Fears as tax credits are reduced: Christine Stopp looks at the changes in dividends

SHAREHOLDERS, anyone investing in a pension, charities and the whole stock market are all feeling the effects of an apparently technical change in company taxation.

But the change in advance corporation tax (ACT) means that tax credits attached to net payments on share dividends are being cut from 25 to 20 per cent.

A dividend payment on shares is made in the form of cash plus a tax credit. Under the pre-Budget system, the tax credit was for 25 per cent of the gross amount. So if the gross dividend being paid was 10p, the investor would receive 7.5p per share plus a tax credit of 2.5p.

The Budget announced reductions in the tax credit to 20 per cent. At the same time, the rate of tax on dividends for basic-rate taxpayers will also be reduced to 20 per cent.

The table shows how this will work in practice for investors paying tax at different rates.

Under the new system the net dividend will remain the same, but since the tax credit is lower, the gross dividend (a notional figure for the company's and the investor's tax purposes) is also lower - 7.5p is 80 per cent of the new gross figure of 9.375p.

Because the tax credit and the tax rate will be the same, the basic-rate taxpayer will still get the same after-tax income.

The higher-rate taxpayer, still paying 40 per cent of a reduced gross dividend, will end up with a smaller net payment.

Given the small amounts involved, only very large personal shareholders will be affected by the change, but there are fears that its implications may have a disproportionate effect on markets.

The measure, said Hilary Cook, senior analyst at Barclays Stockbrokers, has reduced the attractions of high-income shares for higher-rate taxpayers and funds such as pension funds, which are tax-free. Pension funds in particular are very big buyers of such shares, and have enough muscle to affect the health of the market.

Gilts will now look more attractive to these investors because of their relatively higher yields and the fact that they are not affected by ACT.

The experts are finding it very hard to gauge the importance of the changes. It will depend, says Jeremy Alford of gilts specialists Whittingdale, on the importance of income. Pension funds are finding they need to invest more and more for income, because pensioners are becoming a greater proportion of their members. They are having to pay out more pensions while having relatively fewer contributors to help cash flow.

Some think that companies will respond by increasing net dividends in order to maintain gross dividends, but this seems unlikely. Many companies are already pushing themselves to maintain dividends, Mr Alford says, and an increase could be crippling. Hilary Cook added: 'Such an increase would be like an employer saying 'tax rates have gone up so we'll pay you more' '.

Given the current level of uncertainty it would not be advisable for investors to sell equities and buy gilts just on fears generated by the ACT changes. Because of the changes companies will have to pay out less in tax credits, which is estimated to improve their cash flow by pounds 2bn in the next year.

This, said Richard Larner of stockbrokers Waters Lunniss, might mean a bit of extra profit, which in turn could lead to an increase in dividends. For the private investor, he feels that the changes will have 'no great impact'. Institutions do not invest solely for income purposes, and there should be a lot of gilt issues this year, maybe resulting in an oversupply that will depress prices.

In the context of interest rates - which could fall further during the year - equities still look attractive, he added.

----------------------------------------------------------------- DIVIDEND TAX CHANGES ----------------------------------------------------------------- How the investor is affected ----------------------------------------------------------------- Basic rate Old system New system Gross div 10p 9.375p Net div 7.5p 7.5p Tax credit 2.5p 1.875p* To pay - - Net receipt 7.5p 7.5p Higher rate Old system New system Gross div 10p 9.375p Net div 7.5p 7.5p Tax credit 2.5p 1.875p* To pay 1.5p 1.875p* Net receipt 6p 5.625p * 20% x 9.375p. -----------------------------------------------------------------

(Photograph omitted)