In April, the UK introduced new dividend taxation rules, with wide-ranging consequences for clients that invest for tax efficient income, as well as on the tax treatment of dividends paid into trust structures. Under the new legislation each individual holds a £5,000 annual dividend allowance. Within this amount, any dividends received during the tax year are free from any kind of tax liability.
In excess of £5,000, dividend income is taxed at the individual’s marginal rate. For basic rate taxpayers this will be 7.5 per cent, while higher-rate taxpayers will pay 32.5 per cent on dividend amounts above the threshold. Additional rate taxpayers face a 38.1 per cent rate.
Dividends paid from assets held in an Isa or pension account remain entirely exempt from taxation and do not count towards the £5,000 allowance.
Interest in possession trusts
Interest in possession trusts are an effective vehicle for providing income to beneficiaries but they do not have an outright entitlement to capital.
For IIPs, dividends were previously subject to the 10 per cent dividend tax credit. Following the abolition of the credit, all dividend income will be taxed at the basic rate of 7.5 per cent, payable by self-assessment via HM Revenue & Customs.
Ultimately, the underlying beneficiary to income payments from the trust will then have to determine their personal tax liability. If the dividend falls within their own £5,000 allowance there will be no tax to pay and they can subsequently reclaim the tax suffered under the trust. Depending on their personal tax position and marginal rate, they may need to pay the balance of tax owed if the dividend exceeds the £5,000 threshold.
Discretionary trusts, often used by those that do not wish to give beneficiaries indiscriminate access to funds, are also affected.
Any dividend income received will fall into the trust’s normal £1,000 allowance, where available. Within this bracket, the ordinary dividend rate of 7.5 per cent will apply, regardless of the beneficiaries’ marginal rate or their personal dividend allowance.
Above the £1,000 standard rate band, dividends will be taxed at 38.1 per cent, the rate applied to higher-rate taxpayers.
When the trustees award income to the beneficiaries of a discretionary trust, it effectively loses its origin and is treated as trust income rather than dividend income. As a result, the beneficiary cannot use their dividend allowance, even if the income did originally disseminate from a dividend payments from the trust assets.
Absolute (bare) trusts
Dividend tax liability previously fell directly on the beneficiaries anyway, rather than on the trust itself, and this remains the case. Beneficiaries are subject to the new allowance under the terms set out above.
Changes to the dividend taxation process also impact the succession process and the role of the executor. No dividend allowance will apply during the administration period meaning executors will be liable to income tax at the basic rate of 7.5 per cent.
As dividend income will be received gross, rather than taxed at source, this will create an additional administrative burden for executors, who will now need to declare the tax liability.
It is also worth remembering the dividend rule changes are in addition to the administrative burden that now arises as a result of the new personal savings allowance. The allowance means basic rate taxpayers are eligible to receive £1,000 interest per year (and higher rate taxpayers can receive £500) before any tax is due.
As a result, bank interest is no longer taxed at source, and executors and IIP trustees will now need to ensure they pay basic rate tax at 20 per cent. This adds an extra layer of administrative work to be completed, particularly for IIP trustees that will need to pay the tax even if the ultimate beneficiary is then in a position to reclaim the tax: for example, if they are a non-taxpayer or the total interest falls within their own personal savings allowance of £1,000.
The rules will have a knock-on effect on the way clients can utilise collectives to maximise tax efficiency. The new allowance creates financial planning opportunities, whereby clients can mitigate tax on income-generating investment strategies.
Let us use the example of a client with £20,000 in pension income.
He wants to supplement the pension income by investing a £200,000 lump sum generated by downsizing on the family home and moving into a smaller property. He wishes to supplement his pension income with a further £10,000 annually.
Assuming a 5 per cent yield, the new dividend allowance allows the client to invest £100,000 into a collective investment account, using their dividend allowance to withdraw the £5,000 yield with no tax liability.
The remaining £100,000 balance on the lump sum can be used to invest in an offshore bond targeting a 5 per cent yield. Using the 5 per cent tax-deferred allowance the client can take a further £5,000 income with no immediate liability to tax.
By using the dividend allowance, they are able to generate the desired £10,000 income without incurring any tax.
Gordon Andrews is a financial planning expert at Old Mutual Wealth