IR35 Personal Service Companies

The ‘IR35’ rules are designed to prevent the avoidance of tax and national insurance contributions (NICs) through the use of personal service companies and partnerships.

The rules do not stop individuals selling their services through either their own personal companies or a partnership. However, they do seek to remove any possible tax advantages from doing so.

Summary of Approach

Removal of tax advantages

The tax advantages mainly arise by extracting the net taxable profits of the company by way of dividend. This avoids any NICs which would generally have been due if that profit had been extracted by way of remuneration or bonus.

The intention of the rules is to tax most of the income of the company as if it were salary of the person doing the work.

To whom does it apply?

The rules apply if, had the individual sold his/her services directly rather than through a company (or partnership), he/she would have been classed (by HMRC) as employed rather than self-employed.

For example, an individual operating through a personal service company but with only one customer for whom he/she effectively works full-time is likely to be caught by the rules. On the other hand, an individual providing similar services to many customers is far less likely to be affected.

Planning consequences

Employment v self-employment

One of the major issues under the rules is to establish whether particular relationships or contracts are caught. This is because the dividing line between employment and self-employment has always been a fine one.

All of the factors will be considered, but overall it is the intention and reality of the relationship that matters.

The table below sets out the factors which are relevant to the decision.

Exceptions to the rules

If a company has employees who have 5% or less of the shares in their employer company, the rules will not be applied to the income that those employees generate for the company.

Note however that in establishing whether the 5% test is met, any shares held by ‘associates’ must be included.

How the rules operate

The company operates PAYE & NICs on actual payments of salary to the individual during the year in the normal way.

If, at the end of the tax year - ie 5 April, the individual’s salary from the company, including benefits in kind, amounts to less than the company’s income from all of the contracts to which the rules apply, then the difference (net of allowable expenses) is deemed to have been paid to the individual as salary on 5 April and PAYE/NICs are due.

Allowable expenses:

• normal employment expenses (eg travel)
• certain capital allowances
• employer pension contributions
• employers’ NICs - both actually paid and due on any deemed salary
• 5% of the gross income to cover all other expenses.

Where salary is deemed in this way:

• appropriate deductions are allowed in arriving at corporation tax profits and
• no further tax/NICs are due if the individual subsequently withdraws the money from the company in a HMRC-approved manner (see below).

Points to Consider from the Working of the Rules

Income and expenses

The income included in the computation of the deemed payment on 5 April includes the actual receipts for the tax year.

The expenses are those incurred by the company between these two dates.

In order to perform the calculations, you need to have accurate information for the company’s income and expenses for this period. You may need to keep separate records of the company expenses which will qualify as ‘employee expenses’.

Timing of corporation tax deduction for deemed payment

A deduction is given for the deemed payment against profits chargeable to corporation tax as if an expense was incurred on 5 April. This means that relief is given sooner where the accounting date is 5 April.

Will the company make a taxable loss because of the legislation?

If a company’s expenses are high the company may make a taxable loss. This can be relieved against other income or by carry back in the first year of the new rules, but can only be relieved by carry forward against future trading income after this.

If you consider that you may be in a similar position, you need to estimate the effect now. We can help you with the estimates if required.

One reason why the projected expenses will create a loss would be where the company pays a spouse a salary. The amount of the salary may need reviewing.

Pension contributions

Payments made by your company into a personal pension plan will reduce the deemed payment. This can be attractive as the employer’s NICs will be saved in addition to PAYE and perhaps employee’s NICs.

Other Points to Consider

Extracting funds from the company

The advantage of paying a salary is that the tax payments are spread throughout the year and not left as a large lump sum to pay on 19 April. The disadvantage is fairly obvious!

Borrowing from the company on a temporary basis may mean that no tax is paid when the loan is taken out, but it will result in tax and NICs on the notional interest on the loan. There may also be a need to make a payment to HMRC equal to 25% of the loan under the ‘loans to participators’ rules.

The payment of dividends may be the most attractive route. If a deemed payment is treated as made in a tax year, but the company has already paid the same amount to you or another shareholder during the year as a dividend, you will be allowed to make a claim for the tax on the dividend to be relieved to avoid double taxation.

The company must submit a claim identifying the dividends which are to be relieved.

Getting ready for 5 April

There is a tight deadline for the calculation of the deemed payment and paying HMRC. The key dates are:

• the deemed payment is treated as if an actual payment had been made by the company on 5 April
• tax and NICs have to be paid to HMRC by 19 April
• form P35 showing details of the deemed payment has to be submitted to HMRC by 19 May.

HMRC have announced relaxations from the strict requirements above allowing provisional figures to be calculated and submitted. However, interest on overdue tax is chargeable from 19 April if tax and NICs are underpaid on the basis of provisional figures.

It is therefore in your interests to have accurate information on the company’s income and expenses on a tax year basis and, in particular, separate records of the amount of the company expenses which will qualify as ‘employee expenses’.

Partnerships

Where individuals sell their services through a partnership, the rules are applied to any income arising which would have been taxed as employment income if the partnership had not existed.

In other words, where a partnership receives payment under an ‘employment contract’:

• income of the partnership from all such contracts in the year (net of allowable expenses as described above) are deemed to have been paid to the individuals on 5 April as salary from a deemed employment with PAYE/ NICs due accordingly and
• any amount taxed in this way as if it were employment income is not then taxed as part of the partnership profits.

Partnerships excluded from the rules

Many partnerships are not caught by the rules even if one or more of the partners performs work for a client which may have the qualities of an employment contract.

The rules will only apply to partnerships where:

• an individual, (either alone or with one or more relatives), is entitled to 60% or more of the profits or
• all or most of the partnership’s income comes from ‘employment contracts’ with a single customer or
• any of the partners’ profit share is based on the amount of income from ‘employment contracts’.

Penalties

Where a personal service company or partnership fails to deduct and account for PAYE/NICs due under the rules, the normal penalty provisions apply.

If the company or partnership fails to pay, it will be possible for the tax and NICs due to be collected from the individual as happens in certain circumstances under existing PAYE and NIC legislation.

Managed Service Companies (MSCs)

MSCs had attempted to avoid the IR35 rules. The types of MSCs vary but are often referred to as ‘composite companies’ or ‘managed PSCs’. HMRC had encountered increasing difficulty in applying the IR35 rules to MSCs because of the large number of workers involved and the labour-intensive nature of the work. Even when the IR35 rules had been successfully applied, an MSC often escaped payment of outstanding tax and NIC as they have no assets and could be wound up.

The government has introduced legislation which applies to MSCs. The rules:

• ensure that those working in MSCs pay PAYE and NIC at the same level as other employees
• alter the travel and subsistence rules for workers of MSCs to ensure they are consistent with those for other employees
• allow the recovery of outstanding PAYE and NIC from ‘specified persons’ if the amounts cannot be recovered from the company.

MSCs are required to account for PAYE on all payments received by individuals on or after 6 April 2007. NICs are due on payments made from 6 August 2007.

The ‘specified persons’ who may be called upon to pay PAYE and NIC will primarily be the MSC’s directors and the person(s) who provided the company to the individual. The provision is likely to have effect for debts incurred from August 2007. In certain cases the debt can also be transferred to persons who encourage or are actively involved in individuals’ provision of their services through MSCs. This provision will take effect for debts incurred on or after 6 January 2008.

How We Can Help

We can advise as to the best course of action in your own particular circumstances.

If IR35 does apply to you we can help with the necessary record keeping and calculations.

3. Corporate and Business Tax

3.1 IR35 personal service companies
3.2 Corporation tax self assessment
3.3 Quarterly instalment payments
3.4 Tax saving opportunities for companies
3.5 Incorporation
3.6 Franchising
3.7 The Construction Industry Scheme
3.8 Capital allowances

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1. Starting up in business
2. General business
3. Corporate and Business Tax
4. VAT
5. Employment Issues
6. Employment and Related Matters
7. Personal Tax
8. Capital Taxes
9. Pensions
10. ICT
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