Advance Corporation Tax (ACT) Details

Before 1973, Her Majesty's Revenue and Customs (HMRC), the body that collects taxes in the UK, taxed shareholders' dividends similarly to income. This meant that tax-paying and non-tax-paying individuals were liable to pay income tax upon receiving dividend payouts from their affiliated companies.

In 1973, HMRC introduced ACT, a tax law that directed companies with permanent residences in the UK to deduct taxes on dividends before paying their shareholders. This tax was a prepayment on the dividends, but companies still had to pay other corporate taxes from profits. That is why the UK government called it 'advance corporation tax.'

HMRC introduced the ACT for two reasons: to ensure companies pay taxes and remove the tax burden from shareholders. A shareholder who was a non-taxpayer had their dividend taxed, but they had a right to claim a refund for the deducted payment. Non-tax payers are individuals exempted from paying taxes.

Advanced Corporation Tax (ACT) Example

Let's assume the shareholders' dividends for company X have accumulated to £1,000,000. Before the company releases the payments to the shareholders, the advance corporation tax dictates it to withhold 22.5 % of the payout as a corporate tax. Therefore, the ACT for that year will be £225,000.

Non-tax paying individuals were entitled to a refund claim for the tax deducted in the ACT. Let's say Company X had 100 shareholders, and among them, 10 were non-taxpayers. How much money will HMRC give back to the company or the ten individuals as an ACT refund?

In this case, for one hundred shareholders, the company withholds £225,000. So ten shareholders represent approximately £22,500. Therefore, HMRC will refund £22,500 out of the £225,000 taxed on the dividends.

History of Advanced Corporation Tax (ACT)

In 1973, the government introduced a prepaid tax charge on company dividends. This tax was to be deducted from the dividends before the company wired payments to the shareholders. In addition, shareholders received tax credits for the amount deducted by the advance corporation tax.

Non-taxable shareholders also received a refund for the ACT amount withheld, but the government abolished this refund in 1997. HMRC claimed pension funds and other refunds ought to be re-invested in the company instead of giving individuals the refund. The UK treasury came to the conclusion that these refunds were negatively affecting the country's economy.

After operating for over 25 years, the UK government scrapped ACT, replacing it with tax credits on dividends for a 10% income tax rate. HMRC later ditched the income tax credit in 2016. Today, shareholders enjoy tax-free dividends with grants worth £5,000.

Significance of Advance Corporation Tax (ACT)

Before the UK government established the advance corporation tax in 1973, it taxed companies based on their profits. In addition, the shareholders of that company had to pay an individual income tax for the dividends received annually. This taxation elicited divergent views from taxpayers who saw it as double taxation.

When the UK government introduced ACT, two factors influenced the initiative. The system whereby companies paid corporate taxes based on profits had loopholes. Some companies could conceal their actual profits and evade paying the right amount of taxes. ACT solved this problem by holding companies accountable.

Another reason for the establishment of ACT was to shift the tax-paying burden from company shareholders to the company. Before creating this taxation system, shareholders bore the company's burden by filing individual income tax calculated on the dividend. This was a burden for shareholders who also needed to file income tax on their other income sources.