Wealth Management Focus – What does this April’s dividend change hold for EIS investments?

During last summer’s Budget, the Chancellor announced that dividend tax rates would rise by what amounts to an effective 7.5 percentage point increase for each of the three tax bands for the 2016/17 tax year. The impact on SME owners has been dramatic, to the extent that the government estimates that it will receive an additional £2.5 billion in tax on dividends for the current 2015/16 tax year, as a lot of entrepreneurs are expected to take cash out of their businesses ahead of 6 April 2016.

The reasons for this increase in the dividend take are entirely rational. The 7.5 percentage point increase will ensure that Higher Rate Taxpayers (those who earn between £32,000 and £150,000) will now pay tax at 32.5% whilst Additional Rate Taxpayers (those who earn above £150,000) will face a rate of 38.1%.

The sharp rise is leading to a surge in early payments from higher earners who currently retain more income by paying themselves via dividends than from wages.

This is a significant change and will have a big impact on SME owners. Business owners with cash reserves from retained profits have every reason to take money out of the business ahead of the looming rise in dividend taxation.

The table below summarises four such scenarios for an Additional Rate Taxpayer:

Amount to Take-Out from Business Tax Saving by Early Dividend

£1,000,000 £75,000

£750,000 £56,250

£500,000 £37,500

£250,000 £18,750

For individual investors in this position, there are a number of important investment choices to make to accommodate this additional income supplement for 2015/16. Assuming that this incremental income does not get spent in its entirety, it would be anticipated that the first ports of call for the tax-efficient investor would be ISA and pension products. Shareholdings of up to £15,240 can be put into an ISA wrapper this year, which will help protect dividends and capital growth from taxation. Putting money into pensions is also usually recommended but significant changes to pensions mean that many affluent investors can either no longer contribute to personal pensions in a tax-efficient way or can only contribute amounts as small as £10,000 per annum.

Given that many investors have significantly more than £25,000 to invest in a tax-efficient way, the additional forthcoming savings from the new dividend rules will likely gravitate more and more towards Enterprise Investment Scheme (EIS) investments. A £100,000 investment in an EIS fund allows for income tax relief of £30,000 from HMRC and the ability to defer any Capital Gains Tax of up to £28,000 for an indefinite period of time. Moreover, in the unlikely event that all of the constituents of the EIS portfolio lost all of their value, the investor would receive Loss Relief from HMRC totalling £31,500 meaning that the total net exposure of the investor is only £38,500 (not including the £28,000 in capital gains that is being deferred). In the event that the EIS portfolio remains valued at exactly the same level over a five-year time horizon, the investor is effectively 30% better off over that time period due to the income tax relief. Furthermore, any gain in the value of the portfolio is entirely free of income tax, capital gains tax or inheritance tax after a period of time.

Clearly, the best of all worlds involves a situation where the investor escapes the sharp rise in dividend tax payments and invests in an EIS fund that excels in stock picking to provide a number of successful investments over a five-year period.