Money is one of the most powerful motivators of human beings. It has caused conflicts, separated homes, driven average people to phenomenal action and even pushed phenomenal people into desperate decisions.
This was the state of contracting at one point in the UK. Across the board, contracting companies were exploiting legal loopholes to reduce their tax payments and drive their profit margins up. Unwittingly, as companies drove their own liability down, they pushed that of their employees up and it became a matter of chance and time until they were caught by the system.
Personal Service Companies
Personal Services Companies or Ltd. Companies had been the most attractive option all along. Signing up for a Ltd. Company makes the owning contractor a company director. This gives him full control of the use of company revenue and also allows for a number of tax claims that are fully legal. Ltd companies typically show the income earned through contract as business income take advantage of the NI free dividend payments that was typically enjoyed only by the businesses owners.
In fact, personal Service Companies are more tax efficient than umbrella companies, however far more legal documentation is required. This wide spread, continued disguising of employment income, eventually resulted in the IR 35 which forced the creation of umbrella companies.
Institution of the IR35
The IR35 is a tax legislation that was implemented in 1999 to allow the government to properly tax “disguised employees”. The term “disguised employees” refers to contractors who would use an intermediary company, to “receive” payment from their clients, without a direct transfer of money.
Since contractors were using the companies they owned to pay themselves, their income would not be subject to taxes. This is because the profit that the company produced- not the revenue was what was liable to taxation at the time.
Eventually the HMRC (Her Majesty’s Revenue and Customs) and treasuries realized they were being cheated and thus, the IR35 was born.
Once the IR35 legislation was put in place, it became difficult for contractors to claim the tax benefits that a normal small business would. The government would issue “tests” to determine whether contractors qualified or not.
As a result, umbrella companies were born. These companies would work through recruitment agencies to hire contractors on their behalf. This arrangement allowed contractors to use the umbrella companies as their “home” offices and thus claim travel expenses, overnight expenses etc. from the office to the location of their clients, provided you are not under direct supervision, direction and control of your end client.
Managed Service Companies
This type of company is a yet another that was brought about by the IR35. It places 5 to 8 individual contractors as shareholders in a Ltd. Company. The typical approach, is for these contractors to receive the lowest salary possible, while receiving the remaining payments as dividends.
This arrangement was rather popular until new legislation was implemented in 2008 that directly challenged the use of Managed Service Companies to avoid taxation.
The Current State of Affairs
At present, PAYE umbrella companies remain the best way to go about contracting in the UK. Limited companies take second place since they allow for certain tax exemptions. With the introduction of the new law putting the onus of “IR35” employment status determination on public sector employers, ltd companies are going to play lesser role in the contracting market going forward. But some companies may be operating one of the schemes in disguise.
What do you think? Are you a contractor in the UK at the moment? Leave your Comments and Advice Below so that newer contractors will benefit.