What exactly is the April 2007 managed service company legislation which will affect freelancers and contractors?
April 2007 saw the most significant tax changes for contractors since the introduction of IR35 seven years previously. Many contractors had skirted around IR35 by using certain managed service companies. Since 6th April 2007, HMRC has simply taxed and deducted National Insurance Contributions from employees in MSCs.
Contractors genuinely in business on their own account and operating through a limited company have nothing to fear. Contractors using reputable umbrella services, with IR35 insurance and operating PAYE are also safe. Anyone using a composite company or any other MSC merely as an intermediary needs to take professional advice immediately.
What is IR35?
IR35 is designed to deal with “disguised employment” whereby people worked as self-employed – and got all the tax advantages – but were in reality employed. Basically the government decided contractors and freelancers were trying to avoid tax while doing similar work to those permanent employees.
IR35 tax legislation was announced in 1999 (and IR35 itself was merely the name of the press release that explained the changes that would take effect in April 2000).
The government believed people were merely taking advantage of a corporate structure and were avoiding tax and National Insurance Contributions (NICs) by using intermediaries such as personal service companies or partnerships. IR35 has targeted circumstances where a worker would be treated as an employee of the client, if it were not for the existence of the intermediary.
Through these intermediary companies people would be paid a small basic salary and all other monies paid in dividends that incurred far less tax and NI. Where this structure was a limited company, the worker was able to take money out in the form of dividends instead of salary. Dividends are not liable to NIC so workers would pay less than either a conventional employee or a self- employed person.
From April 2007 the loophole that allowed personal service companies and composite companies to act as “intermediaries,” to avoid tax and NIC was closed. The IR35 rule says that if an intermediary was used and the relationship between the worker and their client would normally have been direct employment the worker should pay tax like any other employee. The only way now to gain the tax benefits will be to demonstrate that you are genuinely self-employed (and thus stay outside IR35).
Who is affected by the changes of April 2007?
IR35 affects all freelance contractors – anyone who contracts their own services to a client and acts like an employee of that company and who uses a service company and people working for umbrella companies (although umbrella companies are still legal, but see separate article for complexities).
All contractors need to consider IR35, and whether they are in or outside it. Legitimate freelancers or consultants who are genuinely self-employed, or operate properly through a limited company will be outside IR35. It is the contractors’ responsibility to determine their tax status and IR35 legislation affect all contractors who do not meet the HMRC definition of self- employment. Being caught inside IR35 depends on a number of factors and is determined by the contractors working relationship with the agency and the client and the contracts involved (see below).
What exactly are the IR35 rules?
You have to be genuinely self employed to be exempt from IR35. You will NOT meet the legal definition of self-employment as a general rule if you only have one current contract (i.e. you do not have multiple contacts at the same time), you travel to the same workplace each day, you are paid by the hour or day, you work under the jurisdiction of the client and have no right of substitution (i.e. you cannot send someone in your place to do your work if you cannot go). If you do not meet the self-employment definition you will be “inside” IR35 and that means you will have to pay tax and NI contributions like a normal employee.
How do I stay outside IR35?
You have to be able to prove you are genuinely self-employed. The key to this is the contract. You should ensure you are engaged under a ‘contract for services’, although this alone is not enough. You also need to show that the relationship between yourself and your client would have been one of self-employment if you had been working for them directly (for example with no recruiting company involved).
To show self-employment, for example, perhaps you do not do the work directly yourself and have the right to send someone else, or you can do the work in your own time and/or wherever you choose and you can decide how you do the work as long as it is completed in accordance with the contract.
The above criteria are the main pointers towards genuine self-employment. But other factors can indicate self-employment, but not on their own. For example maybe work performed is specified in the contract and the client has no right to direct you to do other work.
Other minor indicators include signing the visitor’s book and having to obtain a visitor pass. Or being a guest or always giving advice as an independent consultation. But it is possible to be outside IR35 for one job and inside it for the next. By signing the form that says you are outside IR35 it is your responsibility to ensure your relationship with future clients also meets the self-employment test.
What is a managed service company?
A managed service company (MSC) is, generally speaking, a corporate structure through which temporary workers provide labour services. MSCs proliferated after the government announced IR35 legislation in 1999. IR35 legislation aimed to remove the tax advantages of contractors working for companies but claiming to be self employed, but all that happened was various schemes such as umbrella and composite companies sprung up to outsmart the government’s attempt to bring contractors into line and pay more tax. Contactors continued to disguise their employment (with the end client, the recipient of their services) with incorporation (by forming their own limited company through which to trade), and thus cut their tax and National Insurance bills.
HMRC believes that workers in MSCs are not generally in business on their own account, but rather are in “employment” with the end client. Thus it sees contractors gaining the tax benefits of being self employed but not actually being self employed.
In December 2006, the Chancellor announced a plan to tackle these schemes and what it calls “non-compliance by a large number of operatives in the temporary worker industry”.
What is a composite company?
Composite companies, which were generally set up after 1999 to get around IR35 legislation, originally offered contractors a hassle free alternative to running a personal service company. Composite companies meant that contractors could get the tax advantages of being self-employed, by using the composite as an intermediary. Every composite structure had a MSC provider and a number of companies beneath it. Composite companies work with a number of contractors and handle the administration and management of the companies beneath it.
The scheme provider (usually the MSC) sets up the composite company (with shareholders made up of several, often unknown and unrelated contractors) and manages the bank account and tax etc. Most of the income is given in dividends (with no NIC) to pay.
From April 2007 the loophole that allowed personal service companies and composite companies to act as “intermediaries”, to avoid tax and NIC was closed. The IR35 rule says that if an intermediary was used and the relationship between the worker and their client would normally have been direct employment the worker should pay tax like any other employee. The only way now to gain the tax benefits will be to demonstrate that you are genuinely self-employed (and thus stay outside IR35).
What should I do if I use a composite or management service company?
There are about 200,000 individuals working through composite companies in the UK, most of which are operated by dedicated service providers. Composite companies generally have a number of contractors who use the same company to invoice through. Over the years many contractors have joined composite companies to provide them with administrative services. The composite company invoices and receives payment for work carried out by the contractor, and then pays a small salary and expenses to the contractor with the remaining payments made via dividends.
Since 6th April 2007 contractors using a composite company have been required to pay tax as if they were directly employed. So if you do use one, be aware that the HMRC has specialist offices to specifically investigate them and you will almost certainly face a full investigation.
There are two real choices for most contractors; either use an umbrella company, (but the new legislations will also stop the ability to claim high levels of expenses through umbrella companies), or set up a limited company. It is important to take professional advice before making any decision.
What is section 660A?
Section 660A refers to income arising for the partner or spouse of somebody who runs their own business. That income is treated as income for the person running the business and not for the partner or spouse. Often it is the husband who is doing all the work and earning the money but instead of being taxed fully, the spouse’s allowances are used to cut the tax bill.
Does section 660A apply to everyone?
Section 660A, also applies to any company owned by close family members where the objective of shareholdings is tax avoidance and it affects many family businesses. If any family member holds more than 5% equity everyone becomes subject to S660A.
Why does section 660A affect IR35?
The legislation goes back around 70 years and depends on situations where income arises for one person but is allocated to another – known as “settlement”. But it your contract falls within IR35 and all income is paid as salary you will not be affected. The legislation only applies to income allocations to non-fee earners that would not be possible within an IR35 contract.
What about husband and wife personal service companies?
These are treated as a special case by HMRC. Known as Section 660A, it applies to any company owned by close family members where the objective of shareholdings is tax avoidance and it affects many family businesses.
IR35 rules mean that HMRC can claim back taxes and NIC going back up to seven years. In particular inspectors will look at companies that have been trading and have been paying a non-working or lower tax paying spouse when the sole fee earner is paying a higher rate of tax.
What are the advantages and disadvantages of forming a Limited Company?
By forming a limited company you will be in control and there will be no third party administrator to deal with. You will be company director, operate the company bank account and be responsible for running the business. It is the most tax efficient way of working, so you will keep more of what you earn. You will be able to claim a wide range of expenses, from accountancy fees to equipment etc. You will be able to claim VAT back on a wide range of expenditure.
Furthermore as a limited company you will have protection from liabilities for your company debt. So if it became insolvent you, as a director, would not be liable unless it could be proven you acted fraudulently or improperly under company law.
On the downside, there will be more paperwork, as you will have to comply with company law requirements to file accounts and returns to Companies House and various other requirements. However you can appoint Duport as company secretary to take away some of that burden.
What is the quickest way to form a Limited Company?
You can buy a “ready made” company from Duport. As the name implies these companies are ready to go. The name and the Articles of Association can be simply modified. Changes will be notified of names, directors, company secretary, and registered office to Companies House. Duport has direct links with Companies House and you can download the correct forms on our website or contact www.companieshouse.gov.uk
Alternatively you can incorporate your own company. Again because of our links with Companies House this can be done in a couple of hours. It is advisable to contact an accountant and get advice about your specific requirements.
What should I do if I want to form a Limited Company now?
You can read more about limited companies on the Duport website. We have researched a wide range of subjects to help you and your business. You can also search for a company name here and apply online. Alternatively talk to our knowledgeable staff who can guide you through the process.
What are the legal requirements for a Limited Company and are there any special considerations for freelancers or contractors?
Limited companies need at least one director and a registered office. You must use Ltd or Limited. You no longer need to have a company secretary, although many companies find it useful to have someone in this role. Duport can provide a cost effective service for you if you do not have a suitable person to act as your company secretary.
You also need a registered office – an official address. This could be your home (but check with mortgage and lease restrictions), or again you can use Duport to provide one for you. Scottish companies must have their registered office in Scotland.
Other legal requirements include filing annual accounts and an annual return with Companies House and a tax return to HMRC. You must also register for VAT if your turnover exceeds a certain amount. See www.businesslink.gov.uk for more information.
Because directors are not strictly an employee unless they have a contract, many freelancers draw up a contract specifying duties, salaries etc, and because of the IR35 rules it would be advisable to use an employment specialist if in any doubt. Again, if you choose to become a limited company and want help with this Duport can put you in touch with the right people to help.
Would a Limited Liability Partnership (LLP) protect me from IR35?
No. It offers no protection against IR35 as all the usual conditions apply. However a partnership consisting of several contractors, formed under company law, would reduce National Insurance as it saves employers’ NIC and of course has greater flexibility in terms of expenses and what can be offset.
What are the advantages of working for an umbrella company?
An umbrella service is where you are essentially a PAYE employee of the umbrella. Your client or agent enters a contract with the umbrella for your services and you enter a contract with the umbrella. You send your timesheet and expense details; tax and IN are deducted before you receive your money from the umbrella company.
The advantages of using an umbrella company are mainly much reduced administration and paperwork. Some come with built in insurance cover (e.g. IR35 investigation). They might be suitable for a contractor who expects to use a particular agency for a long-term contract or perhaps a new contractor who is starting out and isn’t certain he or she wants to run a limited company.
What are the disadvantages of using an umbrella service?
This is the most expensive way of working in terms of tax and NI and you are reliant on the umbrella company to collect your money from the client or agent and then pay it on to you. Normally you will pay around £100 a month for an umbrella service. Also, new legislation will limit the financial benefits of using these companies. It used to be the case that freelancers could claim high levels of expenses through umbrella companies, but this benefit has gone. The new legislation stipulates that those working through umbrella companies need specific, accurate records for any expenses claimed. If you haven’t actually spent the money and have the receipts to prove it was wholly in connection with work, you simply will not be able to claim expenses.
Can using an umbrella company can protect me from IR35?
No, using an umbrella company will not protect you from IR35. IR35 status is determined by the contractors’ working relationship with the agency and the client and the contracts involved (see separate articles on self employed status and crucial contracts). Umbrella companies may suggest you can remove IR35, and indeed IR56 and S660A by working through them because you, the contractor are an employee and are paid PAYE. While it is true that IR35 does not apply to the umbrella company itself, it is still your working relationship with the agency or client and contracts involved that will determine IR35 status. Each contract should be reviewed in its own right and a decision made on its IR35 status.
If I want to use an umbrella company what questions should I ask?
Not only should you make sure you ask the following questions when enquiring about using an umbrella company, you should also take advice from a good accountant. The only umbrella companies you should even consider dealing with are those that are PAYE umbrella companies. Any type of composite umbrella or managed service company will be seen as a tax avoidance scheme and will be investigated by HMRC.
- what services do you provide?
- how will you examine my contracts to ensure legal issues are covered?
- how do you keep within the legal structure of IR35?
- how do you help maximise my take home pay?
- what expenses can I claim? (beware of companies offering reckless expenses. Expenses all have to be valid and backed up by original receipts and paperwork)
- what are the fees?
- are there any hidden charges for services?
- are there any leaving penalties?
- what is the system for submitting invoices, timesheets etc?
- how quickly will I be paid after submitting invoices?
- will any funds be withheld and why?
- what insurance cover do you offer?
- how effective is the insurance cover?
- how much does it cost?
- how transparent is your system?
- how can I monitor my money?
- who do I speak to when I have a query?
- how well qualified are the staff?
These questions are to be used as basic guidance and you will no doubt have more of your own.
Why don’t I just go PAYE?
It is true that some contractors have found the entire IR35 scheme such a headache that they have reverted to working through an employment agency and having their income PAYE. The agency pays NIC, holiday and sickness pay and manages all administration. But the contractor not only does not get any tax benefits available to limited companies and self-employed people, but also has to pay agency fees. Thus the contractor will receive less being paid via PAYE through an agency than by being self-employed and dealing with IR35.
What are the advantages and disadvantages of going PAYE?
The advantages are that it is simple and your employer does all the paperwork. However you will pay more tax as there is very little you can offset or claim as valid business expenses. Also the company you work for might not want to be responsible for another employee whom they then have to pay holiday pay, sick pay, pension payments etc.
Why not operate as a Sole Trader?
You could operate as self employed only if you find clients directly and do not use an agency. In theory you may find clients and agents that are prepared to engage you on this basis (and you fulfil the criteria for self employment above), but in practice clients and agents will not do this because if your tax status is challenged they become liable for any additional tax and NIC due. Why would they risk it? Furthermore the Income Tax (Earnings and Pensions) Act 2003 Section 44 effectively prevents individuals from being self-employed where an agency is involved as it obliges the agency to treat the clients as if they are employees i.e. deduct PAYE.
The HMRC website has useful information on IR35 and can also determine your IR35 status for you if you don’t want to use costly agencies. There is also a very detailed section on self-employment status. The Duport website provides a wide range of articles on setting up in business and has plenty of quality information and free downloads. As a responsible business Duport wants to be sure you make the right decisions. We can usually help, and if we can’t we can certainly put you in touch with people who can.
The vast majority of the agency freelancing market goes through Observe, Jobsite and Engineers on the Web websites.
Can I use an offshore company to protect me from IR35?
This will not work. It does not matter where your company is incorporated and offshore companies have to register with HMRC like anyone else. IR35 status is determined by the contractors working relationship with the agency and the client and the contracts involved.
Offshore companies have been used in the past by contractors to reduce tax liabilities but recent legislation means that all income generated in the UK by a UK resident is liable to taxation – whether the income is received or not. Such income has to be declared on a tax form and using an offshore fund makes no difference to either tax or IR35 position.
Why are contract details more crucial than ever?
Since the introduction of the IR35 rules contracts have never been more crucial for contractors and freelancers. Contracts outline what each party wants, needs and expects, but perhaps more importantly, they also form a legal framework to work within. Whether the contractor is using an agency or working directly with a client, a contract will provide a formal definition of business within a legal framework. Some contracts may fall inside IR35 and some outside. But because of IR35 confusion many clients insist on outsourcing contracts through agencies. Around 75% of contract work is now secured via agencies and many others use “preferred” clients.
What should I look out for in a contract?
Increasingly contracts from agents are seen as “good” if they fall outside IR35 and are on proper business terms and “bad” if they restrict your ability to look for work or place liability on you, or worse still, your family. These “bad” contracts in fact look more like contracts of employment than business contracts. And if you are going to have a contract of employment you might as well just work for the company and be paid PAYE. Of course companies don’t want that either!
It is vital to have a contract for services with your freelance business, whatever its status. This is not a contract of service or employment contract with you personally and it should include the specific clauses outlined below so that HMRC does not view you as being within IR35. The contract should outline the work being done and the relationship between the parties.
In particular there should be a substitution clause that allows the work to be performed by another person provided by your freelance business. Equally important is a clause that specifies that there is no “mutuality of obligation” between the parties. This simply means there is no obligation for you to work and for them to pay you – unlike an employee of a company. Make sure this is clear.
In addition there should be a clause stating that you will not be subject to supervision, direction or control as to the manner in which you fulfil the agreed services. As a professional you will use your own initiative as to the manner in which the services are delivered.
These clauses are crucially important if you don’t want HMRC eying you up for IR35. But they are just one part of a contract, and it is vital to pay equal attention to all the other clauses in the contract document. Each contract may be different, depending on the client, or you may work in such a way that you can modify your own draft contract accordingly.
What have the 2004 Finance Act and the Proceeds of Crime Act got to do with IR35 legislation?
The Finance Act brought into law the fact that advisors have to report any anomalies or risk fines or prosecution. Because of the Proceeds of Crime Act 2002 accountants and others must report any suspicions about clients and money laundering. If they do not they face criminal prosecution and possibly jail. Basically, tax evasion is a criminal act and is encompassed in the money laundering rules. What is more an accountant has to report you if they think you should be under IR35 (or should have been in the past) even if you disagree.
What is the position of recruitment agents with regards to the new legislation?
Recruitments agencies insist they should not be liable for outstanding tax owed to HMRC by contractors. They say this will cost them millions of pounds. The Association of Staffing Companies (Atsco) plans to protest against the rules to make a third party liable from April 6th, even though they are not responsible for the managed service schemes that many contractors sign. Atsco proposals include drawing up a list of recruitment firms which have carried out reasonable checks and therefore should not be held liable for unpaid taxes owned by contractors.
Should I put my rates up to compensate for all this hassle?
Contractors are expected to put up their rates because of the clampdown on managed service firms which will leave them worse off. A new poll by accountancy firm JSA shows that nearly two thirds of British contractors are seeking a pay rise of 10% this year, while a third expects 15% extra to compensate for the changes.
Are there any more changes that affect contractors?
Self employed consultants and freelance contractors need to keep up with the latest changes in legislation. New company laws, (which update the Companies Act 1985) came into force in January 2007 and mean that companies now have to include their place or registration, registered number and registered office address on all emails, faxes and websites. Previously this information was only needed on letters and order forms, but the new law rules have brought electronic communications into line with other paperwork.
This particularly affects contractors and freelancers – especially limited company contractors and freelancers who work on behalf of client companies. These individuals must make it clear on all emails on whose behalf the email is being sent otherwise risk fines. It would be prudent for contractors to have different email footers with the correct information for each of their different clients. Client companies will assume that self-employed contractors are complying with all current and future regulations.
Where can I get more help?
The Professional Contractors Group (now IPSE) is a great place to start. PCG originally started to lobby against IR35, but now provides advice and reassurance to protect contract workers. Members include professional freelancers, contractors and consultants from many sectors including IT, engineering, oil and gas, management, financial, accountancy, telecommunications and marketing.
Membership starts from £120 (plus VAT) per year and includes tax investigation insurance, draft contracts vetted by experts, pre-created standard contracts to tailor to your needs, guidance on IR35 and S660A, ongoing consultations and a tax and legal helpline.
