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 IR35 Legislation & Personal Service Companies.
Information.


We have received a tremendous number of e-mails from visitors in the UK who are interested in starting in business as independent consultants.

The UK government has recently brought in new legislation to help the taxman clarify the difference between employment and self-employment, in cases where an independent consultant spends a high proportion of their time offering services to one company.

If you have any questions on this subject, the most comprehensive and up-to-date information can be found at : www.pcg.org.uk & www.inlandrevenue.gov.uk

The following article is quite lengthy...may we suggest that you let it completely download, aquaint yourself with our advertisers then read it off-line / print it.

IR 35 & Personal Service Companies - An Outline.

by John Whiting, tax partner, PricewaterhouseCoopers

Introduction

IR35 - the Budget Day Press Release that started the attack on Personal Service Companies (PSCs) - is one of the more notorious Inland Revenue documents. The original proposals were, in essence, unreasonable and unworkable. But the announcement by the Inland Revenue on the 23 September showed some backtracking. The legislation now in the Finance Bill (which will become an Act shortly) follows continual exchanges but still leaves many practical problems around.

Whilst many were hoping the provisions would go away entirely Ministers clearly see avoidance that has to be stopped.

The following note is by way of an outline. Reference should be made to:

•The series of "Frequently Asked Questions" published by the Inland Revenue on their website
•Press Releases of 23 September 1999 and 7 February 2000
Tax Bulletin article in the February 2000 edition
• The legislation in Finance Bill 2000 (which shows some minor changes from that published on 21 February)
• The Revenue's booklet IR175 "Supplying Services".

The PSC problem / opportunity

The Revenue's issue with PSCs stems from an individual (or group) operating through a company instead of being an employee. No PAYE/NIC on fees - and the opportunity to pay out as dividends with no NICs there either. Also, expenses may be deductible via the more generous wholly and exclusively route.

The Revenue made much of the individual who leaves full-time employment on a Friday and returns on a Monday to do, to all intents and purposes, the same job. Other abuses to them included the individual who takes (say) a two-year, full-time role through a PSC - all possibly with the active co-operation of the "employer" who is able to save employers' NICs, sometimes sharing the saving with the contractor.

IR35 branded all PSC users as avoiders, with no acknowledgement of the very practical reasons why many use PSCs - tax savings being a useful by-product rather than the driving force. The fact remains that having a company says something about the operation in terms of status, solidity, permanence, etc. It is easier to employ people, others can have shares - and it even has limited liability!

The IR35 idea

The original IR35 plan put much of the burden on the client - the user - rather than the intermediary - the PSC. The client would have to identify each "tainted" contract, using a new control test. If they were in control of the work then PAYE/NIC would have to be applied to any fees for that contract in the same way as for employment.

There would then be a certification procedure for PSCs to allow them to be paid gross. This created vistas of all PSCs applying and the system disappearing into a welter of red tape and bureaucracy. Whilst the protests and submissions made an impact, it was clear the proposals were never going away entirely. Ministers had avoidance in their sights! There were comments that we were lucky the measures did not come in from April 1999.

Did we get a result?

An announcement on 23 September showed progress. The key points, which are carried into the legislation, are:

•the burden of running the system moves firmly from the client to the PSC with no certification procedure

•the Schedule E/Schedule D employed/self-employed test is used rather than the control idea

•the PSC user is allowed to deduct 5% of income from tainted contracts - "relevant contracts" - to cover the cost of running the PSC

• employees (as opposed to owners) of PSCs are essentially excluded, with a sensible extension to this for those with a "small number of shares" (not more than 5% in the legislation).

•the PSC must assess the position at each 5 April and penalties through imposition of PAYE/NICs loom for the PSC that does not pay out sufficient salary from relevant contracts.

In essence the attack is focussed on those who really own the PSC. The results can be penal as the Illustration shows.



Illustration 1

John's service company, John Ltd, has total income of 60,000 in a year, 30,000 of which is from a relevant contract.

John pays himself a salary of 15,000 for the year; the company has 1,000 of expenses relating to the relevant contract.

There will be a payment caught by deemed PAYE/NIC of:

Income from relevant contract

 

30,000

Less:

 

 

Expenses

1,000

 

Employer NIC

1,303

 

5% deduction

1,500

 

 

 

(3,803)

 

 

26,197

Less: salary paid

 

(15,000)

 

 

11,197

Employer's NIC on deemed payment

 

(1,217)

Deemed payment

 

9,980

The result is that John Ltd would have to pay over PAYE and NICs on the deemed payment of 9,980. If John Ltd does not pay, the Revenue will target John.



Whilst one might accept the above will apply to blatant avoiders, when one tries to apply the rules in the real world, it rapidly becomes apparent that this will not be easy or fair.

The big issue - Schedule D v Schedule E

The new rules rely on the existing tests for the boundary between employment and self-employment. In discussions with the Inland Revenue they have talked in terms of simply looking through the PSC to see if the underlying individual would be self-employed under the usual tests. In essence, they will be looking for "disguised employments". There is confirmation in the September statement and subsequent exchanges that the Inland Revenue's IR56 booklet is still the summary of this with its emphasis on aspects such as:

•does the worker take on risk?
•can the worker substitute someone else?
• is the worker told what to do or does he decide how to do it and when?
•how is payment arranged - by the task or by the hour/week?

Someone who has a single contract during the year will probably end up as in effect employed without regard to the PSC. But what of multiple contracts? There are clear signs that the Revenue want the chance to look for a significant contract in amongst self-employment. Cases such as Hall v Lorimer stress that self-employment (which the new rules are trying to parallel) is an overall state.

It seems unlikely that the Revenue will accept a contract with (say) a substitution clause as sufficient by itself to escape IR35. The facts must support the contract. But it is clearly sensible to have a contract in place that will give the best possible chance of escaping IR35. The Revenue will, in fact, review contracts and opine on whether they rank as "Sch E" or "Sch D".

Other problems

This is a Self-Assessed measure: John Ltd and John filling in their tax returns, on their view of matters. They could validly feel they escape - but then an Inspector gifted with hindsight raises enquiries and problems arise. If in the end John Ltd is penalised, it does seem to be enterprise that is being targeted.

Expenses (plus the welcome 5%) are deductible on a Schedule E lookalike basis. But one can envisage a lot of arguments about expenses that would not be undertaken as an employee (because the employer would provide) but which are necessary in a practical sense because the PSC, however the Revenue might wish to dispute it, is the real employer.

Illustration 2

John Ltd employs John, the contractor, and Jane who acts as administrative assistant for a salary of 5,000. Is Jane's salary deductible from John's Relevant Income under IR35?

No: Jane's salary will be subject to PAYE/NIC as normal; it would not be deductible from John's earnings under Sch E principles, so it is not deductible under IR35.


Thankfully, travel expenses will in the main be deductible, which is welcome. This is on the basis that the individual remains employed by the PSC even if IR 35 bites. Thus in most cases the worker will be based at home and all travel to clients will be travelling in the courses of work and deductible. (It is possible that a new permanent workplace is established.) There is an important underlying principle here - IR35 deems a payment as if the individual was employed - it does not turn the individual into an employee for all purposes of the tax legislation.

Partnerships as well as personal service companies are targeted, but only for the partners themselves. However, the new rules will only apply to partnerships where:

•an individual, or person connected with him or her, is entitled to 60% or more of the profits; or
•all or most of the partnership's in the tax year is derived from relevant income from (in effect) a single client; or
• the PSR provides that the income of any of the partners is to be based on the income generated by that partner through relevant engagements.

Operating the rules

So how are these rules going to operate in practice? How is Hector going to regard that two-week contract that was taken undoubtedly as a self-employed person but lasted for six months? A 5 April post-event review is a bit late to adjust pricing and profits.

Clearly the main impact is on the PSC and therefore anybody who uses a PSC needs to review their way of operating. Here, PSC must extend to almost any business selling services. All must take note of these rules and think through their impact on their business. If IR35 does bite, further issues arise. But the PSC user, although in some ways a deemed employee through notional PAYE/NIC, does not suddenly become an employee of the client with relevant rights.

What about the clients who hire the contractors who use PSCs? On the surface they are unaffected - but they cannot ignore these new rules. If the contractor is actually caught by these new rules, could there be any comeback to the client through the terms of the contract? What if the contractor asks to come on the payroll, with implications for employee benefits? But there is an odd incentive to hire via a PSC to insulate against PAYE/NIC on those argued to be self-employed.

The crunch is that at 19 April the PSC is expected to pay over the PAYE/NIC owing on income from relevant engagements. If this cannot be ascertained exactly - as is highly likely - then an estimate must be made. Providing the payment is made by 19 April and the procedures operated "in good faith" there will be no penalties for underpayments, although interest will run.

One conclusion is that the Revenue intend that hardly anyone will actually be caught by the IR35 rules - because they anticipate those who would be caught will give up and go back on the payroll. Whether this 'solution' happens in practice to the extent they wish remains to be seen. In the meantime, a lot of contractors are having a lot of heartache over their position vis--vis IR35.

July 2000



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last modified: 15-Dec-2001