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:
7.5% on dividend income below the basic rate band
32.5% on dividend income between the basic and higher rate bands
38.1% on dividend income above the additional rate band
What does this mean for income protection claims?
The change in rules means that dividends declared after April 2016 will likely give rise to a different income tax charge than they would have done if declared before April 2016. Whether the income tax charge is higher or lower after April 2016 will depend on the individual’s circumstances.
Given this, although tax payments are not considered in income protection (IP) claims, individuals may change the way they extract money from their owner-managed businesses to reduce their overall tax liability and this could affect how earnings are assessed for pre- and post-incapacity periods. Below are some examples of how this issue could manifest itself in an IP claim.
1. Back dating dividends
If company accounts have not been finalised, policyholders could back date dividend payments to before the introduction of the new rules, i.e. pre- 6 April 2016, to reduce their tax liability. This could therefore have the effect of overstating the policyholders’ pre-incapacity earnings.2.
2. Retaining profits in the business
A policyholder is entitled to retain profits in their business and there are many good reasons for doing so e.g. for cashflow purposes, to facilitate investments in equipment or stock, or they may be keeping profits in the business to withdraw at a later date or on retirement.
However, the change in dividend tax rules may encourage individuals to retain profits in their businesses, which they may not otherwise have done. Many Income Protection policies define earnings as income chargeable to income tax and, therefore, if profits are retained in the business, post-incident earnings may be appear artificially reduced giving rise to increased benefit payments.
The key issue to look out for is whether there is a good reason for any change in the retention of profits in the business and looking at what the policyholder has done historically. If the policyholder has deliberately reduced or stopped withdrawing profits from the business as dividends following incapacity, then their post-incapacity earnings could potentially be understated change in ownership
3. Change in ownership
To make the most of the Dividend Allowance, policyholders may decide to transfer shares or issue new shares to spouses, children or other family members. This would allow them to utilise all individuals’ Dividend Allowances thus reducing the total tax payable. However, if such a change in ownership has happened post incapacity, then, again, this could mean that post-incapacity earnings are potentially understated.
In summary, the change in the taxation of dividends could lead to individuals manipulating how they extract income from their companies to minimise their tax liability, which could, in turn, impact the assessment of pre- and post-incapacity earnings for the purposes of assessing an income protection claim.
While income protection claims assess gross earnings and, therefore, changes in tax legislation may not seem to be relevant, it is still important to be aware of any changes as they could have a fundamental impact on the assessment of income protection benefits.
For more information on this topic, or to learn how Baker Tilly specialists can help, contact our team.