Managed Service Companies Legislation
What is it and do you need to worry about it?


Ever since people first started contracting there have been a number of different ways for contractors to manage their tax and earnings, from sole traders to partnerships and from limited companies to umbrella companies. There have also been a seemingly endless stream of innovative and (temporarily) lucrative schemes for contractors keen to retain a higher proportion of their income. From Employee Benefit Trusts to Offshore Intermediaries, tax vehicles promising the world were opened up to contractors and then, a few months or years later were shut down by HMRC and the contractors using them left facing a nasty bill for back taxes. One of the most popular types of schemes in recent years was the Managed Service Company. Managed Service Companies (also known as Composite Companies) were forms of company structures that organised contractors into large collections of shareholders within a corporation that was owned and managed by a service provider. The Managed Service Company would then provide their contractors with all the benefits and tax advantages of working through a limited company whilst freeing them of any of the overall responsibilities that normally come with those benefits. In effect, the contractors would simply be providing their usual contracting services to their clients via a Managed Service Company which they are shareholders in but do not have any control of in any way. Naturally HMRC were not keen on this ‘style’ of working!

HMRC Gets Tough – Tackling Managed Service Companies

As a result, HMRC set about passing legislation that would prohibit companies from sidestepping tax in this way. They proposed the ‘Tackling Managed Service Companies’ legislation specifically to target companies who were clearly setting up composite structures so that their contractors could avoid paying income tax and national insurance contributions. According to the treasury, any contractors working for such composite companies should be classified as ‘employed’ and their tax status, tax allowance and tax bills would therefore be adjusted accordingly.

In 2006 they therefore announced legislation that would cover all these problems and would remove the tax advantage that Managed Service Companies seemingly offered. The legislation proposed a wide range of powers including giving HMRC the right to retrospectively recover any outstanding PAYE and National Insurance debts from third parties. In a document released by the Treasury at the time (‘Tackling Managed Service Companies’) the intentions of the legislation were made clear:

“The Government is taking action to tackle Managed Service Company (MSC) schemes which are used to avoid paying employed levels of tax and NICs. Income received by workers in MSCs in relation to services provided through the MSC will be subject to employed levels of tax and NICs, with the MSC obliged to operate Pay As You Earn (PAYE) and deduct tax and Class 1 NICs on that income – and the rules for tax relief for travel expenses will be the same as for other employed workers. The Government will also address the problem of MSCs escaping payment of tax and NICs due by allowing the recovery of these debts from appropriate third parties … This will protect the Exchequer and ensure a level playing field for compliant businesses and workers. The Intermediaries legislation will remain in place for Personal Service Companies.”

In 2007 the Managed Service Company legislation became law and made clear that unless a contractor could show that they were in business on their own account and that their business was not controlled by a ‘provider’ they would then be liable and all of the income that was paid to their company must be paid as salary under the standard rules and rates of PAYE and National Insurance Contributions.

Was This Legislation Really Necessary?

HMRC certainly thought so. As mentioned above, providers were setting up composite schemes everywhere across the contracting sector in an obvious attempt to circumvent all the rules of the IR35 legislation. Under these composite schemes, which HMRC called ‘Managed Service Companies’ up to twenty contractors would all become non-director shareholders of the company and the company would be managed overall by something called a ‘scheme provider.’ This enabled the contractors to then be paid a much lower salary whilst receiving extremely generous expenses and the remainder of their salary paid to them in the form of dividends. Such a structure was of course extremely favourable to the contractor and very, very tax efficient seeing as it managed to avoid having to pay large amounts of tax and contributions that would have been due under PAYE. Under the IR35 legislation however the only way that contractors could be paid via dividends was if they fell outside of IR35 and it was the opinion of HMRC that this was not the case with Managed Service Company contractors.

What’s more, HMRC saw a massive growth in the number of such composite structures in the years up to 2007 and this was leading to losses both losses for the Treasury and difficulties in trying to collect outstanding liabilities. The problem was that MSC’s had no real and tangible assets, and therefore were difficult to collect outstanding debts from – and they were also able to cease trading and be wound up very easily, often with their contractors simply moving to a new service company.

How The Legislation Works In Practice

HMRC now defines Managed Service Companies as companies that provide the services of individual contractors to 3rd party clients and which are also ‘involved’ in the provision of those services. Being ‘involved’ means they would be financially benefiting from the provision of services and/or controlling or influencing the provision of those services or the manner in which the provision of those services is paid for. This would show, in other words, that the contractor is not simply in a business on their own account and does not have full control of or responsibility for their own business.

The Managed Service Company is described by HMRC a ‘person who carries on a business of promoting or facilitating the use of companies to provide the services of individuals.’ However, for the MSC legislation to be applicable the service provider of the scheme must not only fulfil that definition of a provider but also be involved with the client companies. HMRC therefore notes that:

“An accountancy/tax adviser, whether or not professionally qualified, who provides advice to clients who are service companies is not an MSC Provider merely by virtue of their client base. The test is whether a person is carrying on a business (or a discernable part of their business) of promoting or facilitating the use of companies to provide the services of individuals.”

And because of the problem mentioned above – that collecting liabilities was so difficult because MSC’s were easily wound up and carried no tangible assets – HMRC was (and is) now able to collect from other, third parties who were now moved within the permitted scope of recovery of debts. The legislation made clear that appropriate third parties for debt recovery were those third parties who have ‘encouraged, facilitated or otherwise actively been involved in the provision by the MSC of the worker.’ This meant that the people who would be liable for debts include the MSC providers, the MSC directors, the associates and any office holders of the MSC. All of these could now be liable for outstanding tax debts. Similarly, workers in the MSC also fall within the scope of those provisions relating to debt transfer and will be liable as long as it can be shown they knew they were working for an MSC. Finally, any third parties who knew they were dealing with an MSC will have the debt transferred to them only if the debt cannot be taken from the providers of the scheme of any of the associates, office holders and directors.

What Was The Effect of the Legislation?

From HMRC’s point of view there can be no doubt that the legislation was another successful step along the road of cutting out tax avoidance in the contracting sector. The aim of the legislation was to deal with those MSC’s who were setting up to help contractors avoid PAYE and NIC’s and it did exactly that. The legislation allowed them to declare these contractors as employed and therefore change their tax status and tax allowance – and reclaim money that was owed. And because MSC’s were set up simply as a way for contractors to get higher returns on their income – which was no longer possible – and they were now falling liable for IR35, most Managed Service Companies simply dissolved once the legislation was on the books. This applied whether the MSC was based in the UK or abroad:

“The legislation also applies whether the MSC is based within the United Kingdom (UK) or outside the UK. If the MSC is based outside the UK for the purpose of seeking to avoid the legislation, there is a greater likelihood that HMRC will invoke the transfer of debt provisions.”

What About Umbrella Companies?

In keeping with their seemingly favourable view of PAYE umbrella companies, HMRC made clear that the legislation did not apply to umbrella companies. For this legislation to apply it is required that there has to be a company which the contractor or freelancer is a shareholder of and they must be receiving their income in dividends. A PAYE umbrella company is secure because by its very nature it is paying all the PAYE and NIC’s that HMRC expect. This was made clear in HMRC’s guidance to the legislation. They first detail who is affected:

“Primarily, individuals who provide their services through Managed Service Companies, since the legislation concerns the taxation of income received by such persons.

But the legislation also affects persons who make Managed Service Companies available (MSC Providers) and under certain circumstances other third parties involved with MSCs.

Where a Managed Service Company is unable to pay its PAYE and NICs liability, its debt can be transferred to third parties including initially the MSC’s directors and the MSC Provider.”

And then clearly state who is not affected:

“Individuals working through Personal Service Companies (PSC) that are not within the new definition of a MSC and individuals working through Umbrella Companies.”

They further qualify this by noting that:

“In umbrella companies workers are treated as employees of the umbrella company and all payments to workers as employment income… Consequently the third condition is not met and the umbrella company does not meet the definition of a Managed Service Company.”

What Does The Legislation Mean Today?

The result of the legislation, in conjunction with the IR35 legislation and the Onshore and Offshore Intermediaries legislation has been that most tax vehicles and loopholes for higher income retention in the contracting sector have been closed down and with the addition of new general anti-avoidance rules contractors should steer clear of anything offering significant tax reductions.

HMRC saw that MSC’s were set up to avoid tax and NIC’s and that because they had few assets were able to quickly liquidate and then they could simply restart under a new name. This made it difficult to chase them for HMRC so they brought in this legislation to allow them to both make clear that the MSC’s were not going to allow contractors to avoid tax and that they could now come after everyone involved and even chase third parties for outstanding debts. The result was that there are few, if any, MSC’s working today and that they should generally be avoided like the plague if you don’t want to incur investigations for IR35 and other things. If a contractor ever operated through an MSC it is worth sitting down with an accountant to check their liability from that time. And if contractors want a fair and decent return on their income and complete security? These days it may well be that the umbrella company is the only tax vehicle left that can offer precisely that.