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Posted: Feb. 22 2004 by ICA (Independent Contractors of Australia)
[Note: There have been considerable developments in the UK in 2007. ICA has not fully researched these.]
In January 2004, ICA was approached by a UK accounting firm to place information on the ICA Website regarding contracting in the UK. We are very happy to do this and make the following points:
1) None of the comments/information contained below is attributable to ICA. They are exclusively those of sjdaccountancy.com. ICA takes no responsibility for the comments of sjdaccountancy.com
2) ICA has been well aware for some time of the contractor tax problems in the UK relating to a tax ruling known as IR35 and we have made comment on our Website on those UK problems. We think the Australian PSI legislation is vastly better than IR35. The comments by sjdaccountancy.com make for interesting comparison with Australia.
3) We note the UK intention (explained at the end of this information) to drop IR35 and replace it with an apparently improved approach. We are seeking further information on this.
FREELANCING IN THE UK
If you intend to work as a freelancer in the UK, you would be well advised to think about the various methods of doing so to ensure that you retain the maximum possible amount of your earned income.
There are four main ways that you could operate:
1. As an employee;
2. Being self-employed;
3. As an employee of a composite company;
4. Setting up your own Limited Liability Company.
AGENCY EMPLOYEE
This is the easiest option and may suit you if you want to try out the freelancing life-style without making a major commitment. It may also suit you if you see freelancing as a very short-term option (say, three months or less).
SELF-EMPLOYED
This is generally the simplest way of being your own boss. The tax savings can be quite high and because the paperwork is likely to be quite modest, the accountancy fees will be low.
Unfortunately, for many freelancers who work through an agency or do a lot of work for the same company, self-employment is not an option. This is because the taxman will often argue that you are actually an employee of the company or agency you are working for and not a self-employed freelancer at all. The taxman has heard (and rejected) most of the arguments freelancers dream up to defend their self-employed status. So arguing with him will usually be a lost cause, unless you can satisfy a long list of conditions.
UMBRELLA/COMPOSITE COMPANIES
Some freelancers opt to join a composite company. Under this type of arrangement, you are employed by the composite company and have some scope to reduce the amount of tax and national insurance you pay. There is also a lot less paperwork than when you have your own limited company. However, you do not own the composite company and you are arguably not really 'in business' at all. There will also be a service charge for using the composite company which could work out to be more expensive than running your own company. As a result, composite companies are probably most suitable for short-term contracts (three months or less) or for those who want to experiment with freelancing.
LIMITED COMPANIES
This is by far the most common way for freelancers to be in business. Essentially you set up, own and run your own Limited Company. You will usually appoint yourself as a director (the Managing Director if you like) and be the major shareholder.
In the eyes of the law, the Company has a life of its own. For example, it will actually be your Company that enters into contracts, not you. A Limited Company also offers its owners (i.e. the shareholders) protection against liability for the company's debts. So, if the company should become bankrupt, as a shareholder, you will only lose the value of your shares. As a director, you will not be liable for the company debts either, unless it is proved that you have acted fraudulently or improperly under company law.
Most importantly, agents and clients like freelancers to work through limited companies simply because this protects them from all manner of tax and employment rights issues.
Operating through a limited company is also the most effective way of minimising your tax liability.
IR35
1.1 Introduction
The original proposals exposed during the early summer of 1999 were roundly condemned as unworkable by all respondents to the consultation. Finally, in late September 1999 the final form of the proposed legislation was publicized. The legislation came forward in Finance Bill 2000 for commencement in April 2000. The measures to implement the National Insurance Contribution aspects are included in the Welfare Reform and Pensions Bill.
The Professional Contractors Group brought an unsuccessful Judicial Review against the measures in March 2001. From this Review, however, came some useful guidelines which make it quite easy to avoid IR35 with proper structure and advice.
1.2 Outline of the proposed rules
The legislation is designed to increase the NIC revenue from the service industry which, on the whole, has found it more tax-efficient to distribute income as dividends, usually subject to the payment of a small salary. To this end, it introduces the concept of 'deemed salary' which will be taxed and subject to NIC as if it has been paid as a salary.
In order to retain some logic to this treatment, it is necessary to identify the situations in which these rules are to operate. The Government's concern is that small limited companies are being used to disguise employment, so this is the test which has been applied:
Where the employee is provided by his company to an ultimate client on terms which would normally constitute employment with that client, this is called a 'relevant engagement' (section 2.1) and the IR35 rules apply.
2.1 Relevant engagements
Where the Company provides the services of a member of staff to a client (either through an agency arrangement or otherwise) and the terms are such that, without the intermediary, the individual would be an employee of that client the IR35 tax treatment is triggered. It is important to remember, therefore, that it is a test of employment as regards the eventual client that is considered. We are not then saying that the individual is an employee of the client, just that in these circumstances the 'relevant engagement' rules will apply.
Income from such work arising from a relevant engagement will be taxed according to the IR35 rules. Clearly, therefore, the planning considerations will depend on the correct classification of the engagement by the company so that the new treatment is adopted when appropriate.
Deemed employment or self employment
As deemed employment will trigger the IR35 rules, it is vitally important to consider what the Revenue will treat as being employed.
The entire IR35 site is available at http://www.inlandrevenue.gov.uk/ir35/index.htm
It would be unwise indeed to pin all hopes on a contract effectively bought 'off the shelf' describing a self-employed engagement. The parties to the contract must behave in such a way as to make it clear that the contract does indeed summarise their working relationship.
Internal Inland Revenue guidance on contracts includes: ' The terms of a contract can be written, oral or implied, or a combination of all three.' In establishing the terms of engagement, the officers enquiring into status are instructed to obtain copies of any contract in existence, and then review the following for additional evidence:
Other documentation such as handbooks, procedures manuals and franchise agreements.These may give more information about the terms of the engagement and may also identity the conditions under which the worker is expected to operate.
Evidence to support oral and implied terms, which might be at variance with the written contract. SE541 warns that the written contract may not have been implemented and that the true contract is made by oral or implied terms. These are identified from verbal agreements at the beginning of the contract, and also from working practices on a day-to-day basis. Guidance highlights 'the prevailing practices or conventions of the particular trade or organisation.'
Thus, where the parties to a contract do not behave in the way described by the agreement, it is normal for the courts (if called upon to make a ruling) to regard the subsequent behaviour as a variation in the terms of the contract, and therefore view the case based upon the working relationship, rather than being bound by a contract which bears little resemblance to reality.
3. EXPENSES AVAILABLE FOR DEDUCTION
3.1 General
In the calculation of the 'deemed salary', certain expenses will be deducted from the income arising from relevant engagements. The most important of these is the deduction for travelling expenses, but to be clear, the following expenses have been mentioned by the Inland Revenue in various consultations and FAQ publications.
Travelling and other expenses deductible under Section 198 of the Income and Corporation Taxes Act 1988.
Employer contributions to approved pension schemes which attract tax relief in the normal way.
Gross salary paid plus any employer NIC on both the salary paid and any deemed payments.
5% of the gross income from relevant engagements to cover running costs.
Any other expenses which do not fall within S198 TA but have another statutory route for deduction, such as payment of professional indemnity insurance.
3.2 Travelling expenses : summary
Employees are entitled to tax relief on the full cost of any travelling in the performance of their duties or any travelling they have to do to attend a place at which they are to perform duties excluding the costs of ordinary commuting and private travel. The terms 'ordinary commuting' and 'private travel' are dealt with in detail by the guidance material, but for the purposes of contract workers the following logic applies.
3.3 Permanent Workplace
Travel from home to your permanent workplace is not tax deductible.(However see 3.4) This is part of the 'ordinary commuting' test. For many employees their permanent workplace is obvious, and any occasional journeys to other locations will clearly be an allowable expense. But in the contracting business, which involves travel to the site of the client, care is needed not to fall foul of the rules.
The guidance indicates that a permanent workplace is to be interpreted as follows
'A place where an employee works is a permanent workplace if he attends it regularly for the performance of the duties of the employment.'
With this definition: the concept of regular attendance, most contract workers would be in difficulty, but they are excused by the exclusion of temporary workplaces.
3.4 Temporary workplace
A workplace:
A workplace ... will not be a permanent workplace if it is a temporary workplace. A temporary workplace is somewhere the employee goes only to perform a task of limited duration or for a temporary purpose.'
Clearly, this will normally exclude your client's site, as you attend it for a fixed period only and then the contract ends. This means that you are performing a task of limited duration there and travel to the site will be allowable. However, mindful of possible abuses, the Revenue have introduced a limitation to the temporary workplace rule. A workplace cannot ever be
'... a temporary workplace if the employee attends it in the course of a period of continuous work which lasts, or is likely to last, more than 24 months.'
A period of continuous work is a period of work throughout which the duties of the employment are performed to a significant extent at that place. For this purpose, significant extent will be interpreted as 40% or more of the employee's working time spent at that place.
This limits your deductions in respect of travelling expenses when you renew a contract repeatedly. Once you have been travelling to the same client's premises for approaching two years, and the next contract renewal will take you over the two year point, you will no longer be permitted to claim with effect from the renewal date. Note that it is at the point that the contract is expected to exceed 24 months that the deduction is lost, not at the point at which the 24 months is exceeded.
Where you decide not to renew immediately at the end of, say, 22 months work, be aware that the 24 month period continues to run (that is any period of 24 months) and if you return to the same client site within about 15 months you should not claim for your travelling expenses. (60% of 24 months is 14.4 months: this is the length of the gap needed to overcome the 40% in 24 months principle).
3.5 Pension contributions
Under the new rules, pension contributions will form an extremely important part of remuneration planning. Not only are the contributions allowable for tax purposes, they can also be paid before paying the new 'deemed salary', meaning that both employees' and employers' National Insurance is also saved.
3.6 Other statutorily allowable expenses include:
Professional subscriptions
Premiums for liability and indemnity insurance
3.7 The 5% deduction
This allowance, being 5% of the total income from relevant engagements, is intended to cover all of the expenses of running the Company, including accountancy fees and Companies House filing fee. In the deemed salary calculation, there is no need for the intermediary to show how and where the expenditure has been laid out, or even whether it has or not. It is sufficient to deduct the 5% in the calculation.
Where the company bears in reality more or less than the amounts allowed, this may give rise to a profit or loss for corporation tax purposes, so there is still a purpose in recording the actual expenditure incurred by the company.
4. Enforcement of tax liabilities
Should the company default on the payment of PAYE and NIC, and claim limited liability will exclude payment, directors should be aware that there are existing procedures (used increasingly successfully in the recent past) to enforce PAYE liabilities on the employee who received the emoluments, and in the case of NIC, on any director of a company which fails to pay NIC due where the director is fraudulently or negligently concerned with non-payment. It is also possible to obtain freezing orders over a director's personal assets to secure payment of NIC liabilities. This is not to be contemplated!
5. Practical considerations
If your contract does fall within the IR35 provisions and, therefore, the income has to be distributed as salary, this creates an administration difficulty in terms of timing of payments. The Revenue have therefore said that the PAYE can be paid annually, no later than 19th April.
IR35 UPDATE (January, 2004)
Information from a source close to the Treasury indicates that IR35 is set to be abolished with effect from 6th April 2004.
This highly criticised tax was introduced in 1999 to counter what the Government argued was a significant loss of tax due to the common practice of 'one man' Limited Companies paying small salaries and high dividends, thereby saving significant sums of National Insurance. Since its inception, there have been a number of schemes set up which purport to avoid the measures, one of which was the highly publicised collapse of Dignatio, leading to hundreds of contractors losing money.
The pre-budget report in December 2003 gave hints that a new regime was to be announced in the 2004 budget which has now become known as IR591. This new regime, we have been told, is set to replace the widely despised and ill-fated IR35 in April 2004.
From the Government's point of view, the collection cost for IR591 will be far lower than IR35 because there is no complicated and subjective criteria judging who must pay. Any Close Company paying dividends will be subject to the new regime. The actual tax collected will be significantly higher also due to the blanker nature of the new measures. IR35 targetted only knowledge-based workers whereas IR591 looks set to target all Close Companies.
What about the freelancers point of view? Well, there will be certainty as to how much tax and NI is to be paid, and no need to worry about an IR35 'knock on the door' from the Revenue. Whilst those contractors not currently caught by IR35 will be financially worse off, those currently caught by IR35 will be significantly better off, so on the whole it would appear that IR591 will be a marked improvement on IR35.
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