Companies that provide organisations with the services of one or more individuals may have to make PAYE deductions from most of their income under tax rules that came into effect on 6 April 2000. Although the first tax payment is not due until 19 April 2001, good planning now can reduce the problems that may result from this complex legislation, commonly known as IR35.

This report explains who will be affected and how the rules will operate and considers various possibilities for:

• Minimising the tax charge.

• Escaping the legislation altogether.

The purpose of the rules is to prevent individuals reducing their tax and national insurance contribution (NIC) liabilities on employment earnings by routing income through 'intermediaries'. Such intermediaries can deduct a range of business expenses, and pay dividends and a spouse's salary - both of which can be tax-efficient.

The new rules will remove these advantages by making the intermediary operate PAYE on all income received from a 'relevant engagement' minus certain very limited expenses.

The new rules will apply where the worker, or an associate, receives, or has the right to receive, income from the intermediary that is not taxable as employment income and:

• If the intermediary is a company, the worker and/or associates own more than 5% of the share capital, or receive income that represents remuneration for work performed and which is not taxable as employment income.

• If the intermediary is a partnership,

  • The worker (on his or her own, or with relatives) is entitled to 60% or more of the profits; or
    

  • Most of the profits of the partnership come from work for a single client; or
    

  • The worker's income from the partnership is based on the income generated personally from relevant engagements.

• If the intermediary is an individual, payments to the worker can reasonably be taken to represent the worker's earnings from a relevant engagement.

Associates include husband or wife, parents, grandparents, children, grandchildren, brothers and sisters, partners, and trustees of settlements formed by the worker.

The rules are drawn very widely. In effect, they catch all relevant engagements except work by genuine employees who have no way of benefiting from their work other than through their pay and taxable benefits package.

Relevant engagements

A relevant engagement exists where:

• A worker provides services under a contract between a client and an intermediary, and

• The income would have been taxed as employment income under the rules that determine the boundary between employment and self-employment, if the worker had contracted directly with the client under the same terms.

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The aim of the provisions is to impose PAYE at the end of the year on any income not already paid out as salary to the worker.

• At the end of the tax year, the worker's employment income, including benefits, plus the permitted expenses, is deducted from the company's income from relevant engagements. The resulting amount is deemed to have been paid to the worker as salary on 5 April. The company must account to the Inland Revenue for PAYE income tax and NICs on the deemed payment.

• The deemed payment is part of the worker's income for tax purposes and is included in relevant earnings for pension purposes.

• The company deducts the deemed payment in arriving at its profit for corporation tax purposes.

• For partnerships, the deemed payment is the income from relevant engagements less the permitted expenses. It is not included when computing the worker's share of partnership profits under Schedule D.

Permitted expenses

In addition to the worker's salary from the intermediary, limited deductions can be made in calculating the deemed payment ('permitted expenses'). These are:

• Employer's pension contributions to an approved scheme that are allowable under normal rules.

• All expenses that would be deductible as employment expenses under the normal Schedule E rules. This includes allowable business travel and other costs incurred wholly, exclusively and necessarily in the performance of the employee's duties.

• All employer's NICs plus the employer's NICs on the deemed payment itself.

• A flat-rate 5% of the income from relevant engagements, intended to cover administrative expenses and company running costs. This deduction is allowed regardless of the level of expenses, if any, the company actually incurs.

Example

Mr Brown's company, Brown Ltd, has an 18-month contract to supply engineering services to M plc, starting on 1 March 2000. The contract, which pays £6,000 a month, is a relevant engagement. Brown Ltd also has income from non-relevant engagements of £10,000 during the year ending 5 April 2001.

During the tax year 2000/01 the company has the following costs:

	£	£
Mr Brown's salary		20,000
Employer's NIC		1,907
Pension contributions		4,000
Allowable expenses related to relevant engagement		3,000
Wife's salary		3,500
Other expenses		10,000
Total		42,407
The deemed payment is therefore:
Income from relevant engagement (12 x £6,000)		72,000
Less:
Salary	20,000
Employer's NIC	1,907
Pension contributions	4,000
Allowable expenses	3,000
Flat rate 5% of £72,000	3,600
		32,507
Total		39,493
Of which the employer's NIC on deemed payment is:		4,294
Deemed payment		35,199
Mr Brown's total taxable earnings (£20,000 + £35,199)		55,199

Corporation tax

A personal service company is liable to corporation tax in the usual way, except that the deemed payment is deductible.

Continuing the example above, if Brown Ltd's accounting period is identical to the tax year, its profits liable to corporation tax will be:

 

	£	£
Gross income (£72,000 + £10,000)		82,000
Less:
Mr Brown's salary and employer's NIC	21,907
Other expenses
(£4,000 + £3,000 + £3,500 + £10,000)	20,500
Deemed payment plus NIC	39,493
		81,900
Total taxable profit		100

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Although the legislation is far-reaching, it can be avoided in many situations. The main ways are:

• Ensuring that the contract with the client is not a relevant engagement.

• Working directly for clients.

• Working abroad.

Avoiding relevant engagements

One of the central questions is whether the worker would have been an employee of the client if he or she had been engaged directly. There is no formal definition of self-employment, but several tests have been derived from case law over many years.

The overriding principle is that self-employed people have to be in business on their own account. Many factors have to be considered. An engagement might show some indications of self-employment but have other factors that point towards employment. In such a case, one has to look at the overall picture. In arriving at this 'overall picture', some of the more important factors indicating self-employment are:

• The right to send a substitute to carry out the work. This is one of the most important tests for personal service companies. Most contracts between client and intermediary specify a named individual to carry out the work. This on its own could make the contract a relevant engagement, because the requirement for personal service is strongly indicative of employment.

  • The Inland Revenue may ask for evidence to prove that a contractual right to send a substitute is genuine. The Inland Revenue has said that a right of substitution is only likely to exist where the client does not mind, from one day to the next for the duration of the contract, who carries out the work, provided that the person is suitably qualified and experienced.

  • The Inland Revenue does not accept that such a right exists where the client's permission has to be obtained before sending a substitute.

• Taking financial risk, for example meeting significant overheads or quoting a fixed price for the contract and bearing the cost if it overruns.

• The possibility of profiting from carrying out the work more efficiently.

• Control over how the work is undertaken. Attendance by the individual worker at the client's premises between set times every day is indicative of employment.

• The necessary provision of major items of equipment. Working at home by choice for part of the time is not enough.

• Payment for the job rather than a fixed monthly salary. Payment for holidays, sickness and other leave, and provision of expenses and benefits by the client, are generally indicative of employment.

• The intentions of the parties. These often form a clause in the contract and are important but not decisive.

• A large number of short engagements. This is more indicative of self-employment than a single longer contract, especially where the company has to adopt a business-like approach to organising the fulfilment of the engagements.

The wording of any contract between the client and the intermediary will normally determine whether the income arises under a relevant engagement, although the Inland Revenue can ignore contractual terms where they differ from the parties' actual behaviour. The client may be unwilling to accept a contract that removes the protection afforded by a typical employment-style contract that lays down a great deal of control over how, and by whom, the work is to be undertaken.

The Inland Revenue has set up a procedure for obtaining formal guidance on written and verbal contracts, either from local districts or by email to a dedicated IR35 email address. The Inland Revenue has not approved any form of model contract.

Working direct

If the contract cannot be amended satisfactorily, it may be preferable to abandon the intermediary company and obtain direct employment or work directly for an employment agency. However,

• In many of the industries where personal service companies are common, the client will be reluctant to grant employment rights and benefits to individuals on limited contracts.

• The individual might have to accept lower income because the client will want to recoup its own liability to employer's NICs.

Working abroad

Whether tax is due on the deemed payment will depend on the residence status of the worker and the location in which the duties of the contract are carried out.

• There is no tax liability if the worker is not resident in the UK in the tax year.

• If the worker is resident but not ordinarily resident in the UK, or is a non-UK domiciled person working wholly overseas for an overseas client, payments in respect of work overseas are taxable only to the extent they are remitted to the UK.

The location of the intermediary company has no effect on the tax liability on any deemed payments.

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Where the new rules cannot be avoided, there may be some scope for minimising the deemed payment. In general, it is more important to avoid circumstances that could lead to double taxation.

Expenses and benefits

Maximising the deductible expenses will reduce the deemed payment.

• An expense will require a genuine outlay, which will often not actually benefit the worker.

• Expenses can only be deducted if they are expended wholly, exclusively and necessarily in the performance of the duties of the employment. In particular, this excludes training courses, secretarial expenses, accountancy fees and the costs of seeking contracts. The cost of professional indemnity insurance is generally deductible.

• Paying a spouse's salary that is higher than the income tax personal allowance and starting threshold for employee NICs should be avoided unless it falls within the 5% allowance because it can, in effect, result in double taxation.

• The cost of using a company car for business travel can be deducted. This could be calculated by using the Inland Revenue's authorised mileage rates. The amounts deductible are the car benefit charge, on which the employee is taxed, and the employer's NICs on it, but not the company's actual costs of providing the car.

• Travel to the site where the work is undertaken will generally be deductible business travel if the contractor does not expect to spend more than 40% of his or her working time at any one site for a period of not more than 24 months. Keeping contracts shorter than two years should normally allow the deduction of travel costs.

• Maximising pension payments will reduce the deemed payment while also benefiting the worker.

Corporation Tax

If a company regularly incurs expenditure that cannot be deducted in calculating the deemed payment, and has little income other than from relevant engagements, it will accumulate corporation tax losses which it will be unable to use - in effect creating double taxation.

• Expenses that cannot be deducted from the deemed payment should be limited as far as possible; or

• The company should try to generate other income that does not arise from relevant engagements. This will absorb those company expenses that cannot be deducted in calculating the deemed payment.

Paying actual salary

The deemed payment is deductible for corporation tax for the accounting period in which the deemed payment date falls. Timing differences can result in income being liable to both income tax and corporation tax, especially where the company's accounting period does not coincide with the end of the tax year.

Paying enough salary to avoid a deemed payment avoids this difficulty by giving the company greater control over its corporation tax.

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The deemed payment for the income of each tax year arises on 5 April of that year and the PAYE income tax and NIC is payable 14 days later. Companies can make a provisional calculation, and by doing so they should normally avoid any penalties on late PAYE returns, but interest on any outstanding tax will run from 19 April.

• Companies need to have good records in order to calculate the deemed payment quickly.

• Paying actual salary will minimise interest due to underestimating the deemed payment.

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If the additional tax cannot be avoided, there might be scope for charging the client organisation more in order to cover the extra costs. Room for manoeuvre may be limited but other workers are likely to be doing the same and market forces could well transfer at least some of the extra costs to the ultimate client.

If you have any questions about these changes please call us.