Now the calculation method has been confirmed, the new rules will take effect from April 2016 and will mean an increase in the amount of tax that contractors and freelancers operating through Limited Companies will have to pay.

The changes are designed to reduce the amount of “tax motivated incorporations” but due to the wide reaching nature of the new rules virtually all small business owners will be negatively impacted.

How dividends are currently taxed

As it has been for over 40 years, the amount of dividend paid out is classed as a net dividend for tax purposes. This net dividend is ’grossed up’ so what you’re paid is only 90% of the taxable income and the 10% difference serves as a notional tax credit.

For example: if you receive a £900 dividend payment, the gross value received for tax purposes is £1,000 and the tax credit is £100.

All tax calculations are then based on this higher gross dividend figure.

Basic rate tax payers pay 10% tax on dividends, so their tax is completely offset by the 10% tax credit meaning they have no further tax to pay personally - remember your Limited Company has already paid 20% Corporation tax.

For higher incomes, some dividends will fall into the higher rate tax bracket.  These dividends are taxed at 32.5% (on the gross figure).  After the 10% tax credit has been applied this equals a rate of 22.5% on gross dividends, effectively a tax of 25% on the amount you’ve received - the net dividend.

For example: if you receive a dividend payment of £900 in the higher rate tax bracket, you would incur a tax liability of £225 (25% of £900).

Using the 25% just avoids the need to gross up dividends so you can calculate the amount you need to set aside quickly, much easier than calculating the gross dividend of £1,000 then working out 32.5% (£325) and then applying the 10% tax credit (£100).

How the new rules work

As you can tell from above the current system can be fairly complex.  The new rules scrap the 10% tax credit and the need to deal with net and gross dividends.

Instead, the amounts paid are the amounts declarable for tax purposes and the amount charged has changed.  The first £5,000 of dividend income will attract a 0% tax rate after which the following tax rates apply:

Basic rate – 7.5%

Higher rate – 32.5%

Additional rate – 38.1%

How does this impact contractors?

These new rates equate to a 6% increase in the marginal rate of tax once the dividend allowance has been used.

Whilst this increase will hurt contractors it is important to remember that dividends, unlike salary, do not attract any National Insurance.

This still makes a Limited Company the most tax efficient method for many contractors, just the tax efficiencies aren’t quite as good as they once were.

Below shows the additional tax you may pay on dividends from 2016/17:

What can I do about this?

We feel that these changes are unfair and go against the government’s pledge to assist small businesses! We have seen some lobbying from business groups and an online petition was even set up that attracted over 36,000 signatures.

However from the government’s response to the petition and other statements it seems highly unlikely that they will perform another U-turn and change these rules.

This means that contractors really need to review their current set up through their Ltd Companies to ensure they are saving tax wherever they can. This will include considerations such as ensuring they are claiming all expenses allowed, looking at making pension contributions etc.

We would strongly recommend you speak to an expert contractor accountant about how these rules will impact you.

We also have our very own Dividend Tax Calculator to help provide you with an estimate of your personal tax bill once these changes come in to force. You can try the calculator here.