Few people enjoy thinking about taxes. But if you asked investors to pick the tax rules that baffle them most, dividend taxes would probably top the list. A thicket of notional rates, tax credits, effective rates, withholding taxes and other jargon, dividend taxes seem to be designed to be as incomprehensible as possible. Yet the upshot of most of these rules is simpler than it seems.
In the UK, dividend income is taxed at special dividend tax rates that are lower than normal income tax rates. Basic-rate taxpayers pay a 10% rate, higher-rate taxpayers pay 32.5% and top-rate taxpayers pay 37.5%. However, dividends come with a notional tax credit of 10%. This offsets some or all of the tax you’d otherwise pay on the dividend.
So the effective rate of tax (what you actually pay on the cash dividend you receive) is reduced to nothing for basic-rate taxpayers, 25% for higher-rate taxpayers and 30.56% for top-rate taxpayers.
Most people assume that the dividend tax credit means that 10% tax has been deducted from the dividend before it reaches you, and so even non-taxpayers have paid some tax on their dividends.
But while it’s common for tax to be deducted from dividends in other countries (this is known as a withholding tax), this is not the way of the UK system.
The tax credit doesn’t relate to any tax that’s been deducted from your dividend. In the past, there was a tax that companies paid based on the value of the dividends they distributed, called advance corporation tax (ACT). The rate of the tax credit was linked to the rate of ACT.
But ACT was abolished in 1999, partly because it encouraged companies to favour paying dividends over reinvesting profits. Since then, the tax credit has been an entirely notional concept – and one that causes a great deal of confusion.
The great Isa tax myth
This confusion tends to be at its greatest with individual savings accounts (Isas) and pensions. Many investors believe that dividends received in an Isa or pension are still taxed because of this tax credit.
That’s partly because you used to be able to reclaim the 10% tax credit within an Isa or pension. For pensions, this right was abolished in 1997, while for Isas it lasted until 2004.
However, since the tax credit no longer relates to any real tax payment, the fact that you can no longer reclaim it doesn’t mean that your dividends are being taxed.
Indeed, since you were able to reclaim the credit in an Isa for five years after the tax it was linked to – ACT – was abolished, the fact is that the tax credit reclaimhad ultimately evolved into a kind of perk rather than a rebate of any real tax paid. In practice, dividends received in Isas and pensions are still completely free of income tax.
Cross-border complications
Once we throw in dividends from foreign firms, things get a bit more complicated. Historically, these were not entitled to the tax credit. This was originally logical enough, since they had not paid any tax to the UK tax authorities, but became a bit unfair once ACT was eliminated.
But in 2008 the rules changed and dividends from most overseas firms became entitled to the tax credit as well. So the tax due on foreign dividends now works in the same way as for UK dividends.
However, since many foreign governments deduct withholding taxes from the dividend before it’s paid to you, this means that you could end up being taxed twice. For example, if the foreign government withholds 25% tax on dividends and you are a higher-rate taxpayer, you could end up losing half your dividend to tax.
To avoid this, you can offset some of the withholding tax deducted from your dividend against your UK tax liability. But this isn’t entirely straightforward.
The UK has a double taxation agreement with many other countries and these usually specify the maximum withholding tax that can be deducted from dividends paid to UK citizens. This is usually lower than the headline rate of withholding tax.
For example, if a country normally levies 25% withholding tax, UK citizens may be entitled to a reduced rate of 15%. Unfortunately, few countries allow your dividends to be paid at the reduced withholding tax rate. Instead, they’ll be taxed as normal and you need to reclaim the excess. Some countries make this process relatively easy, while some seem to go out of their way to dissuade investors from doing it.
Regrettably, whether you manage to reclaim the extra withholding tax or not, the amount that you can offset against your UK tax liability will be capped at the reduced rate specified in the double taxation agreement. So if it says 15% and the country normally withholds 25%, your maximum relief will be limited to 15%. That means that our higher-rate taxpayer will still lose 35% to tax unless they manage to reclaim the excess.
The rules for Reits
These rules only apply to dividends paid by conventional companies. The income distributed by real-estate investment trusts (Reits) is treated differently. Most of their payouts are classed as property income distributions (PIDs) and the way PIDs are taxed is more consistent with how most people assume dividends are taxed.
The PID is paid with 20% tax already deducted. This is a real deduction, not a notional tax credit. They are subject to tax at normal income tax rates. So for a basic-rate taxpayer, there is no further liability. Higher-rate taxpayers will owe a further 20% of the value of the PID (including the amount already deducted), while top-rate taxpayers owe 25%.
Unlike the notional tax credit, the PID deduction can be reclaimed by some investors. These include non-taxpayers and those who hold Reits in an Isa or pension. Your Isa or pension manager should do this for you automatically. Some are set up to get PIDs paid gross, while others reclaim the tax later.