Sometimes there is more to a Payment solution than meets the eye!
IR35 has added to the complexity of taxation legislation and forced many more contractors to seek specialist tax advice. Unfortunately, a lot of this advice can be misleading, offering short-term gains with high risks.
HM Revenue & Customs (HMRC) are actively investigating some of the practices used by contractors to minimise their tax payments (tax avoidance) and may well examine each of your contracts individually rather than take your earnings as a whole. Therefore, as a contractor you need to be very careful when you choose your payment solution.
Pay as You Earn (PAYE)
Avoids the entire IR35 headache and is the HMRC compliant standard. The PAYE system is a method of paying income tax. Your employer deducts tax from your wages or occupational pension before paying you your wages. Wages includes sick pay and maternity pay.
This means that you pay tax over the whole year, each time you are paid. Your employer is responsible for sending the tax on to HM Revenue and Customs (HMRC).
Contractors that work through an employment agency and receive all income via PAYE
Agencies, only pay a reduced rate as they still have to pay out National Insurance, holiday and sick pay costs, together with the additional administrative burden of running a payroll and complying with current employment legislation.
Personal Service Companies (PSC) / Limited Companies
PSC's are commonly one man bands, processing income as part salary and dividend payments. In the past, contractors used this method to exploit tax loopholes and improve tax efficiency. Contractors set up a limited company and pay themselves via a minimum wage and dividends.
However, this method is now classed as risky because:
Contracts inside IR35 dividend payments are simply NOT viable anymore.
HMRC view minimum wage/dividend options as tax avoidance and may impose PAYE.
If there is no "goodwill" in the company, a contractor may be seen as receiving "disproportionate return on initial investment" and dividend will be taxable as PAYE.
(according to section 447 of the ITEPA, 2003)
Outside IR35: if a dividend payment takes a contractor over the 40% tax threshold they will face an end of year tax liability.
You will find many agencies and clients will not allow you to use this method until you've had your employment contract reviewed by a IR35 specialist, which can cost upwards of £150 per contract assessed.
An umbrella company acts as employer to independent contractors who work under a temporary contract, usually through an employment agency.
Since the introduction of the Managed Service Company (MSC) legislation in the budget 2007, the only way an independent contractor can comply with this requirement is to set up his or her own personal limited company or use an umbrella company.
An umbrella company issues invoices to the recruitment agency (or client) and, when payment of the invoice is made, will typically pay the contractor through PAYE (although historically the term has also been used for salary and dividend type payment structures).
Umbrella Companies are fast becoming both the choice for both contractors and agencies alike:
-Company pays the contractor via PAYE on the total contract sum and uses a HMRC approved dispensation to offset business expenses.
-IR35 is irrelevant as all income is paid as PAYE.
There is no legal or tax law definition of the word "composite company". However, this term is commonly used in the context of service providing companies to the contracting industry.
The word "composite" means "made up of various parts" and in the context of contractors, is represented as a service providing company, through which many contractors place their contracts.
A mixture of salary & dividend payments now, could be viewed as blatant "tax evasion" by the HMRC, according to section 447 ITEPA, 2003:
-Company provides administrative services, invoicing and receiving payment for work carried out - eases burden for contractor.
-Contractor paid a small salary plus expenses, remaining income paid via dividends.
Popular in the past, this option was viewed by the government as 'tax avoidance'. New legislation introduced in the budget 2007 means that it's now looked upon as blatant 'tax evasion' for workers Inside IR35.
If you are deemed employed, this option should no longer be pursued.
Employee Benefit Trusts (EBTs)
Once an attractive option, the 2002 Pre-Budget Report announced immediate legislation to counter the avoidance of Tax and National Insurance contributions (NICs) through the abuse of EBTs.
Contractor works under company receiving basic salary, usually 20-30% of contract value, with balance paid into an offshore trust from where it is loaned back to the contractor.
Loan is in foreign currency so avoids IR35, taxation and NI.
HMRC has now closed the loophole on this scheme and EBTs can no longer operate.
Tax relief is now only allowed on PAYE payments made by the trusts, i.e. the lower salary figure, and not on loan.
The HMRC Anti-Avoidance Group has set up a team to project manage these cases to ensure that the tax outstanding is collected systematically and consistently.
Foreign loans are a legal means of "avoiding" Tax and National Insurance, however Gordon Brown announced in his budget on 17th March 2004 the intention to introduce a scheme which will force any Company setting up and marketing "tax avoidance schemes", to register with the HMRC.
As with most tax law, the measures are not at all clear. For example who defines "the obtaining of a tax advantage"? Presumably anything we do which does not involve us paying the highest amount of tax possible could be covered by this? The penalties for not registering or notifying will be up to £600 per DAY.
-Loans made to contractors in foreign currencies and repaid (often at very low rate).
-Must be operated in conjunction with an offshore company, not taxed on profits.
-Offshore companies are scrutinized by HMRC and all dealings would be challenged and taxed as income if received by a UK resident.
In short, this tax avoidance scheme is under so much scrutiny that for the average contractor the hassle and risks involved are just not viable.
Offshore schemes are classified as any financial setup where income is moved outside the UK to avoid paying the host countries rate of Tax and National Insurance contributions. Payments are usually made as distributions, loans and dividends.
The Inland Revenue's Special Compliance Office is gearing up for a crackdown on offshore umbrella companies and other tax avoidance schemes designed for solo contractors caught by the unpopular IR35 legislation.
The HMRC have warned contractors not to rely on schemes they have developed to get around IR35, as they could crumble when examined.
All income generated in the UK by a UK resident must be declared - whether received or not - and is subject to IR35 criteria and taxation.
HM Revenue & Customs now have power to view details of around 100,000 UK-domiciled clients of Offshore Schemes.
Investors with undeclared offshore accounts are being urged to come forward and HMRC is proposing to offer reduced penalties for a limited period, although investors will still have to pay their tax bill plus interest for up to 20 years.
An offshore account is a high risk option.
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