PAYE & National Insurance
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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 rules target 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 to income earned in respect of work done after 5 April 2000 under contracts which would have been contracts of employment if the worker had been working direct for the client (relevant engagements). They do not introduce any statutory definition of employment or self-employment, so the existing case law will still apply to decide employment status (see : Employed or Self Employed?). The rules catch those employed in a domestic situation - eg nannies - as well as workers in the wider business sense after 5 April 2003.
Workers with up to 5% share in the intermediary (taking into account the holdings of family and domestic partners) are not subject to the rules, unless they receive payments or benefits which are not taxable under Schedule E.
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 and include it on the year end return P35 by 19 May. 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.
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 new 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 caught by IR35 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
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 new 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 an approved 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.
At the end of the tax year E Ltd will have 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 |
(653) |
|
(653) |
| Pension contributions |
(2,000) |
|
(2,000) |
| Flat Rate 5% expenses |
(1,000) |
|
|
| Shortfall |
5,847 |
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| Apportioned as: |
|
|
|
| Deemed Payment |
5,184 |
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(5,184) |
| Employers NICs on this |
663 |
|
(663) |
| Corporation Tax Profit |
|
|
6,000 |
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From 1 April 2004, profits distributed to individuals incur a non-corporate distribution charge of 19%
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