Tax Helpsheets
Back to HelpsheetsIR35 Personal Service Companies
The IR35 legislation is designed to ensure that individuals working through intermediaries such as personal service companies (PSCs) pay broadly the same amount of tax and NICs as any other employees, where they would have been an employee if they were providing their services directly.
For example, by using a PSC it has been possible to extract profits from the company in the form of dividends rather than salary potentially saving significant amounts of national insurance. In addition, shares of the company may be split with the spouse or civil partner of the worker to help reduce liability to the higher rate of income tax. There is also often greater scope for making tax-deductible expenses by operating through a company rather than as an employee.
The regulations are applied where a worker supplies services through a relevant intermediary (which can be a company, partnership or individual), to a client and had the worker contracted directly with the client, the income would have been treated as employment income for tax purposes. The status tests outlined below are used to help determine whether the worker would have been treated as an employee or self-employed if they had contracted directly.
Large amounts of tax and NIC may be at stake. Every case needs to be judged on its merits and several factors need to be considered in coming to a conclusion on whether a contract is caught or not.
HMRC can provide an opinion on whether the contract is caught by IR35 or not, but do not provide opinions on draft contracts.
HMRC's online Check employment status for tax (CEST) tool is designed to help determine a worker's employment status for tax and NIC purposes. It gives HMRC's view of a worker's employment status based on the information provided. It can also be used to check if changes to the contractual or working arrangements alter the employment status.
CEST is also covered in HMRC's Employment Status Manual (ESM) from paragraph ESM11000.
Unsurprisingly perhaps, the view of HMRC often tends to come down on the side that the contract is caught by IR35 but very often their view has been shown to be wrong and should not be accepted without further investigation. Whether HMRC should also be asked for their opinion also needs consideration.
We can help advise you on how to stay on the right side of the law.
A company is a relevant intermediary for the IR35 rules if...
- the worker (together with his close family and business partners) controls more than 5% of the company; OR
- the worker receives payments or benefits which are not salary but which could reasonably be taken to be payment for services provided to the client
For partnerships the IR35 rules are only applied when any of the following apply...
- a partner (together with his close family) has more than 60% of the profits;
- most of the partnership profits come from the work of a single client;
- where a partners share of the profits is based on their income from the relevant contracts.
The Calculation
Any salary paid during the year has PAYE operated on it in the normal way during the year.
However, where there is income that is caught by IR35, then to the extent that it exceeds any salary to which PAYE is already applied plus taxable benefits, the excess will be treated as a deemed salary and is treated as pay on 5th April, and is liable to PAYE and Class1 NIC's accordingly. This makes the extra tax and NIC payable on 19th April following the tax year concerned, which is a very short timescale so contractors need to be organised. Interest usually runs on underpayments from this date.
In arriving at the excess salary, certain expenses can be deducted from the income derived from IR35 contracts as follows...
- a flat rate allowance of 5% of the net of VAT income;
- expenses that would have been allowable as an employee - this includes travel from home to the client's premises as long as the job is expected to and does not last more than 24 months;
- employer pension contributions;
- employer national insurance contributions;
- some capital allowances.
The excess amount is treated as being inclusive of employer's Class 1 NIC, so these are deducted to arrive at the deemed salary on which tax and NIC is calculated.
The deemed payment and employers NIC payment thereon are then deductible expenses for the intermediary company, treated as if paid on 5th April.
If actual salaries are paid later of amounts that were included in the deemed salary calculation, they cannot be paid free of tax and NI as they only reduce the salary payment of the actual year in which they are paid. To avoid potential double taxation it is better to use dividends.
If caught by IR35, the method of extracting funds from the company once the deemed payment calculation has been applied needs to be considered. For example...
- A salary could be paid during the year to avoid a large tax and NIC payment on 19th April but it does mean you pay the tax earlier.
- It is possible, subject to Companies Act 2006 compliance rules, to borrow from the company and then repay the borrowing out of a salary nearer the 5th April. There can be tax and NIC on the notional interest on the loan and it is possible a payment to HMRC of 25% of the loan will be required if the loan is not repaid in full within nine month of the company's year end.
- Paying interim dividends in the tax year following the deemed payment and then claiming for the dividend not to be treated as a dividend for tax purposes relieved to avoid any double taxation - this is often considered the best way forward.
Status Tests
In determining whether the contract is caught by IR35 it is necessary to consider the existing tests developed over the years to determine whether an individual is employed or self-employed. These tests can be summarised in one question: Is the individual in business on his own account when offering services to the client? If the answer is not a definite 'yes' the following factors need to be considered...
Requirement to provide a personal service
- Must you complete the work personally?
- Can you send substitute to do the work?
Control and supervision of the worker by the client
- Can you work at times to suit you?
- Does the client control how you do the work?
Mutuality of obligation between the parties for the duration of the contract
- Do you have the option to turn down work offered and does the client have the option not to offer work?
- Is each side obliged to offer work and accept work?
Financial risk of the worker
- Do you correct defective work in your own time, at your own cost?
- Are invoices raised by reference to the job rather than hours worked?
- Is public liability insurance in place?
- Is work carried out for more than just one or a very small number of clients?
Provision of equipment and materials by the worker
- Do you use your own equipment?
- Are materials supplied by you?
- Do you work from your own premises?
- Does your company have its own business stationery?
Trappings of employment
- Is holiday and sick pay paid to you by the client?
- Are any employment type benefits provided to you by the client?
- How long have you been working for the client?
- Is there a notice period to end the arrangement?
Intention of the parties
- What was the intention of the parties in forming the contract?
The first three factors are the most important. If one of these does not exist the contract does not have the attributes of an employment contract so must be another type of contract, such as a self-employment relationship. However to determine whether the worker is self-employed the other factors also need to be considered.
Dragonfly Consulting
The Dragonfly Consulting tax case established that the Tax Inspector can question the relationship between the end client and the worker, and if he decides that it is really one of employee and employer, in spite of all the various contracts, agency and service company in place, the extra tax due will fall on the worker's own company.
The case demonstrated how the contract between the agency and the final client can knock for six any clever contract drawn up between the worker's company and the agency. HMRC have proved that the entire stream of contracts needs to be considered and compared to what actually happens on the ground.
For example, the agency may agree to include a substitution clause in the contract with the worker's company, but if this clause is not reflected in the contract with the final client it is ineffective. Even if a substitution clause does exist in the agency/client contract it will be ignored if the client tells HMRC or the tax tribunal that it would never actually accept a substitute for the worker.
To ensure your working arrangement with your client will stand up to challenge by HMRC you need to see all the contracts in the chain, and be sure your client would agree to accepting a substitute if asked to.
MBF Design Services Ltd
In the 2011 case of MBF Design Services Ltd, a hypothetical contract was sought to be created to examine the relationship between the end client and the worker, the three key status tests of personal service, control and mutuality of obligations led to the decision in favour of the taxpayer. It was particularly noted that the ability to cancel the contract without notice and the fact that contractors were sent home without pay whilst employees had to remain on site meant there was a lack of mutuality of obligations.
RALC Consulting Ltd
The concept of hypothetical contract has continued to feature heavily in more recent IR35 cases. In the 2019 case RALC Consulting Ltd, the First Tier Tribunal (FTT) allowed an appeal against HMRC's determination that IR35 applied because a 'hypothetical contract' between various parties making up a service provider chain lacked the requisite 'mutuality of obligation'. The outcome of the decision in this case rested largely on the FTT's interpretation of mutuality of obligation. HMRC's interpretation that where one party agrees to work for the other in return for payment, satisfies mutuality of obligation between the two parties, was dismissed by the Tribunal. The appellant's circumstances were such that they were not caught by the IR35 legislation, and in turn, this outcome now throws further uncertainty into the IR35 framework.
Reform of off-payroll working rules
The government has always believed that PSCs perpetuate unfairness between two individuals working in the same way, but paying different levels of tax.
Over the past ten years, various steps have been taken to improve the effectiveness of the IR35 rules, with limited success.
Legislation in Finance Act 2017 reformed IR35 in the public sector. From 6 April 2017 responsibility for operating off-payroll working rules, and deducting any tax and NICs due, moved to the public sector body, agency or third party paying an individual's personal service company.
To further increase compliance with the off-payroll working rules for the public sector, the rules are being extended to medium and large organisations in all sectors of the economy, so they will take responsibility for assessing the employment status of individuals who work for them through their own limited company.
Medium and large-sized private sector clients have had to apply the rules since 2021. The private sector includes third sector organisations, such as some charities.
The rules apply to all public sector clients and private sector companies that meet two or more of the following conditions:
- an annual turnover of more than £10.2 million
- a balance sheet total of more than £5.1 million
- more than 50 employees
Balance sheet total means the total amounts shown as assets in the company's balance sheet before deducting any liabilities.
This is in line with the small companies' regime.
Further information on preparing for the changes to the off-payroll working rules can be found on the gov.uk website Prepare for changes to the off-payroll working rules (IR35).
Managed Service Companies
A Managed Service Company differs to a Personal Service Company in that there is normally a scheme provider that operates the company on behalf of the worker. Often these are known as "composite companies" with perhaps 10 to 20 workers being put through the same company or "managed personal service companies" with one for each worker but managed by the scheme provider on behalf of the worker.
HMRC will taken action to tackle Managed Service Company (MSC) schemes which are used to disguise arrangements that should be treated as employment arrangements for tax purposes and are used to avoid paying the employed levels of tax and national insurance.
Income that is received by workers through MSCs is now subject to employment levels of tax and NI. It is the responsibility of the MSC to operate PAYE and deduct the necessary tax and NI on the income.
In addition the rules for tax relief on travel expenses are the same as for other employed workers.
Whilst in many cases these companies should be caught by the IR35 legislation, they did not follow the legislation and when caught they simply liquidate as they have no assets, and start up another company the next day. To stop MSCs avoiding payment of these taxes, recovery of underpaid taxes and NICs will be possible from appropriate third parties, principally those behind the company operating such schemes including directors, shadow directors and connected or controlling parties.
These individuals will also be easier to catch as there will be no need to consider the specific relationship between each individual worker and the end client which was proving too labour intensive for HMRC.
The IR35 intermediaries legislation remains in place for personal service companies where the worker operates the company himself. The MSC rules are not targeted at these companies.
How we can help you
We can assist you with...
- Resolving contentious status disputes with HMRC
- Advice on your contract and an opinion on whether it falls within the scope of IR35
- Assistance in improving your contract for the purposes of remaining outside IR35
- All aspects of the accountancy and tax affairs of your business.