By Jonathan Williams
19 April 2000
The Inland Revenue's offensive against the use of personal service companies has been the subject of exhaustive debate. Those affected feel that the Revenue is perceiving a tax avoidance motive when the primary reasons for using such structures are commercial. In the modern business environment temporary contracts are a fact of life and a personal service company is often the most sensible way effectively to manage these.
Despite all protest, the legislation is now in the 2000 Finance Bill, with an effective date of 6 April 2000. The Professional Contractors Group is launching a challenge under European law, but regardless of the outcome of this, it is clear the Govern- ment is unwilling to allow the status quo to continue. Given these facts, those affected need to consider exactly what the new rules mean and how they might minimise their impact.
The problem is best approached by looking first at what it is about personal service companies which has excited such attention from the Revenue. The underlying source of the difficulty lies with the UK's eccentric schedular system of taxation, which demands that income be neatly pigeonholed into one of various specified types.
On the whole, being self-employed is preferable to being an employee from a tax perspective. In those professions where the line between the employee and the freelancer is easily blurred, such as IT contracting, it has become commonplace for individuals to avoid the whole issue by setting up a limited company (a personal service company). The company employs the individual and sells his or her services to whoever needs them.
This simplifies life for all concerned - the purchaser can be comfortable that it has no obligations as an employer (under employment, general or tax law) and the service provider knows all his or her earnings will flow into the personal service company, from where they can be extracted as salary or dividends.
Unfortunately from the Inland Revenue's point of view, a personal service company structure also gives rise to opportunities for tax planning, most significantly in the area of national insurance contributions (NIC). Firstly, the service purchaser does not have to pay employer's NIC, which is levied at 12.2 per cent for the current tax year, and so would represent a significant cost for employers. Secondly, employee's NIC and PAYE become due only if and when the individual takes money out of the personal service company as wages. The individual may instead take the cash out as dividends, which carry a tax credit and do not attract NIC.
It is also possible to pay dividends to other shareholders, such as a spouse, which uses the benefit of the second person's personal allowance and lower/basic rate bands. More aggressively, the individual may even choose not to remove the cash immediately. It will then be taxed only at corporation tax rates, which are lower than the highest rate of income tax. The individual can then try to plan any eventual extraction as a capital gain, which could attract various reliefs and exemptions.
The new legislation effectively obliges anyone who uses a personal service company to remove all their earnings as salary. The mechanics of this are that at the end of each tax year (for the first time on 5 April 2001) you must work out the total earned for your services for the year. From this figure, you can deduct the following: any expenses which would normally be allowable for an employee together with a flat 5 per cent for overheads, employer contributions to an approved pension scheme (within certain limits) and employer's NIC (12.2 per cent). If the resulting figure is less than the amount that you have taken from the personal service company in the form of salary for the year, the balance is treated as deemed salary and an appropriate amount of PAYE and NIC must be paid to the Revenue. This is due at the same time as all other year-end employee taxes, ie 19 April.
Thus, the effect of the new rules is twofold: there is the extra cost of NIC in respect of payments which would otherwise have been made as dividends (any payment of value to the individual or a family member will now be treated as salary) and there is a possible acceleration of income tax in respect of earnings which might otherwise have been left within the personal service company for a time.
Protesters have warned that the new rules will cause IT professionals to leave the country. More prosaically, those affected must think about whether they can mitigate the impact by careful planning. Claims for legitimate expenses should be maximised by means of scrupulous record-keeping, and additional pension contributions could be considered. If family members perform any work for the personal service company, they should be adequately remunerated to use up their tax allowances.
It may also make sense to withdraw more from the company than formerly (up to the full deemed salary amount where the company's cash position allows) and re-invest the surplus.
Contractors should also analyse carefully each of their consultancy contracts. The new rules apply only where, in the absence of the personal service company, the engagement would constitute an employment relationship. So, for example, if it can be shown that a direct arrangement between individual and service purchaser would not be an employment, this income may fall outside the scope of the new provisions.
It may even be that just such a direct arrangement could be substituted, removing the need for the personal service company to be involved, although care would be needed in this case to ensure the contractual relationship is clearly defined. Equally, as a formal contract of employment is now less obviously disadvantageous, some contractors may want to consider renegotiating their position and becoming employees. But this might not appeal to the "employer", who will need to consider the potential impact of any such redefinition of roles, including obligations under employment law and their additional NIC cost.
These new rules undoubtedly create concerns for consultants and are best faced up to sooner rather than later. By addressing the issues now rather than next April it should be possible to manage their impact. For most, this will be a more practical solution than emigration.
The author is a manager at Arthur Andersen, specialising in employment solutionsReuse content