PAYE vs. Dividends


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Hi all,

Can someone help me to understand this:

In the case of some individual contractors, I understand it is more tax efficient to set up as a Ltd Company and pay themselves up to the tax free allowance of £8105 (for 2012-13) via PAYE and the rest as dividends, instead of paying 100% PAYE or in fact being self-employed (whereby their taxable income is subject to the relevent income tax rate).

If I'm correct, at the basic rate tax limit, dividends do attract income tax of 10%, but for most shareholders this is normally offset by a tax credit of 10%. So the individual in effect doesn't pay income tax.

However in the case of consultant working under their own Ltd company, they (as the company) pays the tax credit and so still reduces their available remuneration by 10%). Higher earners attract a higher rate of income tax (32.5%) less 10% tax credit.

Dividends do not attract National Insurance (although you can make manual payments to HMRC) and therefore overall the contractor appears to save on tax.

But dividends do attract Corporation tax along with the rest of the company 'earnings' (profit), which in most cases is 20%.

As a contractor earning over the threshold, they would also have to register for VAT - I assume in this case, they charge VAT to their employer to offset any VAT they pay to HMRC.

Assuming the above is correct (please tell me if not), could someone give me some examples (using figures) to illustrate how paying yourself this way is more tax efficient than via PAYE and where people can feasibly fall foul of HMRC.

This is baffling me, so would appreciate any advice.

Many thanks

Adam
 

Becky

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Hi Adam,

Just one point re the above - the 10% tax credit on dividends is purely notional - it does not get paid to HMRC by the company. Therefore shareholders will only start to pay tax on dividends if they are higher rate tax payers. You are correct that dividends are not a tax deductible expense for the company, so the taxable profits will be subject to corporation tax before being distributed to shareholders.

If you are operating as a contractor, you need to be careful that the relationship between you and the client is not viewed as being similar to an employment relationship as it can lead to additional tax charges for you. This is quite a complex area and it's worth reading up on:

HM Revenue & Customs: IR35 - Countering Avoidance in the Provision of Personal Services
 
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Assuming you fall outside of IR35, which you need to be very careful with and you should seek professional advice on this point, paying yourself a salary of £7,488 or £624 a month and paying the rest in dividends is the most tax efficient way of paying yourself. This also ensures that you qualify for NI credits towards your state pension.

See here for more details: how much should I pay myself from limited company?

If you are a basic rate tax payer you will not pay any income tax on the dividends you receive from your limited company but corporation tax is paid on company profits. The tax here is a lot less than PAYE.
 

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