Dividends have their own tax rules and their own rates of tax. The rules and the rates apply in the same way regardless of whether the dividends are paid from your personal or family company as part of a profit extraction strategy, or whether they represent investment income on shares. As part of the Government’s health and social care plan, the rates at which dividends are taxed are to increase by 1.25% from 6 April 2022.

Dividends have already suffered corporation tax

Dividends can only be paid out of retained profits. This means that if you want to pay a dividend from your personal or family company, you can only do so if you have sufficient retained profits from which to pay. ‘Retained profits’ are post-tax profits which have not yet been paid out. Consequently, they have already suffered corporation tax. The rate of corporation tax is currently 19%, but is due to increase from 1 April 2023 where the company’s profits are more than £50,000.

Dividends covered by the dividend allowance are tax-free

All taxpayers, regardless of the rate at which they pay tax, are entitled to a dividend allowance. This is available in addition to the personal allowance, and, unlike the personal allowance, is not abated once income reaches £100,000.

Although termed a dividend ‘allowance’, it is not an allowance as such; rather it is a nil rate band. Dividends that are covered by the dividend allowance are taxed at zero rate. However, they count as part of band earnings. The dividend allowance is set at £2,000 for 2021/22.

Dividends are treated as the top slice of income

Dividends are taxable to the extent that they are not sheltered by the dividend allowance or, if not fully used elsewhere, the personal allowance. In determining the appropriate rate of tax, dividends are treated as the top slice of income.

Dividend tax rates are lower than income tax rates

Dividends have their own tax rates. These are lower than the usual rates of income tax. However, as noted above, dividends are paid from profits which have already suffered corporation tax.

Dividends are taxed at the dividend ordinary rate to the extent that they fall within the basic rate band. This is set at 7.5% for 2021/22. It is to increase to 8.75% from 6 April 2022.

Dividends are taxed at the dividend upper rate to the extent that they fall in the higher rate band. This is set at 32.5% for 2021/22. It is to increase to 33.75% from 6 April 2022.

Dividends are taxed at the dividend additional rate to the extent that they fall in the additional rate band. This is set at 38.1% for 2021/22. It will increase to 39.35% from 6 April 2022.

During the Covid-19 pandemic, the advice was ‘work from home if you can’. As a result, millions of employees found themselves working at home, often at very short notice. Many still have not returned to the workplace, and homeworking (whether fully or flexibly) is here to stay.

Employees will generally incur additional costs as a result of working from home. They will use more electricity to run their computer and light their workspace and may use more gas as a result of having the heating on during the day.

While for many years there has been a statutory exemption that allows employers to meet or contribute towards the additional costs of working from home, in recognition of the homeworking requirements imposed by the pandemic, employees who do not receive homeworking payments from their employer are able to claim tax relief for the extra household costs that they have incurred while working from home.

Exemption for costs met by the employer

Employers can pay employees a homeworking allowance of £6 per week (£26 per month) tax-free, and without the employee having to demonstrate that they have actually incurred additional household costs of at least this amount as a result of working from home. The tax-free amount is the same, regardless of whether the employee is required to work from home full-time or one day a week. Consequently, the payments can be made to employees who work flexibly, working from home part of the time and at the employer’s workplace part of the time.

Where the employee’s actual additional household costs as a result of working from home are more than £6 per week, the employer can meet the actual costs tax-free, as long as the employee is able to provide evidence in support of the actual additional costs.

Tax relief for employees

Employees who have been required to work from home can claim tax relief for the additional costs of doing so where these are not met by the employer. HMRC will accept claims of £6 per week/£26 per month without needing evidence of the actual additional costs. Where these are higher, the higher amount can be claimed, as long as this can be substantiated.

HMRC are now accepting claims for 2021/22. Claims can be made online at www.tax.service.gov.uk/claim-tax-relief-expenses/only-claiming-working-from-home-tax-relief?_ga=2.193253997.1398232652.1624373729-980780301.1612354164.

Relief is given for the full tax year, even if the employee returns to the workplace before 5 April 2022. Employees who were entitled to the relief for 2020/21 can also claim for that year if they have not yet done so.

Where an employee is required to complete a self-assessment tax return, the claim can be made on the return. A claim of £6 per week (£312 for the year) will save a basic rate taxpayer £62.40 in tax and a higher rate taxpayer £124.80 in tax.

It is not uncommon to realise a loss in the early years of a trade. However, traders who commenced their self-employment in 2019 or 2020 may also have suffered as a result of the pandemic. Although the Self-Employment Income Support Scheme (SEISS) provided help for traders who also suffered from the impact of the pandemic, those who started trading in 2019/20 were unable to benefit from the first three grants (qualifying only for grants 4 and 5 if they had filed their 2019/20 tax return by 2 March 2021 and met the other eligibility criteria). Traders who started a business in 2020/21 are not able to benefit from the SEISS.

However, they may be able to claim loss relief under the early trade losses relief rules, and generate a tax repayment in the process.

Nature of the relief

The relief for losses in the early years of the trade allows a trader who makes a trading loss in any of the first four years of a new trade to carry that loss back against taxable income of the previous three years. The loss is set against the income of the earliest year first.

Accruals basis not cash basis

Relief for the loss under these rules is only available where the accounts are prepared on the accruals basis. Thus, if losses in the early years are likely, it is worth considering preparing accounts using the accruals basis to open up a claim to relief. This relief is not available where accounts are prepared under the cash basis –  where this is the case, the loss can be carried back against any previous trading profits of the same trade, should they exist, or carried forward and set against future profits of the same trade.

Case study

Polly was employed as a beautician earning £25,000 a year prior to setting up her own beauty business on 1 June 2020. Her business was badly affected by the pandemic, and in the 10 months to 5 April 2021, she makes a loss of £10,000. This is a loss for the 2020/21 tax year.

She can carry the loss in her first year back against her income of 2017/18, 2018/19 and 2019/20, setting the loss against her income for 2017/18 first.

She carries the loss back to 2017/18, setting it against her employment income for that year of £25,000, reducing her taxable income to £15,000 in the process. Carrying the loss back generates a tax repayment of £2,000 (£10,000 @ 20%).

Personal allowances may be lost

It should be noted that the loss carried back cannot be tailored to preserve personal allowances, which may be lost as a result.

For personal and family companies, a tax efficient strategy for extracting profits is to take a small salary and to extract any further funds needed outside the company in the form of dividends. However, while there are no restrictions on taking a salary if the company is making a loss, the same is not true of dividends.

Need for retained profits

Dividends can only be paid out of retained profits (i.e. profits left in the business after corporation tax has been paid).

However, if a company make a loss for a particular year, this does not necessarily preclude the payment of a dividend, as long as the company had retained profits at the start of the year, and the loss has not completely eliminated those profits.

Example

Andrew runs a personal company A Ltd. He prepares accounts to 31 July each year. At 1 August 2020, he had retained profits of £20,000. He expects to make a loss for the year to 31 July 2021 of £5,000. He will have retained profits available after taking account of the predicted loss of £15,000 from which to pay dividends.

Plan ahead

If a company needs funds outside the business and is unsure regards to future profitability, it may be worthwhile taking dividends while there are retained profits available.

Using the figures in the above example, assuming that Andrew has cash available, he may wish to extract all his retained profits as a dividend while he can to benefit from the more favourable tax treatment of dividends. If he makes further losses, his remaining profits may be eliminated, removing the option of taking a dividend.

The dividend will be tax-free to the extent to which it is covered by the dividend allowance (set at £2,000 for 2021/22) and any unused personal allowance. Thereafter, dividends (treated as the top slice of income) are taxed at 7.5% to the extent to which they fall in the basic rate band, at 32.5% to the extent to which they fall in the higher rate band and at 38.1% if they fall in the additional rate band. There is no National Insurance on dividends.

It is prudent to prepare management accounts to show that the company had retained profits at the time at which the dividend was paid, in case of a challenge by HMRC.

No retained profits

In the absence of retained profits, it is not possible to pay a dividend; any payment made that is classed as a dividend, will be made illegally and may be challenged by HMRC and reclassified as a salary or bonus payment, and taxed accordingly. However, if the company is loss making, but funds are need to meet personal liabilities, it is possible to pay a higher salary or a bonus, even where this increases the amount of the loss. The salary or bonus payment, and any associated employer’s National Insurance, can be deducted in working out the taxable loss, which may be carried back to generate a repayment of corporation tax.

If you operate through a limited company, for example as a personal or family company, you will need to extract funds from your company in order to use them to meet your personal bills. There are various ways of doing this. However, a popular and tax efficient strategy is to take a small salary which is at least equal to the lower earnings limit (set at £6,240 or 2021/22) to ensure that the year is a qualifying year for state pension and contributory benefits purposes, and to extract further profits as dividends.

However, this strategy requires the company to have sufficient retained profits from which to pay a dividend. If the company has been adversely affected by the Covid-19 pandemic, it may have used up any reserves that it had. As dividends must be paid from retained profits, if there are none, it is not possible to pay a dividend.

Are there other options for extracting funds to meet living expenses?

1. Pay additional salary or bonus

Unlike a dividend, a salary or bonus can be paid even if doing so creates a loss – it does not have to be paid from profits. However, this will not be tax efficient once the salary exceeds the optimal level due to the National Insurance hit and the higher income tax rates applicable to salary payments.

• Take a director’s loan

If it is expected that the company will return to profitability, taking a director’s loan can be an attractive option. Depending when in the accounting period a loan is taken, a director can benefit from a loan of up to £10,000 for up to 21 months free of tax and National Insurance. If the company has returned to profitability within nine months of the year end, a dividend can be declared to clear the loan in time to prevent a section 455 tax charge from arising. If the account is overdrawn at the corporation tax due date nine months and one day after the year end, a section 455 tax charge of 32.5% of the outstanding amount must be paid by the company (although this will be repaid after the corporation tax due date for the accounting period in which the loan balance is cleared).

• Put personal bills through the director’s loan account

Another option is for the company to pay the bills on the director’s behalf and to charge them to the director’s loan account. Again, if the company has sufficient profits to clear the outstanding balance within nine months of the year end, a dividend can be declared to prevent a section 455 tax charge from arising. A benefit in kind tax charge (and a Class 1A National Insurance liability on the company) will also arise if the outstanding balance is more than £10,000 at any point in the tax year.

• Provide benefits in kind

Use can be made of various tax exemptions, such as those for trivial benefits and mobile phones, to provide certain benefits in kind in a tax-free fashion.

• Pay rent

If the company is run from the director’s home, the company can pay rent to the director for the office space. This should be at a commercial rate, and the director will pay tax on the rental income. However, there is no National Insurance to worry about and the rent can be deducted in computing the company’s profits, even if this creates a loss.

As a bonus, if the extraction policy creates a loss, it may be possible to carry the loss back to generate a much-needed tax repayment.

Special rules apply to company directors when it comes to calculating their Class 1 National Insurance liabilities.

Why the rules

Directors, particularly of personal and family companies, can control how and when they are paid and, in the absence of special rules, would be able to reduce their Class 1 National Insurance liability by manipulating the earnings period rules. The rules circumvent this.

Annual earnings period

Company directors have an annual earnings period for National Insurance regardless of their actual pay frequency. This means that if they do not opt to apply the alternative arrangements, their National Insurance liability is calculated cumulatively by reference to the annual thresholds.

For 2021/22 these are as follows:

	Annual threshold
Lower earnings limit	£6,240
Primary threshold	£9,568
Upper earnings limit	£50,270

Example

A director is paid £8,000 a month. In month 1, he pays no National Insurance as his earnings are below the annual primary threshold of £9,568.

In month 2, his earnings for the year to date are £16,000. By applying the annual thresholds, his total liability on his earnings to date of £16,000 is £771.84 (12% (£16,000 – £9,568)). As he paid no National Insurance in month, his liability for month 2 is £771.84.

For months 3 to 6 inclusive, his earnings for the year to date fall between £9,568 and £50,270. Consequently, he pays employee’s National Insurance at 12% on his earnings for the month of £8,000, equal to £960 each month.

In month 7, his earnings for the year to date are £56,000 (7 months @ £8,000 a month), on which total contribution of £4,998.84 (12% (£50,270- £9,568)) + 2% (£56,000 – £50,270)) are due. He has already paid £4,611.84 (£771.84 + (4 x £960)), leaving £387 due for the month.

As his earnings for the year have now exceeded the upper earnings limit, he will pay National Insurance at the rate of 2% of all future payments – a liability of £160 per month.

Applying the annual earnings period rules means that the contribution liability falls unevenly throughout the year. The liability for the year is £5,798.60 ((12% (£50,270 – £9,568) + ((2% (£96,000 – £50,270))).

Alternative arrangements

As seen in the example above, calculating the liability by reference to the annual thresholds on a cumulative basis each time the director is paid means that their pay is uneven throughout the year. To overcome this, the director can opt for their National Insurance to be calculated throughout the year on their earnings for each earnings period using the relevant thresholds for the earnings period, as for employees who are not directors, with an annual recalculation on an annual basis at the end of the year.

If this basis is adopted, the director in the above example would pay National Insurance of £483.26 (12% (£4,189 – £797)) + (2% (£8,000 – £4,189))) each month for months 1 to 11, with a final payment of £482.74 in month 12.

Over the course of the year, the annual liability (£5,798.60) is the same which-ever method is used, but collected differently.

Directors can choose the method that suits them best.

Employers who provided taxable expenses and benefits to employees during the 2020/21 tax year will need to report these to HMRC, on form P11D by 6 July 2021, unless the benefit or expense has been payrolled or is included within a PAYE Settlement Agreement. Benefits covered by an exemption do not need to be included.

Where taxable benefits have been provided, the employer must also file a P11D(b) by 6 July 2021. This is the employer’s declaration that all required P11Ds have been filed and also the statutory Class 1A amount.

Exempt benefit

The tax legislation contains a number of exemptions which remove a charge to tax. These may be specific to a particular benefit, such as those for mobile phones and workplace parking, or may be more general, such as the exemption for paid and reimbursed expenses, which applies if the employee would have been entitled to a tax deduction had they met the expense directly.

There are also a number of temporary Covid-19 specific exemptions that apply for the 2020/21 tax year. These include the provision or reimbursement of Covid-19 antigen tests and reimbursed homeworking equipment (such as a computer) to enable the employee to work at home during the pandemic if the equipment would be exempt if made available by the employer.

Remember, exemptions are only available if the associated conditions are met. However, care must be taken here where provision is made under a salary sacrifice arrangement and the alternative valuation rules apply as this may negate the exemption.

Taxable amount

The amount on which the employee is taxed is usually the cash equivalent value. This is calculated in accordance with the benefit-specific rules where these exists, as is the case for company cars, vans, living accommodation and employment-related loans. Where there is not a benefit-specific rule, the cash equivalent is determined in accordance with the general rule. This is the cost to the employer, less any amount made good by the employee. Amounts made good are only deducted where the employee makes good by 6 July 2021.

If the benefit is provided under an optional remuneration arrangement (OpRA), such as a salary sacrifice arrangement, the alternative valuation rules are used to calculate the taxable amount, unless the benefit is one which is specifically excluded from the ambit of those rules (such as childcare vouchers, pension provision and advice, employer-provided cycles and low-emission cars (l75g/km or less) or within the transitional rules for 2020/21. Under the alternative rules, the taxable amount is the salary foregone or cash alternative offered where this is more than the cash equivalent value.

HMRC produce worksheets which can be used to calculate the taxable amount for some benefits. These can be found on the Gov.uk website.

Reporting options

There are various options for filing P11Ds and P11D(b):

• using a payroll software package;
• using HMRC’s Online End of Year Expenses and Benefits Service;
• using HMRC’s PAYE Online Service; or
• filing paper forms.

Whichever method is used, the forms must be filed by 6 July 2021. Employees must be given a copy of their P11D or details of their taxable benefits by the same date.

Any associated employer-only Class 1A National Insurance must be paid by 22 July 2021 if paid electronically, or by 19 July 2021 if paid by cheque.

To help the hospitality and leisure industry recover from the impact of the first national lockdown, a reduced rate of VAT of 5% was introduced for a limited period from 15 July 2020. The reduced rate of VAT was originally to apply until 12 January 2021. However, in September last year, the Chancellor announced that it would remain at 5% until 30 March 2021.

By the time of the Spring 2021 Budget on 3 March 2021, the hospitality and leisure sectors were suffering the effects of further lockdowns. To provide more help to this sector, the period for which the reduced the temporary 5% rate of VAT will apply has been further extended until 30 September 2021. From 1 October 2021, a new reduced rate of VAT of 12.5% will apply until 31 March 2022. The rate will revert to the standard rate of 20% from 1 April 2022.

Affected supplies

The following supplies will benefit from the reduced rate of 5% until 30 September 2021 and the new reduced rate of 12.5% from 1 October 2021 to 31 March 2022.

1. Food and non-alcoholic beverages sold for on-premises consumption, for example, in restaurants, cafes and pubs.
2. Hot takeaway food and hot takeaway non-alcoholic beverages.
3. Sleeping accommodation in hotels or similar establishments, holiday accommodation, pitch fees for caravans and tents, and associated facilities.
4. Admission to cultural attractions that do not already benefit from the cultural VAT exemption, such as theatres, circuses, fairs, amusement parks, concerts, museums, zoos, cinemas, exhibitions and other similar cultural events and facilities.

Where an admission to an attraction is within the existing cultural VAT exemption, this takes precedence over the reduced rate.

To help meet some of the costs incurred in dealing with the Covid-19 pandemic, the Chancellor announced in his 2021 Budget that a number of allowances and thresholds will remain at their 2021/22 levels until 6 April 2026. Those affected are outlined below.

Personal allowance

The personal allowance was increased to £12,570 for 2021/22, up from £12,500 for 2020/21. It will remain at this level for the following four tax years, up to and including 2025/26.

The personal allowance is reduced by £1 for every £2 by which adjusted net income exceeds £100,000. For these tax years, individuals with adjusted net income in excess of £125,140 will not receive a personal allowance.

Income tax bands

The basic rate band was increased to £37,700 for 2021/22, from £37,500 the previous year. It will remain at this level for tax years up to and including 2025/26.

With a personal allowance of £12,570, the point at which an individual in receipt of the basic personal allowance starts to pay higher rate tax is set at £50,270 until April 2026.

National Insurance threshold

The upper earnings limit for Class 1 National Insurance purposes and the upper profits limit for Class 4 National Insurance purposes are aligned with the point at which higher rate tax is payable. Both are set at £50,270 for 2021/22 and will remain at this level for the following four tax years, up to and including 2025/26.

Other National Insurance thresholds and limits will be reviewed at the appropriate time.

Capital gains tax annual exempt amount

The capital gains tax annual exempt amount remains at its 2020/21 level of £12,300 for 2021/22. It will stay at this level for subsequent tax years up to and including 2025/26.

Inheritance nil rate bands

The inheritance tax nil rate band has been set at £325,000 since 2008/09 and was due for review in 2021. However, it will remain at this level for 2021/22 and subsequent tax years, up to and including 2025/26.

The residence nil rate band (RNRB), which is available where a main residence is left to a direct descendant, remains at its 2020/21 level of £175,000 for 2021/22 and the following four tax years. Where the estate is valued at £2 million or more, the RNRB is reduced by £1 for every £2 by which the value of the estate exceeds £2 million. It is not available where the value of the estate is £2.35 million or above.

Pension lifetime allowance

The pension lifetime allowance limits the amount of tax-relieved pension savings that an individual can build up. The lifetime allowance remains at ££1,073,100 for 2021/22 and for the next four tax years.

Impact of freezing allowances and thresholds

By freezing allowances and thresholds, the tax take will rise and incomes and assets rise with inflation. More people will pay tax and more people will pay tax at higher rates as a result, and more estates will be liable for inheritance tax.

It may be prudent to plan ahead. For example, review the value of the pensions fund before making any further tax-relieved contributions – where the value of the fund exceeds the lifetime allowance, a tax charge is levied on the excess, at 25% where the excess is taken as a pension and at 55% where it is taken as a lump sum.

A popular profit extraction strategy for shareholders in personal and family companies is to pay a small salary and to extract further profits as dividends. The optimal salary will depend on whether the employment allowance is available to shelter any employer’s National Insurance liability that may arise.

Preserving pension entitlement

One of the main advantages of paying a small salary is to ensure that the year remains a qualifying year for state pension and contributory benefit purposes. To qualify for a full state pension on retirement, an individual needs 35 qualifying years.

For the year to be a qualifying year, earnings must be at least equal to the lower earnings limit. A director has an annual earnings limit, and for 2021/22, the annual lower earnings limit is set at £6,240. Where the shareholder is not a director, earnings for each earnings period must be at least equal to the lower earnings limit. For 2021/22, the weekly and monthly thresholds are, respectively, £120 and £520.

Contributions are payable by the employee at a notional zero rate on earnings between the lower earnings limit and the primary thresholds. The employee starts paying contributions once earnings exceed the primary threshold.

Optimal salary – Employment allowance is not available

The employment allowance is not available to companies where the sole employee is also a director. This means that personal companies will generally be unable to claim the allowance.

For 2021/22, the primary threshold is set at £9,558 (£184 per week/£797 per month) and the secondary threshold is set at £8,840 (£170 per week, £737 per month).

Although the maximum salary that can be paid without paying any National Insurance is one equal to the secondary threshold of £8,840 for 2021/22, it is beneficial to pay a higher salary equal to the primary threshold of £9,568. Employer’s National Insurance will be payable on the salary to the extent that it exceeds £8,840 at a cost of £100.46 (13.8% (£9,568 – £8,840)), however, this is outweighed by the corporation tax deduction at 19% on the additional salary and the employer’s NIC.

Once the primary threshold is reached, employee contributions are payable at 12%. At this point, the combined National Insurance cost of 25.8% (13.8% + 12%) is more than the corporation tax saving and paying a salary in excess of the primary threshold is not worthwhile.

Thus, where the employment allowance is not available, the optimal salary is equal to the primary threshold for 2021/22 of £9,568 (£184 per week, £797 per month).

Optimal salary – Employment allowance is available

In a family company scenario, the employment allowance will be available if there is more than one employee on the payroll. As long as the employment allowance is available to shelter the employer’s National Insurance that would otherwise arise, the optimal salary is one equal to the personal allowance, set at £12,570 for 2021/22. No National Insurance is payable until the primary threshold is reached. Above this level, employee National Insurance is payable at the rate of 12%. However, the additional salary saves corporation tax at 19%. However, once the personal allowance has been used, tax at 20% is payable as well as employee’s National Insurance of 12%, which exceed the corporation tax deduction of 19%.

Thus, where the employment allowance is available, the optimal salary for 2021/22 is one equal to the personal allowance of £12,570 (£242 per week, £1,048 per month).