The complexity of dividend taxation could be swept away under a ‘radical’ proposal to remove the current system of discounted rates and treat payments the same as income tax.
The proposal by the Office of Tax Simplification, an independent advisory body commissioned by the government, would likely hit wealthier, older savers and business owners by removing some of the discounts currently applied to dividends versus earned income.
But that may be justified by sweeping away incremental changes imposed in recent years which have made tax so complex that leading software packages can fail to correctly calculate liabilities, it said.
The OTS stressed that the proposal was considered to be an outlier and not a core recommendation.
Dividends held outside tax wrappers are currently subject to a tax-free allowance of £2,000. Above that, within the basic tax rate band dividends are taxed at 7.5%, in the higher rate band at 32.5% and in the additional rate band at 38.1%.
Those offer a substantial discount to income tax set at a basic rate of 20%, higher at 40% and additional at 45%.
The OTS noted: ‘The various savings and dividend rates, together with the PSA and dividend allowances, mean that the calculation for taxpayers whose income falls into a marginal category is sufficiently complex that HMRC’s software has sometimes computed the tax due incorrectly.
‘Few such taxpayers would be able to check their own calculation unaided. While the introduction of each of these rates and allowances made sense on their own, they have led to unintended consequences as well as greater complexity.’
In particular, widely-used software will commonly weight self-assessment equally against various sources of income, rather than weighting it against the maximum allowance for each to yield the highest tax exemption.
‘One way of tackling this could be to specify the order in which the allowance is to be deducted, for example in line with the order in which the components of income are taxed,’ it said.
‘A drawback is that this would increase the tax due in certain cases. A more radical option would be to end the differential tax rates for dividend income. If all taxable income was taxed at the same rates, it would not matter how the personal allowance was used.
‘Making this change would have the effect of increasing the amount of tax due from those who receive amounts of dividend income above the allowance. It would also impact on the taxation of profit extracted as a salary or as a dividend, from family-owned companies.’