Martin Hesketh is managing director of Brookson, one of the leading accountancy services and tax advice providers to contractors in the UK. In this special article for the DPA Newsletter, he explains the options for different ways of working that are available to contractors and how new 'Managed Service Company' legislation impacts upon them.
There are 1.6 million contractors in UK industry and it’s fair to say a large percentage of them are operating in engineering sectors. Over the last year or so there have been some significant changes in the legislation that governs how contractors work in the UK. As a result, many contracting engineers have been left confused about what the new rules mean to them and how they can remain working as a contractor without falling foul of the rules and potentially facing a hefty tax bill.
It is fair to say the 2007 Budget turned the contracting world on its head. The Government, in its understandable attempts to prevent significant abuse in the temporary worker industry, particularly in relation to teachers, nurses, drivers and cleaners, introduced legislation that has wide ranging implications for genuinely self-employed contractors working in engineering as well.
Why? Because for a number of years now, HMRC and the Government have been trying to ensure that only genuinely self-employed contractors who are in business on their own account were able to access the benefits of limited company working. Historically, IR35 was the key tax legislation measure designed to ‘clean-up’ the market and enable genuine contractors to work compliantly and benefit financially due to legitimate increases in net income.
However, the IR35 legislation made the job of widescale industry enforcement almost impossible, because it required any abuse to be proven on a case-by-case, assignment-by-assignment basis. And HMRC simply did not have the resources to make this approach work. This meant that the IR35 legislation remained ignored across large elements of the temporary worker and contractor industry, with many so-called service provider companies simply not operating compliantly.
It is fair to say there were cowboys out there. The market did need a shake up. However, it is also fair to say no-one expected the Government to go quite as far as it has!
In a nutshell the Government has confirmed that a genuinely self-employed individual can still operate their own limited company and access the benefits that this way of working provides. However, they must be very careful in choosing the service business they use to support this way of working.
The Government wants such individuals to take on more responsibility, understand these responsibilities properly and work a little harder to access the available benefits. Essentially, this has been achieved by removing the tax benefits available to genuinely self-employed contractors if they use a ‘Managed Service Company Provider’ (MSCP) to support their limited company and where that MSCP is “involved with” the contractor’s limited company (often referred to as a personal service company).
An MSCP is a company that promotes or facilitates the use of limited companies for the supply of the services of individuals. And an MSCP is “involved with” the contractor’s company essentially if it “influences” or controls any aspects of the limited company operation or finances. So, fundamentally, what does this mean for contractors and how they work going forward?
What this all translates to for the contractor is that, now the legislation has become effective, they still have four potential paths to follow but one of these paths has changed significantly. The four options are:
1 Agency payroll (PAYE)
2 Umbrella companies
3 Sole trader
4 Own limited company
The right option to choose will vary from individual contractor to individual contractor, dependent upon their personal and professional circumstances. And each contractor should take individual advice to understand which option is most appropriate for them, and the risks and responsibilities associated with each. That said, a key factor in determining the best way of working is whether the contractor is genuinely “in business on their own account” or not. Simplistically, if an individual is not in business on their own account, options one or two are likely to be the most appropriate. If an individual is in “business on their own account,” potentially option three or four will be the more appropriate option.
For option one, a full PAYE service will invariably be available via a recruitment agency for assignments placed through them. Effectively, the contractor is treated as employed, for tax purposes, and the agency will deduct income tax and national insurance on this basis. The agency will ensure the contractor has all the relevant insurances to enable the services to be supplied compliantly to the end client. The contractor simply turns up to perform the services.
Umbrella companies provide PAYE services for contractors and in specific circumstances allow for certain tax deductible business expenses to be claimed. The contractor is an employee of the service provider (the umbrella company) and the service provider should put the necessary insurances, employment contracts, and service contracts in place to enable the services to be provided. As with the first option, this option requires relatively minimal input from the contractor. Compliant providers of umbrella services have not been affected by the new legislation. However, it is important to note that some service providers in this sector are offering non-compliant tax relief on reimbursement of certain expenses and it is to be expected that HMRC will seek to stamp out this abuse.
For those contractors who are genuinely self-employed, two further options exist. One is to work on a sole trader basis and the other is to start and run their own limited company. Being a sole trader there is no corporate entity involved. All income and costs are seen as individual income and costs and taxed as such. There are fewer returns to submit each year as compared to running your own limited company.
Unlike contractors working through their own limited companies, sole traders cannot choose to receive dividends, potentially taxed at a low corporation tax rate. However, that said, the gap between income tax and small company corporation tax is narrowing - the latter being set to increase from 20% to 22% by 2008/2009.
Sole traders can claim income tax relief on a wide range of allowable business expenses, including travel and subsistence expenses. But they are not protected by limited liability, unlike working through a limited company, and therefore ultimately can be held personally financially liable in the event of something going wrong.
Finally, and an important point to note, most recruitment agencies are not prepared to engage contractors on a self-employed basis because of the risk of the individual not being genuinely self-employed and the agency being liable for underpaid PAYE and national insurance.
The final option, and again one only available to genuinely self-employed contractors, is to set up and run a limited company. As well as the increased risks and responsibilities there are some distinct advantages of operating a business in this way due to, for example, the choice of receiving dividends which are taxed at a low corporation tax rate. As with sole trader operations, a wide range of business expenses can potentially be reimbursed tax-free. Limited liability protection means that if things go wrong, directors and shareholders have the protection that they are not personally liable for the debts of the company providing they have been acting appropriately.
Running a limited company comes with significant responsibility and administration. For example, the director and company secretary are responsible for ensuring that the limited company meets its obligations and is run in accordance with the Companies Act. The director must ensure the limited company complies with company law, accounts properly with full disclosure, makes all statutory returns, is adequately insured and meets all its health and safety obligations.
And it is this way of working that has changed significantly because of the new MSC legislation. Previously, the responsibility for managing and operating a company could be passed on to the service provider, with the contractor able to take all of the benefits of this way of working with none of the hassle or responsibility. Under the new legislation, whilst it is perfectly legitimate for a contractor to obtain administrative and accountancy support to help them fulfill all of their company responsibilities, they cannot pass on the responsibilities themselves and they must manage and control their own company.
Many contractors previously operated via a managed service company model, allowing the managed service company provider to handle the financial and legal aspects of all their transactions. This is one of the areas the new legislation has hit hardest as this would now be seen as the MSCP being “involved with” the contractor’s company and the tax benefits of working this way would be lost.
So now, not only do contractors have the challenge of IR35 to navigate, the new MSC legislation requires them - if they wish to run their own company and be taxed accordingly - also to ensure that the services they are receiving to support their limited company do not put them inside the new MSC legislation. This is not an easy judgement for each contractor to make. And individuals can be held personally responsible for any unpaid tax if they get this wrong.
In an industry proliferated by complicated legal and compliance legislation, this must feel like walking on eggshells to most contractors who are, at the end of the day, engineers, not lawyers or accountants.
So, what services can a contractor buy to support them running their own limited company without falling within the new MSC legislation?
HMRC issued guidance in July 2007 to assist contractors and service providers in answering this very question. It is Brookson’s view that comprehensive accountancy and tax advice services can still be provided compliantly to genuinely self-employed contractors in business on their own account who are running their own limited company businesses.
The traditional accountancy support services that all businesses need such as invoicing, bookkeeping, monthly, quarterly and annual returns, annual accounts, monthly management accounts and so on, can still be provided. These are services that individuals who are in business on their own account can compliantly receive help, advice and support with.
However, any element of influence or control from an accountancy services provider would potentially make the company an MSC and thus the individual would be taxed as though they were an employee of the end user. HMRC’s guidance sets out examples of services provided, which would be considered as the service provider having control or influence in this context. HMRC reiterate that all decisions and management of the business needs to be carried out by the individual contractor if they do not want to be taxed under this new regime.
The Government clearly wants genuinely self-employed contractors to accept the risks and full responsibility of running their own company to obtain the benefit of limited company working. They must understand more clearly and take on more fully the responsibilities of being in business through a limited company. And for those individuals that do this, accountancy support is still available and can still assist in making the running of the company genuinely straightforward.
www.brookson.co.uk