Sarah Bradford considers whether in light of the changes to the off-payroll working rules operating through a personal service company is still worthwhile.
For some time, the personal service company (PSC) has been the ‘holy grail’ of tax-efficient business structures. This model is one in which the optimal profit extraction strategy is to pay a small salary at a level that is free of National Insurance contributions (NICs) but sufficient to count as a contributing year for state pension purposes and to extract further profits as dividends, which despite being paid from profits that have already suffered corporation tax, offer the availability of a tax-free dividend ‘allowance’, no NICs, and the lower dividend rates of tax.
However, in recent years, the PSC has begun to lose its shine. Back in 2016, the taxation of dividends was reformed and the ability to extract profits in the form of dividends without paying until the basic rate band had been used up was lost. The dividend allowance provided something of a sweetener, allowing some dividends to be extracted tax-free, although this allowance was subsequently reduced from £5,000 to £2,000. While the dividend tax rates are still lower than income tax rates, they come with the condition that they can only be paid out of retained profits on which corporation tax at 19% has been paid, and they must be paid in proportion to shareholdings.
Where a PSC has been set up as an alternative to operating in a self-employed capacity as a sole trader, the PSC generally remains a more tax-efficient option; but the costs and administrative burden of operating as a company are higher, and should not be overlooked.
However, where the personal company is something of a smokescreen for a relationship that would otherwise be one of employee and employer, the waters are somewhat muddied and will become more so from April 2020 with the extension of the off-payroll working rules.
Extension to the off-payroll working rules
From 6 April 2020, the off-payroll working rules as they already apply where the end client is a public sector body are extended. From that date, the rules will also apply where a medium or large private sector organisation engages workers who provide their services through an intermediary such as a PSC. The end client will be required to determine whether, ignoring the intermediary, the worker would be an employee if the services were provided directly.
HMRC’s check employment status for tax (CEST) tool can be used for this purpose. If the verdict is that the worker would be an employee of the end client, the client (or the fee payer, if different) must deduct tax and NICs from the deemed payment made to the worker’s PSC. The sums deducted must be reported to HMRC via real time information and paid over to HMRC, together with employers’ NICs.
If the end client fails to make a determination or apply the rules, HMRC will hold them liable for the tax and NICs on payments made to the worker’s intermediary.
The change in the rules is already having an impact on the way in which workers are engaged, with many private sector organisations having announced that come April they will no longer engage contractors providing their services through a PSC or another intermediary; instead, they will take on employees.
Impact on contractors
The test as to whether the extended off-payroll working rules will apply from April is the same as the pre-existing test for determining whether the worker is within IR35; and in this respect, nothing is changing. In each case, the rules will bite if, ignoring the PSC or another intermediary, the worker would be an employee of the end client.
Thus, assuming that the relationship is the same before and after 6 April, if the extended off-payroll rules apply after 6 April 2020 the worker should be applying IR35 prior to that date and the PSC should be working out the tax on the deemed payment at the end of the tax year and paying it over to HMRC.
However, the reality is that many workers providing their services through a PSC that should have been applying IR35 were not actually doing so. The lack of compliance with the IR35 rules and the associated difficulties in policing the rules were key drivers for the change.
As a result, from April 2020, many workers who should have been within IR35 will find themselves within the off-payroll working rules and will suffer deductions for tax and NICs on payments made to their PSC. Where this is the case, the worker will have the associated costs and administrative burden of running a PSC, but none of the associated advantages. In this situation, it may be preferable to throw in the towel, become an employee, and wind up the PSC.
On the plus side, if the worker had been operating IR35 from April 2020, the employers’ NICs liability will fall on the end client rather than the worker’s PSC.
Where the end client is a small private sector organisation, the off-payroll working rules will not apply. Instead, the IR35 rules will continue to apply. It is prudent for workers who supply their services to a small private sector organisation through a PSC or another intermediary to check whether they should be operating IR35. HMRC’s CEST tool can be used to provide a status determination.
Not all workers who provide their services through a PSC are disguised employees; many operate in what would otherwise be a self-employed capacity – something that can be confirmed by running a status determination using HMRC’s CEST tool. In the same way that they are outside IR35, they will fall outside the extended off-payroll working rules. For such workers, it should be business as usual from April 2020 and the PSC will remain a valid modus operandi.
PSC no longer required
In the event that, as a result of the off-payroll working rules a worker will be on-payroll from April 2020 and their PSC is no longer required, the next issue is what to do with it. There are various options available.
(a) Striking off
If there is less than £25,000 to extract, striking off can be a tax-efficient option. Special rules allow distributions made in advance of dissolution to be treated as capital rather than as a dividend. This has the advantage of being able to shelter some or all the gain by the capital gains tax (CGT) annual exempt amount, with the balance being taxed at 10% where entrepreneurs’ relief is available or the taxpayer’s total income and gains do not exceed the basic rate band.
To qualify for this treatment, the company must first satisfy any debts that it has, and the company must be dissolved within two years of making the distribution.
Capital treatment will not always be beneficial. If the CGT annual exempt amount has been used and entrepreneurs’ relief is not available, paying a dividend will result in a lower tax bill. To secure the dividend treatment, it is necessary to breach the conditions for the capital treatment to apply, for example, by waiting at least two years after making the distribution before dissolving the company.
(b) Members’ voluntary liquidation
The use of a striking off application to secure capital treatment and benefit from entrepreneurs’ relief is not an option where the funds to be distributed exceed £25,000. If the taxpayer’s personal circumstances are such that it is beneficial for the remaining funds to be taxed as capital (and liable to CGT) rather than as a dividend, a members’ voluntary liquidation (MVL) can be an attractive option, as depending on the level of funds to be extracted the costs of the liquidation may be more than covered by the tax savings that can be achieved.
Under an MVL, the capital extracted from the company is treated as a capital distribution and is liable to CGT, rather than being taxed as a dividend. Where entrepreneurs’ relief is in point, the rate of tax will only be 10%, assuming sufficient of the entrepreneurs’ relief lifetime limit remains available. If significant funds are available for distribution, this can generate considerable tax savings.
Practical tip
Where the off-payroll working rules apply from April 2020, consider whether operating through a PSC remains worthwhile. It is recommended to take professional advice.
