Update – the below advice is relevant only for before the 2016/17 tax year – from 2016/17 there have been changes to how dividends are taxed.

One of the weirdest things to understand with dividends is that there is a difference between a “cash” dividend and a “gross” dividend.

From the Limited Companies point of view we are only interested in the cash dividend, i.e. how much cash is paid out of the company to the shareholder(s).

But from a personal tax point of view the cash dividend must be grossed up by dividing it by 0.9, and it is this gross dividend which is used to calculate whether any personal tax is due.

The difference between the two is because of a notional “dividend tax credit” which is a tax that never needs to be paid, it is just to deal with the differences between how a company is treated for dividends compared to personally. This 10% dividend tax credit was brought in to effectively compensate company owners for the fact that the dividends are paid out of profits after corporation tax i.e. the dividends are not a corporation tax deductible expense (unlike salaries which are a tax deductible expense). But to keep things simple just think that from a companies perspective you need to think “cash” and from a personal perspective you need to think “gross”.

From a personal point of view if your overall earnings are below the higher tax band (for the 14-15 tax year this is £41,865) is no income tax to pay on your dividends , but if you go into the higher tax band you will have to pay personal income tax on the element of dividend that goes into the higher tax band. This is an effective tax charge of 25% of the cash dividends you receive above the higher tax band – and even higher when you hit other tax trigger thresholds such as £50k (child benefit withdrawal), £100k (personal allowance withdrawal) and £150k (upper tax band).

As an illustration if someone received £20k of cash dividends from their company during a tax year, you would need to convert this to gross dividends by doing : 20,000 / 0.9 = 22,222.

This 22,222 is then added to any other income earned in the tax year and if overall you are below the higher tax band then there is no personal tax to pay.