the individual was a basic, higher or additional rate tax payer. If a basic rate tax payer, then dividends were effectively taxed at 0% after accounting for the tax credit; if a higher rate tax payer, dividends were taxed at 25%; and for additional rate tax payers, dividends were taxed at 30.5%.

On 6 April 2016 everything changed: the notional tax credit was finally abolished and the new dividend taxation rules came into effect.

So what changed?

From April 2016, individuals are entitled to a new Dividend Allowance equivalent to £5,000 per annum. All dividends received up to this limit are received tax free regardless of any other income an individual has and this is in addition to the traditional Personal Allowance. However, whereas the Personal Allowance does not impact the income tax earnings bands, the Dividend Allowance reduces the bands, depending on an individual’s total dividend income.      

All dividends above the Dividend Allowance are now chargeable to income tax at new dividend income tax rates. For the 2016/17 fiscal year the dividend tax rates are: