Readers Question: I have a trading company with a high level of retained earnings. Rather than liquidate, I am thinking of taking £500k in dividends (grossed up to £555k) and then making a donation to the charity of say £500k (adjustable for tax efficiency), which would extend my basic rate band by £625k. Am I correct in thinking that this combination of dividend and charitable donation is a tax efficient way of charitable giving, in the sense that I would avoid the higher rate dividend taxes?
Expert Answer: The expert was Keith Tully of RBR Advisory, specialising in turnaround and restructuring solutions for businesses experiencing financial distress.
Charitable payments made by an individual under the Gift Aid provisions are fully tax deductible and basic rate relief is given at source. If you pay Income Tax at the higher rate or additional rate, you’ll be able to claim relief based on the ‘grossed-up’ amount of your gifts.
With a basic rate of Income Tax of 20%, gifts are grossed-up by multiplying the amount you give by 100 divided by 80 (100/80). Higher Rate and Additional Rate Relief is given by increasing your basic rate band and higher rate band by the grossed-up amount of your gifts. In most cases, if you pay tax at the higher or additional rates (40% or 45%); your relief will be equal to the difference between basic rate and either 40% or 45%.
If eligible for Gift Aid, making a donation of £500,000 can be grossed up to £625,000. If you are paying Additional Rate tax, you are able to reclaim £156,250 (£625,000*(45%-20%)). However, the above calculations are only valid when you are paying income tax at 20%, 40% or 45%.
When including dividend income into the mix, this is slightly complicated. Until 5 April 2016, the tax credits that were attached to dividends could be used to discharge an individual donor’s requirement to account for basic rate tax deducted from gift aid payments, even though the dividend tax credit was only 10%.
From 6 April 2016, dividends no longer carry a tax credit. As the donor, you must have paid enough tax to cover the 20% credit that a charity claims under Gift Aid. If you do not pay enough tax, but you sign the gift aid declaration and fail to withdraw it, HMRC will ask you to pay the additional tax.
For example, if a taxpayer receives £500,000 in dividend income and makes gift aid donations of £320,000 net (grossed up the donation of £400,000), the actual tax withheld on the gift aid donation would be £80,000 (20% of £400,000). This means that for 2016/17, you must have paid at least £80,000 in tax which is substantially more than the actual tax liability on the total income of £100,000 (as reduced by the gift aid donation).
In conclusion, dividends in the basic rate are taxed at 7.5%, but the charity will claim 20% which gives you 20% tax relief. So effectively, you will be receiving too much tax relief as you are receiving 20% relief (as a result of their donation), but you’re only paying 7.5% tax. This is known as the “gift aid tax trap”.
Tax relief can be claimed by completing the charitable giving section on the annual self-assessment tax return or asking HMRC to amend the tax code which is used to calculate how much tax-free income you are entitled to.