The abolition of tax credits on dividends from 6 April 2016 has had some potentially serious consequences for donors whose income is largely made up of dividends as well as for charities receiving gift aid.
This has been referred to as the “gift aid tax trap” and it affects, from 6 April 2016, individuals who make gift aid donations and whose income predominantly comprises of dividend income. Whilst on the one hand this could be interpreted as unintentionally penalising the donors, on the other hand the change appears to be a logical consequence of what, in fact, has been a fiction of the tax credit since the abolition of the advance corporation tax.
The problem has arisen because of the way that relief on gift aid payments is given. Basic rate relief on such payments is given at source while the relief at the higher rate or additional rate is based on the grossed up amount of the gifts (grossed up at 20%). Higher rate and additional rate relief is then given by increasing the basic rate band and the higher rate band of the donor by the grossed up amount of the gift. The relief is not given against any particular type of income although, obviously, if the result is that the individual is no longer a higher rate taxpayer (by virtue of their basic rate band having been increased by their gift aid donation), then effectively they will pay tax at the basic rate. Where their income originates predominantly from dividends, the basic dividend rate is only 7.5%. This assumes the dividend income exceeds the £5,000 annual dividend allowance where it is received tax free. It should be noted that the dividend allowance is due to reduce to £2,000 from 6 April 2018.
It can be seen from the above that there is a mismatch between the tax relief on gift aid being given at 20% and potentially no tax or tax at only 7.5% having been paid by the individual donor on their dividend income. Clearly there will be a problem if most of the individual’s income originates from dividends so that the individual in question has not actually paid enough income tax to cover the 20% tax credit.
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%. Since from 6 April 2016 dividends no longer carry a tax credit, the donors must have paid enough tax to cover the 20% credit that a charity claims under the gift aid. If the donor has not paid enough tax but signs the gift aid declaration and does not withdraw it, HMRC will ask them to pay the additional tax.
So, for example, if a taxpayer receives £500,000 in dividends and makes gift aid donations of £320,000 net (grossed up donation of £400,000), the actual tax withheld on the gift aid donation would be £80,000 (ie. 20% of £400,000).
This means that for 2016/17 the taxpayer must have paid at least £80,000 in tax which clearly would be substantially more than their actual tax liability on their total income of £100,000 (as reduced by the gift aid donation).
It would have been possible to carry back any gift aid payments to the previous tax year as long as it was done by 31st January 2017. If the individual doesn’t want to pay the extra tax, they would need to withdraw any gift aid declaration, which of course would mean that the charity receives so much less.
The gift aid declaration forms published in October 2015 by HMRC include a very clear statement and an explanation confirming that the donor needs to pay the same amount or more of tax (UK income tax and/or capital gains tax) as charities will claim on the donor’s gifts in any specific tax year. It also explains that the donor is responsible for any difference. Clearly while gift aid is an excellent way of reducing a taxpayer’s tax liability and possibly the tax rate on their other income, this potential “trap” needs to be borne in mind.