IR35 rules (named after the Inland Revenue press release), introduced with effect from 6 April 1999 have been some of the most controversial and most litigated of recent years. During the 1990s many professionals, particularly in the emerging IT market but also other areas of consultancy, began to incorporate their micro-businesses rather than work as employees. Implemented due to the desire of large organisations to be able to utilise more flexible labour without the associated costs (such as holiday pay or employer National Insurance) but also a realisation by contractors that opportunities existed to significantly minimise their tax liabilities. Typically these companies would pay their owner (and Director) a minimal salary at the NIC threshold (to ensure an up-to-date NIC account) then draw the remainder as dividends, thus paying a maximum effective tax rate of 25% and no National Insurance.
There was no real change with the work or terms and conditions for many contractors and in some cases the only change was that on a Friday they had been an employee and on a Monday began working through their own personal service company. The Inland Revenue became concerned at the situation and introduced the IR35 provisions to counter what they saw as “disguised employment”, meaning that the contractor would have remained an employee taxable directly under PAYE if it had not been for the introduction of the company.
Whenever an individual provides their services to another through the vehicle of a Limited Company or a partnership (including a Limited Liability Partnership) the IR35 test applies. The test requires that both the contractual relationship and the actual terms and conditions in place between the parties are examined to determine whether or not employment would have existed where it not for the personal service company. Many of the tests are therefore similar to those used to determine the correct employment status of an individual worker.
Many contractors will use an agency to source work and there will often be contracts in place between the agency and the personal service company (the “lower” contract) and the agency and the end client (the “upper” contract). These can often be contradictory and contractors must ensure that they have sight of both contracts to ensure compliance.
If a contract is caught by the IR35 provisions then the special rules dictate that PAYE and NICs must be applied (retrospectively if need be) regardless of any dividends that may have been made. The business must calculate PAYE on the total income received under the contract less a flat 5% deduction for running costs, any pension contributions made, any expenses allowable for tax relief purposes, any capital allowances claimable, and any amounts already subject to PAYE. An example of the “deemed payment calculation” follows:
Income received £ 75,000
Less : 5% flat rate deduction £ 3,750 -
Less : pension contributions £ 5,000 -
Less : allowable expenses £ 2,000 -
Less : capital allowances £ 350 -
DEEMED PAYMENT £ 63,900
Comprising Employer Class 1 NICs £ 7,748
AMOUNT SUBJECT TO PAYE & EMPLOYEE NICs £ 56,152
Guidance and opinion on what contracts may or may not be caught be IR35 is constantly evolving thanks to appeals, Special Commissioners and Tax Tribunal decisions, and Court of Appeal decisions, including a major ruling at Tribunal in January 2011 in favour of the contractor and against HMRC which will affect the application of IR35 to many skilled professionals. This is a complex area where advice from experts is invaluable. Our team includes former HMRC Inspectors who have previously made IR35 challenges and are now well-placed to help you defend an attempt to deem a contract as “caught” and can also assist at the planning stage by drafting contracts, reviewing terms and conditions, working relationships, and other relevant factors to help you avoid the costly pitfalls and problems in this area.
In the 2011 Budget the Chancellor announced that IR35 would not be suspended or scrapped but that it would be “better administered” by HMRC. IR35 will now be handled only by dedicated and specially trained teams, which should lead to increased clarity through a more consistent approach. Compliance activity surrounding IR35 would in future be restricted to “high risk” cases. Whilst as yet we have no definition of what “high risk” means, it is probable that this will be limited to organisations using a large number of contractors, contractors earning larger sums of money, cases where a fellow contractor at the same organisation has been deemed as caught by the rules and where an Employment Tribunal has awarded employee status and rights to a worker.
Managed Service Companies
Many contractors were either unable to or did not wish, to deal with the day-to-day requirements of running their own companies. These included not just statutory matters but also record-keeping, invoicing, preparation of accounts and the like together with obtaining the necessary advice to ensure compliance with IR35.
Managed Service Companies (“MSCs”) are companies have been widely marketed to the contracting community and use a variety of means to minimise the effective tax rate paid by the contractor. An MSC is typically where the contractor will be a shareholder in the company but will not be the Director and will not control the running of the company. This will typically be undertaken by the person or organisation setting up the company, known as a “provider”.
In 2006 HMRC introduced special rules to counter the use of these companies, as they have been concerned for some time at the operation of these companies, both at the means used to minimise the effective tax rate and that, where an arrangement was deemed to have “failed”, there was no effective means of collecting any tax found to be due.
The Managed Service Company rules attempt to define an MSC in law and, where a company is caught by these rules, it must operate PAYE and NICs on all monies in a similar manner to the IR35 “deemed payment” calculation. Accompanying these rules, however, was legislation allowing any tax debts of an MSC which were irrecoverable from the company to be transferred to another relevant party. Typically these would be the Directors of the MSC, the provider, the contractor, or the end user client. Many MSCs, however, are ultimately operated offshore outside of the jurisdiction of HMRC and so the contractor or the end user client are most likely to be targeted for payment of tax.
WMT do not offer Managed Service Company solutions to our clients. But we have expertise in assisting clients in identifying an MSC to ensure that they are aware of any and all risks before entering into business with such organisations, ensuring that businesses do not place themselves in a situation of risk that tax debts could be transferred to them. We also offer advice and alternative solutions to contractors thinking of using a tax-mitigation solution which could, in fact, lead to enquiries from HMRC.
To discuss any of this information further, please contact Peter Davies on 01727 838 255.
