Service Companies – More Trouble Ahead?

Jennifer Adams explains the different types of ‘service company’ and why the Chancellor’s Autumn Statement 2013 could have an impact on them.

As with any Autumn Statement, last month’s was not short of surprises. One announcement that should not have come as a surprise was the Chancellor’s intention to “tackle the growth of intermediaries disguising employment as false self-employment, depriving workforces of basic employment rights like the minimum wage in a bid to avoid employer national insurance”. The Government therefore intends “strengthening existing legislation to ensure the correct amount of tax and NICs are paid where the worker is, in effect, employed”. 

The Chancellor did not have to define what he meant by “intermediaries” as the term is well known to all who have dealings with those types of businesses – notably ‘IR35’ service and ‘managed service’ companies. The intention would appear to be the reinforcement of anti-avoidance rules already in place to such an extent that these companies will no longer find it beneficial to exist.  

Furthermore, a Select Committee has been meeting during the last month to discuss the tax collection consequences of the increased use of such companies. This article looks at the special type of companies being targeted, the reasons as to why the original legislation has failed, and the potential effect of the proposals currently being made.

In the 1999 Budget, the then Chancellor announced that he intended to stop what he saw as tax and National Insurance contributions (NIC) avoidance through the use of ‘intermediary’ companies and partnerships. The provisions remain highly controversial, being known as ’IR35’ after the number of the 1999 Budget Press Release of 9 March 1999. 

Prior to the introduction of the ’IR35’ legislation, it was not unusual for an individual (“the worker”) to set up a PSC (or partnership) as an ‘intermediary’, effectively placing itself between the worker and the contractor business for which he was actually working, thus avoiding the tax and Class 1 NIC that would have been deducted should the worker be an employee. The worker would then withdraw payment as dividends rather than salary. The downside of a true PSC structure is that the individual cannot claim unfair dismissal or other employment rights because he is not an employee. 

Should such an ‘intermediary’ situation now exist, the ‘IR35’ provisions will apply requiring the use of a special PAYE and NIC regime, such that the individual must pay the same amount of tax and NIC as if he were a direct employee (subject to a minor allowance for costs). 

The rules are to be found in HMRC’s Employment Status Manual at ESM0500. www.hmrc.gov.uk/manuals/esmmanual/ESM0500.htm).The guidance details how HMRC assess the risk (i.e. low, medium or high) as to whether the business entity might fall within the system. The assessment works on a points system; fewer points mean higher risk.

On 6 April 2007, the Government built on the ‘IR35’ anti-avoidance provisions with further rules aimed at the ‘managed service company’ (MSC). Under a MSC structure, a number of unrelated workers are shareholders with different classes of shares (but intentionally not directors), receiving dividends as payment rather than salary. Under the MSC anti-avoidance legislation, the MSC must deduct full PAYE on income paid to each contractor. Again, there are certain criteria that must be satisfied for the rules to apply.  

Under this arrangement the individual performs the work but the service company contracts with an agency which contracts with the end client. The individual is not an employee of either the agency or the end client. The contract is likely to be a bulk contract with a large number of people, such that the actual contract sometimes is not seen by the individual.

As so often with anti-avoidance legislation, all of the provisions are widely drawn, and could apply to a number of cases outside the original target area. More misleading still is that the term ‘service company’ is not used in the IR35 legislation, or indeed anywhere in tax legislation other than that covering MSCs (which is intentionally separate from the IR35 legislation). 

The IR35 rules were originally introduced to act as a deterrent against tax avoidance whilst recognising that some people were being forced off the payroll by contractors thus losing their employment rights and their right to state benefits. HMRC believe that such companies are increasingly being used as a shield against personal liability for the contractor, as well as being a method of reducing the risk of the individual being re-categorised as ‘employed’ by HMRC. 

In October 2012, newspaper reports claimed that up to 25,000 BBC employees had escaped paying income tax and NIC by actively promoting and making use of the service company method of payment. Thousands of senior public sector workers were also using PSCs. HMRC believe that many employers are ”…forcing employees to use PSC, telling them that their continued income was dependant on them taking that step, thereby moving NIC, holiday and sick pay costs from the employer to the (former) employee, more often or not with little or no explanation of those financial consequences…” (Select Committee comment). 

The Government is possibly awaiting the result of the consultation following the Select Committee’s report before deciding on how to proceed in ‘strengthening existing legislation’, as the Finance Bill 2014 clauses only refer to the section in the “Income Tax (Earnings and Pension) Act 2003” headed ‘Treatment of workers supplied by agencies’. But the result is the same - the usual PAYE must be paid. 

The new rules are clearly aimed at removing the obligation for personal service rather than focusing on the question as to whether the work is subject to ”supervision, direction or control” as quoted in HMRC’s guidance at ESM2005 - Agency workers. If the arrangement can be so described then the new rules will apply.

It can only be a matter of time before the IR35 rules themselves are strengthened to follow the same focus. Meanwhile, it is suggested that in order to attract the lowest possible points, the following could be considered:

The Self Assessment tax return has a section requiring details of salary and dividends if derived income is from a PSC. However, this has no statutory backing, and taxpayers cannot be penalised for failing or refusing to answer. The reason is that the purpose of a return is limited to the declaration of information that enables an individual’s tax liability to be calculated; it is not the legal purpose of the return to highlight possible ‘IR35’ cases.