More on the taxation of dividends

In the context of this article tax credit does not refer to the child or working tax credits – these are part of the benefits system. Tax credits in this article refer to a deduction made from your overall tax liabilities, usually at a fixed percentage rate of the relevant income.

For example, up to 5 April 2016, dividend payments were made net of a deemed tax credit of 10%. If you received a dividend of £100 this would actually be a gross dividend of £111.11, less a 10% tax credit of £11.11. As far as HMRC was concerned, if your dividend income formed part of your basic rate band no additional tax would be payable. In this case your basic rate Income Tax liabilities on your dividend income could be said to be covered by the tax credit.

After 5 April 2016, the 10% tax credit was abolished and replaced by the so-called dividend tax allowance. Dividends received of up to £5,000 are taxed at 0%, and any dividends received in excess of this amount are taxed at 7.5%, 32.5% or 38.1% depending on whether the dividends fall into your basic, higher or additional rate bands.

However, the £5,000 allowance does not reduce your income for tax purposes. If your income from dividends is £5,000 or less this amount will still be added to your taxable income. The relief is actually applied further down your tax computation for the year. The first £5,000 of your dividend income is effectively taxed at 0%.

Why does this matter? After all, the effect would appear to be the same…

Unfortunately, it does matter. If the allowance is no longer a valid deduction from your income, but instead, is a reduction in the tax payable, the extra income may push you into the higher rate or additional rate bands, or if your income is in excess of £100,000 you may lose part of your personal allowance.

The Treasury seems to be viewing this reclassification of tax allowances as tax credits as an uncontroversial way to increase their Income Tax take simply by turning reductions in taxable income into a tax credit, even when, as with the title “dividend allowance” the £5,000 is not an allowance/deduction but a 0% tax band.