Personal Service Companies

The legislation known as IR35 is intended to tackle the avoidance of tax and national insurance contributions (NICs) through the use of intermediaries such as service companies or partnerships.

The proposals targeted circumstances where a worker would be treated as an employee of the client, if it were not for the existence of the intermediary. Where this was a limited company, the worker was able to take money out in the form of dividends instead of salary. Dividends are not liable to NICs so the worker would pay less in NICs than either a conventional employee or a self-employed person.

Scope of the Rules

The ‘IR35’ rules apply where a worker provides services under a contract which would have been a contract of employment if the worker had been working direct for the client (relevant contract).  There is no statutory definition of employment or self employment, so case law still applies in deciding employment status (see our title Employed or Self Employed?)

A company is not within the provisions if the worker (together with his close family) does not control more than 5% of the dividends unless he or she receives payments or benefits which are not taxable under Schedule E.

A partnership is within the provisions if the worker (together with his close family) is entitled to 60% or more of the partnership profits, or where most of the partnership profits come from work for a single client, or where a partner’s profit share is based on his income from relevant engagements.

HMRC Guidance

In May 2012, HM Revenue & Customs (HMRC) issued “Intermediaries Legislation (IR35) Business entity tests Example scenarios”. The purpose of this document was to provide information about their risk-based approach to checking taxpayers’ compliance with the intermediaries legislation. It tells taxpayers which of three risk band they are in, and what the risk bands mean they have to do.

There are twelve business entity tests covering the following:

  • Business Premises
  • Professional indemnity insurance
  • Efficiency
  • Assistance
  • Advertising
  • Previous PAYE
  • Business plan
  • Repair at own expense
  • Client risk
  • Billing
  • Right of substitution
  • Actual substitution

The total of the scores for these tests determines the risk bands:

            Less than 10                             High risk
            10 to 20                                   Medium risk
            More than 20                           Low risk

There are six example scenarios which illustrate when and why IR35 will apply to an engagement and when and why it will not.

Calculations

If you are caught by the IR35 rules, you are treated as receiving a notional salary on the last day of the tax year (5 April) equal to the company’s gross income from relevant engagements less certain specified deductions. You will have to pay over PAYE and NICs on this notional salary by 19 April. It is evident that there is very little time to process the calculations, and HM Revenue & Customs have indicated that they will not penalise the use of provisional payments and calculations in order to meet the deadlines, see "Real Time Information" below.

The deductions cover expenses that would normally be available to direct employees, contributions to approved pension schemes and the actual salary and employers NIC plus the employer’s NIC on the deemed salary. Also allowed is a 5% flat rate deduction to cover the company’s running costs. The example on the next page illustrates some of the main features of the computation of the deemed payment.

Apportionment

Where a company has relevant engagements and other business which does not fall within the IR35 rules, allowable expenses will have to be apportioned. Likewise, if a payment for a relevant engagement covers more than one worker, the payment can be apportioned between them on a ‘just and reasonable’ basis.

Other Taxes

Corporation Tax is computed in the normal way, including the deemed salary and associated employers’ NICs as allowable expenses. VAT operates regardless of any IR35 adjustments.

Dividends and Other Payments

Nothing in the legislation prevents a service company from paying money to the worker or others in the form of dividends, or retaining cash in the company. It will simply mean that an extra payment of PAYE tax and NICs will be calculated on 5 April. Dividends which are reclassified as deemed salary are relieved from tax so the PAYE takes priority, thus preventing double taxation of the payment.

Amending Contracts

Workers who think they may be subject to the new proposals should consider their position carefully, and should seriously think about renegotiating contracts so that they are no longer relevant engagements. Particular items to cover are:

  • getting away from payment at hourly rates
  • ensuring that the client will accept a capable substitute worker
  • creating freedom in the way the work is carried out

It is, of course, essential that the contracts should actually operate within the scope of the written terms.

Example Calculation

Mr E works through a service company, E Ltd, in which he owns all the shares. The company receives £20,000 during the year for contracts which fall within the IR35 rules (relevant engagements), and £10,000 for contracts which are outside the IR35 rules.  E Ltd pays Mr E a salary of £10,000 in the year, in accordance with the normal PAYE rules. E Ltd also pays pension contributions of £2000 to a registered scheme. £500 of travel costs relate to the relevant engagements. The company has £5,000 of other business expenses, all allowable for Corporation Tax purposes.

Under the IR35 rules, at the end of the tax year E Ltd has to calculate the amount of PAYE and NICs due on Mr E’s earnings. If they have not actually paid enough PAYE and NICs during the year, then further PAYE and NICs will be payable on a ‘deemed payment’ on the last day of the tax year.

Item
Relevant
Engagements
Other
Engagements
For Corporation
Tax
£
£
£

Income

20,000

10,000

30,000

Less

 

 

 

Expenses

(500)

(5,000)

(5,500)

Salary paid in year

(10,000)

 

(10,000)

Employers NICs on this

(260)

 

(260)

Pension contributions

(2,000)

 

(2,000)

Flat Rate 5% expenses

(1,000)

 

 

Shortfall

6,240

 

 

Apportioned as:

 

 

 

Deemed Payment

5,483

 

(5,483)

Employers NICs on this

757

 

(757)

Corporation Tax Profit

 

 

6,000

Managed Services Companies (MSCs) are a special type of Personal Service Company. Please see our separate factsheet for details of the more rigorous rules that apply to MSCs.

Real Time Information (RTI)

Personal Service Companies, just like any other employers, will be legally required to tell HMRC about deductions they have made for PAYE, NICs and student loan repayments at the time (or before) they are made. This new scheme is being phased in from April 2013.

Payments of salary made during the year should be reported on a full payment submission (FPS). If there are no payments in a month, then the company should submit an employer payment summary (EPS) so that HMRC is aware not to expect an FPS or any payments that month. The final FPS will include a specific question to indicate that this is a Service Company which has operated the Intermediaries legislation.

Payments of deductions to HMRC should be made on the same basis as before – quarterly or monthly depending on the size of the business by the 19th or 22nd of the month. The provisional calculation of the deemed payment should be reported on an FPS on or before 5 April. As at present, any deductions on the deemed payment that cannot be calculated before 19 April should be paid by the following 31 January. Where a provisional payment has been made, then any adjustments should be reported via an earlier year update (EYU) submitted electronically to HMRC before the following 31 January.

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