How to pay dividends before 31 March 2004
It is clear that the key question arising from the budget on 17 March is the new 19% tax charge on dividends. This is reflected in the number of ask an expert questions we have had since the budget that relate to paying dividends. I thought it might be useful to cover a few basic issues.
Do I need to do anything?
The first question is whether the change introduced in the budget – the so-called 19% dividend tax – is going to affect you significantly?
We are awaiting the detailed legislation but the way it is likely to be applied is becoming clearer. The first point to make is that it is NOT a tax on dividends. It is corporation tax on the profits of the business. The tax is designed to ensure that, for any dividends paid out of the company to a non-corporate shareholder (i.e. an individual shareholder or trust), the underlying company profits have borne corporation tax at a rate of at least 19%.
This is based on the lower rate of corporation tax paid in respect of companies with small profits.
The 19% tax band for companies applies to taxable profits between £50,001 and £300,000. Where profits are below £10,000 the corporation tax rate is nil. Profits between £10,000 and £50,000 are taxed at an effective marginal rate of 23.75% to ensure that when profits reach £50,000 the overall corporation tax charge is 19%. Hence, at £50,000 profit, a company will have paid nil CT on the first £10,000 and 23.75% on the next £40,000 = £9500, which gives an overall rate of 19% on £50,000 of profit.
Clearly the maximum effect that the budget change can have on the company corporation tax charge is an increase of £1900 for a company whose profits were below £10,000 and which will have paid no corporation tax. By the time profits reach, say £30,000, the increase in corporation tax is reduced to £950. That is because the profit of £30,000 will have borne CT of 23.75% on £30,000 - £10,000 = £4750. However, at a rate of 19% the charge would be £5700 – leaving an additional charge of £950 if all of that profit were paid out as a dividend. As profits near £50,000 the impact of the additional charge becomes largely immaterial.
So if your profits are already being taxed at or near the 19% rate then there is probably no pressing reason why you should take a dividend before 31 March 2004 unless your personal cash flow or taxation situation requires it. Bear in mind that, when the company pays a dividend, the dividend has a tax credit equal to 10% of the gross dividend. If you are a lower rate tax payer, the dividend is taxed in your hands at 10%, which equals the tax credit. Hence lower rate tax-payers do not have to pay any additional tax on their dividend income.
However, if you are a higher rate tax-payer the dividend is taxed in your hands at a rate of 32.5% which, after the tax credit, means you pay additional tax at 22.5% on the dividend. So if you are likely to be a higher rate taxpayer in the tax year 2003/4 but not in 2004/5 paying a dividend of £10,000 now, to avoid additional corporation tax at a maximum rate of 19%, does not make sense if it then attracts an additional 22.5% income tax charge in your hands.
Clearly this decision depends on individual circumstances.
It is now also clear that the new corporation tax charge will apply to any dividends paid on or after 1 April 2004 regardless of when the profits arose. However we do not yet know exactly how the new rules will be applied to dividends paid out of profits brought forward from earlier years. It seems safest to assume that if your effective corporation tax rate, when you pay the dividend, is likely to be less than 19% (regardless of what rate of CT you may have paid in the past) then there will be an additional corporation tax charge if the dividend is paid after 31 March 2004.
Paying a dividend – the mechanics.
In order to pay a dividend at all there must be profits in the company. It does not matter when these profits were made. If your accumulated profits brought forward exceed any current year losses you can still pay a dividend even though there is a loss in the current year. However you do need to bear in mind the cash requirements of the business. A director would be negligent if s/he stripped out all the accumulated reserves of their business knowing full well that future commitments (e.g. corporation tax or leasing costs on a car) could not be met.
In order to be sure that there are sufficient profits available to pay a dividend the director has to consider what was available at the end of the previous financial year (as shown in the statutory accounts) plus what has happened in the current year. Hence before paying a dividend you need to have some idea of the current state of the business. For most freelancers the state of the company's bank balance will largely mirror the state of the reserves as most freelancers' businesses work almost on a cash basis. However you do need to factor in creditors. The two main ones are likely to be any VAT that might be due and the corporation tax that may still be due on last year's profits and will be due on this year's profits.
If your company has only recently started up and there are no previous statutory accounts then you must prepare what is known as 'interim accounts' in order to demonstrate that the company has made a profit. These need to reflect all income and expenses to date plus provision for corporation tax on that profit. For most new businesses a provision of 19% corporation tax will be more than adequate to cover the likely tax.
The new legislation talks about dividends paid on or after 1 April 2004. Hence we have to consider what is meant by 'paid'? For most freelancers looking at paying a dividend by 31 March we are looking at what's called an interim dividend – one declared and paid by the directors ahead of the year end and any final dividend.
There is a useful discussion in the Revenue's Corporation Tax manuals about declaring and paying dividends. See here:
Dividends
For an interim dividend they conclude that " In the case of an interim dividend (which does not create an enforceable debt and which can be varied or rescinded prior to payment), payment is only made when the money is placed unreservedly at the disposal of the directors/shareholders as part of their current accounts with the company. So, payment is not made until such a right to draw on the dividend exists (presumably) when the appropriate entries are made in the company's books."
Hence, as a minimum, for the dividend to be 'paid' the dividend needs to be formally agreed by the board and credited to the shareholder's current account in the company's books. However, to be safe I suggest that the dividend cheques should actually be drawn before 31 March and handed over to the shareholders. The Revenue will undoubtedly be looking at the timing of dividends that are paid on or about 31 March 2004 and it would be better not to get into debates about when and whether the dividend was actually paid.
Dividend Warrants
To pay a dividend the company should record in the board minutes the decision of the directors to pay a dividend – after due consideration of the business's financial state. This decision should note the dividend to be paid per share and should also note the effective date of payment – i.e. a date before 1 April 2004.
A dividend warrant should be issued to each shareholder. This should state:
The amount of the dividend per share
The tax credit
The net dividend.
A suitable form of wording could be:
Dear Sir/Madam
I have pleasure in informing you that your Account with the Company has today been credited with £x,xxx being a Final Dividend of £xx (Net) per share on your Ordinary Shares in the Company for the period ended 31 March 2xxx.
This voucher should be retained and will be accepted by the Inland Revenue as evidence of notional tax credit which is not repayable.
Ordinary Shares Held - 100
Notional Tax Credit - 10% of gross
Dividend - net value
So for a dividend of £10,000 on 100 shares the entries would be:
Dividend per share £100
Tax Credit £1,111 (being 10% of the gross dividend of £11,111)
Net dividend £10,000