From April 2016 the government will abolish the dividend tax credit and replace it with a new tax-free dividend allowance of £5,000 a year for all taxpayers.

Increasingly the government is identifying abuse of the current dividend scheme and hence the decision to reform current rules which were introduced in the 1970s when corporation tax rates were more than 50% and individual tax liability was as high as 80%.

Now the system is frequently used as a useful tax planning tool by company owners, consultants and intermediaries.

‘The dividend tax system was designed partly to offset double taxation on profits. But the system has not changed despite sharp reductions in corporation tax. Lower rates are creating rapidly growing opportunities for tax planning,’ warned the Chancellor in his Budget speech.

The reform of dividend taxation will not affect the current regime of tax reliefs for investments held in ISAs and pensions.

The Chancellor also said that long-term ambition to further reduce corporation tax [CT] rates would be hampered without a review of dividend taxation.

George Osborne said: We can’t take it [CT] lower than that while such strong incentives are created for people to self-incorporate and pay the lower rates of tax due on dividends.’

The changes will benefit small shareholders, but 15% of shareholders will be hit by the changes.

New dividend tax rates will be set at 7.5% for basic rate taxpayers, 32.5% for higher rate taxpayers and 38.1% for additional rate taxpayers.

While these rates remain below the main rates of income tax, those who receive significant dividend income – for example due to very large shareholdings (typically more than £140,000) or as a result of receiving significant dividends through a closed company – will pay more.

The government hopes that ‘these changes will also start to reduce the incentive to incorporate and remunerate through dividends rather than through wages to reduce tax liabilities'.

Small business owners with incorporated companies will often pay themselves a combination of dividends and salary so they could be hard hit by the changes to the tax position on dividends.

Bivek Sharma, head of small business accounting at KPMG, said: ‘This measure could be a blow for those thousands of small business owners paying themselves considerable amounts in dividends.

‘For example, if an owner makes £55,000 a year of which £30,000 is salary and £25,000 is dividend, the increase in tax under the new measure will be just over £1,600.'

‘This will reduce the cost to the Exchequer of future tax motivated incorporation (TMI) by £500m a year from 2019-20. The tax system will continue to encourage entrepreneurship and investment, including through lower rates of corporation tax.’

The changes to dividends tax will raise £2.54bn in the first year of operation in 2016-17, although the government envisages that the benefits of the tax changes to the Exchequer will be negative in year two, settling down at around £2bn a year by 2019-20.

Over the course of the parliament the dividend tax take is set to raise a total of £6.78bn in additional revenue.

Commenting on the changes to the taxation of dividends, Alex Henderson, tax partner at PwC, said: ‘There are going to be some big losers as a result of this change. Entrepreneurs who pay out dividends in companies they own will see their tax rate increase by nearly 20% to 38.1% which is on top of the 20% paid by the company.

‘It remains to be seen what effect this tax rise will have on enterprise. One consequence is that it becomes relatively more attractive for entrepreneurs to sell up their business and retire as it could reduce their tax rate by between 10 and 18%.’

While the Chancellor stressed that changes to dividend taxation were required to limit abuse, this will put pressure on small business owners who traditionally use dividends to mitigate their tax liability.