Most owner managed businesses are usually caught in a dilemma of trying to maximise directors’ rewards and minimise tax exposure at the same time. One question that comes to mind is which option is better, to reward the directors with dividends or bonuses? Generally, the cost benefit approach seems to be a logical way around such a predicament. However, a cost benefit analysis infused with a bit of tax planning can prove to be actually a smarter route. Today’s article seeks to unpack how businesses can better structure directors’ rewards in a tax friendly manner or in other words, through tax planning. As a tax firm, we intend to demystify the technical jargon applicable to the issue at hand and enhance your understanding of tax matters.
In simple terms, tax planning relates to the arrangement of one’s tax affairs in a way that legally minimises tax liability. However, for someone to legally arrange their tax affairs, they first need to have an understanding of the tax legislation and its provisions. Accordingly, in order for a business to properly structure a tax efficient remuneration system for its directors, it needs to understand the tax implications surrounding various elements of that system. In the tax sphere, the decision to either pay dividends or a bonus usually rests on the option that provides a tax saving or a lesser tax liability than the other. Let us briefly have a look at the tax effects of these two below.
Dividends vs Bonus
A dividend is basically a distribution made to shareholders from a company’s retained earnings (i.e., from after-tax reserves, where tax is applicable). Dividends are declared and paid when a company makes profits and is subject to the availability of funds to keep the company solvent after the dividend declaration. Technically, this entails that a dividend is paid out of money that would have suffered corporate income tax, currently at 22%. In terms of the Income Tax Act, the dividend paid is further subjected to withholding tax at 10%, after 1 July 2021. Now, let us look at this closely, 1st the money will suffer corporate tax at 22% to obtain a profit after tax, then another 10% tax on dividends. Ultimately, the effective tax rate on directors who withdraw dividends is 29.8%.
On the other hand, a bonus payment to a director constitutes part of the remuneration which is subject to payroll tax i.e. PAYE. The tax laws do not prescribe any restrictions or limitations on bonus payments. This actually means that directors can be rewarded or can reward themselves with a much higher bonus that will be subjected to PAYE rates. Currently, the highest PAYE bracket is 25% but the effective tax rate for high income earners is around 23%, after the exempt portion and staggered tax rates.
Based on the above, it is prudent to state that directors who are rewarded with bonuses pay less tax than those who are paid dividends. As stated above, a dividend earner parts with tax of 29.8% whilst a bonus earner pays tax of around 23%. Assuming a tax base of P10m, the bonus earner makes tax savings of around P 680 000, compared to the dividend earner. Numbers don’t lie!!
Before we conclude, we need to state that this works well for directors who work for their own companies and may not be ideal for directors of big corporations which are not owner-managed. Further, directors may simply need to withdraw a high enough salary so as to enjoy the above-mentioned tax benefit. Lastly, it is critical to have the arrangements covered by a legal document such as an employment contract between the director and their company, for completeness.
The team at Tax Fountain, your go-to Tax Consultants hopes that you found this article useful and should you require further assistance or to join our free tax WhatsApp group, please contact us using the following details: firstname.lastname@example.org or 311 6269/+267 760 910 79.