Understanding the UK dividend tax credit

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Many investors get confused about how dividends from UK companies are taxed. These dividends come with a notional 10% tax credit that can be used to offset some or all of the tax that a UK taxpayer owes. As a result, people assume that the dividend has already had some tax deducted before it reaches them.

Yet that’s not the way it works. Yes, it’s common in many countries for dividends to have some tax deducted before being paid, known as withholding tax (WHT). But the UK does not operate a withholding tax regime on dividends. Instead, the tax credit is purely notional and doesn’t relate to any tax actually paid.

This article will explain why the background to the tax credit and why it doesn’t represent a tax payment. But for investors who simply want to know what the outcome is and don’t need to understand the details, here’s a short summary of what matters:

  • Dividends from UK companies (excluding distributions from real estate investment trusts (Reits), which are a different tax regime) are paid without any tax on the dividend being deducted at source. No income tax will be payable for non-taxpayers and basic rate taxpayers. Higher rate and additional rate taxpayers are subject to income tax on dividends received when shares are held outside a tax wrapper.
  • When share are held within an individual savings account (ISA) or self-invested personal pension (SIPP) no income tax will be payable regardless of the status of the taxpayer. Nor has any income tax been deducted before the dividend reaches the investor. The widespread belief that dividends received in an ISA or SIPP still have some tax deducted is due to a misunderstanding of what the tax credit is.
  • In contrast, distributions from Reits have 20% tax deducted at source. When Reits are held outside a tax wrapper, basic rate taxpayers have no further tax to pay, but higher rate and additional rate taxpayers will have to pay more. When Reits are held in an ISA or SIPP, the 20% WHT can be reclaimed and your ISA or SIPP provider should usually do this for you automatically.

How dividend taxation works

Dividends paid by UK companies carry a notional tax credit of 10%. They are then subject to the following notional tax rates.

  • Basic rate taxpayers: 10%
  • Higher rate taxpayers: 32.5%
  • Additional rate taxpayers: 37.5%

The notional tax credit then fully or partly offsets the notional tax due. This means that for dividends outside an ISA or SIPP,  there is an income tax liability at the following rates.

  • Basic rate taxpayers: Nothing
  • Higher rate taxpayers: 25%
  • Additional rate taxpayers: 30.5%

Since there is no UK income tax on income paid within an ISA or SIPP, no income tax will be due from any taxpayer when the shares are held within one of these wrappers. This applies regardless of their marginal tax rate.

So far, so good. The complication is that because this notional tax credit can’t be reclaimed by non-taxpayers and in ISAs and pensions, investors tend to assume it means that they’ve paid some tax they can’t get back. They haven’t – but to understand why that is, you need to understand what the tax credit represents.

Understanding the notional tax credit

It’s crucial to appreciate that this notional tax credit is not currently a withholding tax. The history of UK dividend taxation is quite complicated, but in 1973 the government introduced a tax called advance corporation tax (ACT), based on income tax rates.

Companies had to pay ACT on dividends before they distributed them. The dividends were received with a tax credit, representing the ACT paid, which offset some or all of a shareholder’s income tax liability.

However, ACT was abolished in 1999, in part because of concerns that it encouraged firms to prioritise dividends over investment. At that point, the tax credit became entirely notional and no longer tied to any specific tax that had been paid.

You might have expected the tax credit to be abolished at this point as well – but it wasn’t. Instead, it was halved (from 20% to 10%) and the rates of income tax due on dividends adjusted to ensure that each band of taxpayers paid the same amount of net tax that they did under the old system.

Non taxpayers and pensions could no longer reclaim the tax credit (indeed, this was eliminated in 1997, before ACT was abolished). However, it remained possible to reclaim the tax credit for shares held within a ISA until 2004. Since then, no non-taxable UK entity – non-tax payers, ISA holders or pensions – can reclaim the credit.

It’s not hard to see why having a real tax credit that could be reclaimed suddenly evolve into a notional tax credit that can not be reclaimed has caused a great deal of confusion and makes people believe that their dividends have been taxed. The ISA rule change in particular has caused a great deal of bafflement, because it occurred years after the ACT change, and essentially looked like a separate tax grab.

However, at the point when the ability to reclaim tax in an ISA was abolished, the tax that it was supposedly tied to – ACT – had not existed for five years. In other words, by 2004 ISA holders were getting to reclaim a tax that hadn’t actually been paid. When the rules changed they lost a perk that didn’t really make any sense, rather than losing more money to tax.

No money changes hands

Under the current tax regime, the tax credit is entirely notional – it does not directly represent a payment made to HMRC at any stage. To see this, it may be useful to note that with effect from April 2008 the notional tax credit has also applied to dividends paid to UK taxpayers by most foreign companies. In that situation, it’s obvious that no tax of any kind – even corporation tax – has been paid to HMRC at any stage.

So the credit is essentially an accounting exercise that serves only to offset part of the notional income tax liability in cases where that liability exists (eg where the dividend is received outside an ISA or SIPP):  The functional outcome is that today the UK has a tax system under which:

  • Non-taxpayers and basic rate taxpayers pay no income tax on dividends
  • Higher rate taxpayers pay 25% income tax on dividends
  • Additional rate taxpayers pay 30.5% income tax on dividends
  • Anybody holding the shares in an ISA or SIPP pays no income tax on dividends

Exactly why this illogical system still exists, instead of getting rid of the credit and changing the dividend income tax rates accordingly, doesn’t seem to be entirely clear. One explanation I’ve heard is that it would be politically tricky to remove it entirely, since it would be wrongly perceived as a tax break for the more affluent. Another is that it might create liabilities under some older double taxation agreements.  Regardless of the reasons, it continues to make dividend taxation seem far more complicated than it really should be.

 Posted by at 2:43 pm

  6 Responses to “Understanding the UK dividend tax credit”

  1. If the tax credit is notional, does this mean that no amount at all has been deducted from the dividend payable? Even though it might seem that the 10% calculated is an amount that has been deducted before payment?
    Thanks for help!
    Sue

  2. This is a PS to my comment just now:
    When doing a tax declaration, should the 10% Tax Credit amount be added to the “dividend paid” amount? Example:
    ARM Holdings Tax Credit: 3.25 Dividend paid: 29.25 taxable amount (if tax liable): 32.50
    i.e. are both the Tax Credit amount and the dividend amount taxable?
    Thanks again
    Sue

    • Yes, the notional means that no tax has been deducted from the dividend before it’s paid. This is widely misunderstood – most people think 10% tax is deducted, but it isn’t. The way it’s presented is very confusing.

      You don’t include the tax credit in the amount paid on the self-assessment form – it’s just the total actually paid. See HMRC’s guidance on completing the form (PDF) – bottom of page 9.

      Reits are different – they are given including 20% tax (which is an actual tax deduction, not notional) – but they go in a different box on the form.

      This changes with effect from April 2016, when then tax credit system for dividends is being abolished. So it’s only relevant for one more set of returns.

  3. Is the tax credit reclaimable for non residents who pay their taxes in another Country?
    Thank you.

    • No, the tax credit wasn’t reclaimable by anybody because no tax was actually paid and so nothing existed to be reclaimed. It was purely notional. The exception to this is the 20% deducted from distributions paid by UK Reits, which does involve tax being actually being deducted, but that’s separate to the standard dividend tax credit.

      Incidentally, this is an old article that doesn’t reflect the dividend taxation from the current tax year onwards. The notional tax credit system was removed and replaced by a simpler system from April 2016, so only applies when working out the tax position of dividends paid in prior tax years.

  4. Hi cris.
    I’m interested in the new dividend tax system since April 2016 and in regards to non residents.
    Let say, as example, a Belgium resident (through his Belgium bank) who has shares in a UK company and a dividend is paid…
    If less than 5000£ are paid is their tax to be paid? If more than 5000£ is paid what happens? And maybe this Belgium resident has shares in a few UK companies… how is he taxed?…. or are all non residents non taxable and whatever perceived dividend amount?
    Thanks in advance
    Anthony

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