We are often asked to clarify the amount of tax payable by shareholders when dividends are paid by private companies.
Dividends are distributions of company retained profits, after any corporation tax due has been deducted. To acknowledge the corporation tax deduction dividends paid are treated as if a tax credit of 10% has been deducted prior to payment. This 10% tax credit clears any standard rate income due but cannot be refunded. Accordingly, if your total, taxable income, after all allowances and reliefs have been deducted, is less than £37,400 for the tax year 2010/11, there is no further income tax to pay on dividends received.
Because the tax credit of 10% only covers your basic rate income tax liability, higher rate tax payers will have to pay additional tax. The amount applied to the notional gross dividend (cash dividend plus the notional tax credit) is as follows:
- If you are a higher rate tax payer but your income does not exceed £150,000 then the additional tax due is 22.5% of the notional gross dividend;
- If your income exceeds £150,000 the additional tax due is 32.5% of the notional gross dividend.
This produces marginal rates of tax on the actual cash dividends received of 25% and 36.1%! If your dividend income causes you to cross tax bands, then the dividends will be taxed partly at each tax rate.