The Finance Act 1997 abolished the payment of dividend tax credits to pension funds.
This decision led to the loss of about £5bn annually from such funds, causing much public disquiet. In order to address the shortfall in their pension funds, many employers switched from defined benefit (final salary) schemes to the less attractive defined contribution (money purchase) schemes.
But what is the dividend tax credit, and why did the above tax change have such a significant effect on pension funds? This article will attempt to answer these questions.
It all began in July 1997. Notes accompanying the Budget Statement informed us that: "[p]ayment of tax credits will be abolished for pension schemes and UK companies (other than charitable companies) on dividends paid on or after [Budget Day]."
Some background. A company is charged to corporation tax on its profits, as adjusted for tax. Dividends are paid out of taxable profits. Where dividends are paid to individuals who are liable to income tax, there is likelihood of a double tax charge arising: first, the corporation tax payable on the distributed profits, and then, any income tax payable by the shareholders for the dividends received. To address this, the legislation provides for a dividend tax credit of 1/9 of the dividend, to be imputed to the shareholder. The result is that the shareholder is treated as having paid income tax of 10 per cent on the dividend received. This notional payment is deemed to satisfy the income tax liability for a basic rate taxpayer. As the dividend higher rate is 32.5 per cent, higher rate taxpayers must pay a further 22.5 per cent on any dividends received. This gives an effective rate, for higher rate taxpayers, of 25 per cent.
But what about shareholders who are outside the charge to income tax, such as charities and pension funds? The imputation of 1/9 of a dividend received would be of no use to them, as they wouldn't have been liable to pay income tax, anyway. Different rules therefore applied to payments to such exempt bodies. Instead of deeming them to have paid a notional 10 per cent tax, as is the case with individual shareholders, the law permitted such shareholders instead to claim an actual payment of the tax credit.
Following Budget 1997, things changed. With effect from Budget Day, pension funds were no longer entitled to collect the tax credit on any dividends paid to them. Two main reasons were given for this. One was that because of the availability of the tax credits, many companies were disinclined to reinvest their profits, choosing instead to pay them out as dividends. The second was that many pension funds were in surplus at the time, with some employers even taking pension holidays, so abolishing the payment of the tax credit wouldn't, it was assumed, cause much hardship. At that time, the amount of tax credit estimated to be collected by pension funds was £5bn per year. Abolishing the tax credit therefore created a shortfall of around that amount on a yearly basis.
So how did employers react to the fact that their pension funds were no longer as healthy as they once were? Many of them started looking again at the pension arrangements they had made with their employees. Suddenly, final salary schemes no longer seemed such a good idea. With pension funds no longer doing so well, employers were no longer comfortable with guaranteeing pensions to employees at a percentage of their final salaries. What if, when the employee came to retire, there wasn't enough money in the pot to meet their obligations?
To avoid this situation, many employers switched to money purchase schemes. Here, there was no guarantee of a defined amount of pension. Rather, the employee would be entitled to a pension of whatever the available funds in the pot could buy at the time of his retirement. Under this scheme, the risk lay, not with the employer, but with the employee. This was overwhelmingly judged to be the best way of dealing with the pensions shortfall. In 1997, 90 per cent of employers operated final salary schemes. By 2007, that has fallen to around 10 per cent. Some of the employers who still operate final salary schemes have had to increase their contributions to make up for the loss of the tax credit, and in many cases, employees have been required to do the same as well.
Comments (2)
With the advent of Internet purchasing by Jo Public from overseas suppliers, there is growing confusion over the duties and taxes that have to be paid on "imports" to the UK. For instance, importing second hand cars from the US has seen a large increase in the duty/tax payable recently. Also, I have the option of buying a particular new gas BBQ rig, from the US, for US$ 300 or purchase the identical model, in the UK, for UK£ 300. Can you advise where I can find out about the import duty/tax and how you pay it? Gordon B seems to have been stealthily active in this area of commerce recently.
Posted by Colin Baker | May 18, 2007 11:33 AM
Posted on May 18, 2007 11:33
Hi Colin, thank you for stopping by. I can look into this and give you a few pointers.
Kind regards,
The Editor.
Posted by The Editor | May 18, 2007 2:11 PM
Posted on May 18, 2007 14:11