After you have scored your first contract and you have agreed to a starting date, your invoicing company and recruitment agency will sign a contract between them. In case you are connected directly with a client bypassing the recruitment agency, the contract will be signed between client and invoicing company.
Almost 90% of agencies will want you to send invoices through a limited liability company. Your umbrella company or even limited company will be able to help you with that. On the other hand, some agencies operate PAYE through their own payroll services. Although this sounds more convenient, this is probably the least efficient way considering available tax benefits. Nevertheless, an expert can easily help you assess the effect of IR35 and minimise its tax disadvantages.
Whats IR35 about?
The IR35 legislation was aimed at contractors who had found a way to dodge tax according to the government. This legislation aimed to increase NIC revenue by implementing new legislation on the service industry. Since the service industry was generally using dividends to distribute income, the government introduced the concept of ‘deemed salary’.
In order to understand IR35, it is important that you understand how it operates under specific situations and circumstances. The test applied to determine the nature of a contractor’s engagement looks into the manner of work and time spent on workplace instead of relying on the wordings of the contract alone.
These rules apply when a company provides a member of staff to a client in a way that it amounts to employment if the intermediary is removed. In all similar circumstances, the rules of IR35, especially that of relevant engagement, will apply. Any income that results from such relevant engagement is going to be taxed according to IR35 rules.
Is IR35 an end of a dream for contractors?
In 2001 a new legislation was introduced named IR35. This new legislation targeted intermediaries which meant end of dreams for many contractors. Before these times, contractors could find a dozen contracts to apply during the lunch time.
But things never remain the same and that’s what happened to contracting havens. The IR35 changed the scenario. The rates plummeted and job positions were minimal to find, resulting in a massive disaster. For many contractors, it was a 15-year backwards push. For many contractors, it wasn’t just the rates and lack of work but the revenue also chipped in with penalties for failure to run business properly.
During this horrid period, many contractors continued working the way they were using limited companies. These companies required two shareholders and a secretary back in those days. For majority of contractors this was a settlement that worked for them as they were able to apply commercial contracts instead of employment contracts.
The problem with these and similar other settlements was that government regarded them as a way to dodge the tax. For example, it will be easy to pay certain profits as dividends to shareholders to gain certain income advantage when working via a limited company. Since such payments are not salary, they are taxed differently. As a result, the government had a reason to believe that these contracts were offering a way to conceal the true employment relationship and decided to put a stop to it through legislation.
Determining the tax status: Employee or self-employed?
IR35 provided a way to determine the true nature of contract by looking closely at day-to-day work relationship instead of considering the contractual nature between the two parties. This legislation also implemented that the work environment plays a vital role to determine the nature of relationship.
Under the new legislation, the tax status of contractors is determined by the following factors.
- The way your client treats you
- The time you spend on the site
- Is there a project manager involved?
- The wordings of the contract.
Contractors caught by IR35 lost all major tax advantages of operating through a limited company. However, contractors won majority of cases that HMRC brought up against them largely because of a mismatching rationale behind the legislation and its enforcement. As a result, contractors made small changes to the way they work and re-wrote their contracts to stay safe from this new legislation.
Many contractors comment that IR35 is utterly complex. Even HMRC failed to comprehend and implement it. On the other hand, HMRC continues to believe that it can address all the compliance issues that arise from this legislation.
What is settlements legislation (S660) and what does a Managed Service Company has to do with it?
What is S660?
S660 or settlements legislation sets up certain rules and regulations that keep limited company owners from dodging taxman for lower tax by passing company’s income to another shareholder with lower tax rate.
Transferring income to another shareholder in order to pay lesser tax in this way is called ‘settlement’. Settlement results in lesser tax being paid on income, thus profiting the person to whom such income has been transferred. Among many other ways, ‘husband and wife’ companies have used this technique for tax planning for years. All shareholders of such settlements receive profits as dividends.
There are number of cases that indicate there is still some confusion over S660 and whether all obvious cases of settlement fall within the legislation. One such prominent case is that of Arctic Systems Ltd. The company is a ‘wife and husband’ company in a way. The argument is that since husband performs most of the work that generates income, it should become a settlement when the income passes from wife through her shares in the company.
HMRC looks at the ‘whole’ arrangement to determine whether it falls within S660 or not. The factors that are of importance in such arrangements are commercial rewards, contribution of both parties to the company, and whether salaries are being paid at the market rate or not. Commercially run joint ventures don’t fall within the meaning of a settlement according to HMRC’s guidance.
Managed Service Company (MSC)
A Managed Service Company was once a popular alternative scheme for contractors who were already using limited or umbrella companies. Contractors working as sole traders also benefitted from Managed Service Companies before they were brought under the scrutiny of the law.
Under a Managed Service Company, number of contractors form a group that acts as shareholders of a company. This company is run by the service provider who also owns it. This resulted in various tax benefits and helped contractors work just like a limited company without having to deal with the hassle of running a limited company as a director.
HMRC removed all tax advantages from MSCs that were once available. Today, contractors will have to pay employed levels of taxes and National Insurance contributions if they work through an MSC.