When a company makes profit you need to pay corporation tax. After paying corporation tax the remaining of the profit if the director wants can withdraw as dividend. Dividends are paid to an individual out of the company’s remaining profits after Corporation Tax is paid, it can be said that tax has effectively already been paid on dividends. For this reason a dividend carries a national tax credit. Whenever a dividend is paid there is a national tax credit equal to (1/9) of the amount actually received.
For illustration purposes, when a dividend of £90 is paid, the notional tax credit is £10 (£90 x 1/9). The person is treated as if they have received a dividend of £100 (£90 + £10) but with a tax credit of £10 deducted at source.
The deemed dividend of £100 (£90 x 10 /9) which includes the tax credit of £10 (£90 x 1/9) is referred to as the ‘gross dividend’. The £90 paid is referred to as the ‘net dividend’. When it comes to totaling up the individual’s total taxable income the deemed ‘gross’ dividend is counted. The amount of dividend income which an individual can be paid tax free is therefore 9/10th of the remaining unused amount of their basic rate tax band.
Thus the maximum amount of tax free dividends which a director may receive in 2013/14 (if they had no other income) is actually only £37,305 (£41,450 x 9 /10) (and not £41,450 which is a common misconception). One of the most tax efficient ways to operate as a shareholder of a limited company is therefore to draw a director’s salary of £7,696 (no Employer’s or Employee’s NIC due) and extract dividends of £30,378 (£41,450 – £7,696 = £33,754 x 9 / 10). This ensures you extract £38,074 (£7,696 as tax free salary and £30,378 as tax free dividends) which is the maximum tax free amount for the 2013/14 tax year.