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Among the PBR notices was one that explained the Government's intention to tackle "Managed Service Company" (MSC) schemes. These schemes are used to avoid paying employed levels of tax and NICs. MSC schemes will be taken out of the scope of the "IR35" tax rules and will require income received by workers, in relation to services provided through the MSC, to be subject to employed levels of tax and NICs, with the MSC obliged to operate PAYE and deduct Class 1 NICs on the income. The rules for tax relief for travel expenses will be the same as for other employed workers.
IR35 rules for services provided through an intermediary
The "IR35" tax rules apply where workers supply their services through an intermediary. The intermediary may be a limited company or partnership. Where the business of a company consists of selling the services of its worker it is known as a "Personal Service Company" (PSC). The worker is usually a director of the PSC. While PSCs may supply the worker's services direct to the end client, in practice they more often find work through an agency. The end client pays the agency, which deducts its fee, and then pays the PSC for the services of the worker. The worker may draw a salary from the PSC but, as a shareholder of the company, is also able to receive dividends. By paying dividend income in place of salary both the worker and end client can avoid paying employed levels of tax and NICs.
The IR35 rules require the PSC to look at the contractual nature of the relationship between the worker and the end client to establish whether the contract is akin to one of employment. The PSC may have a number of clients and contracts during the year and each engagement must be considered separately. Where the particular contract is one of employment, the legislation requires the intermediary company to pay employed levels of tax and NICs on that part of the income deemed to be employment income and not already taxed as employment income.
Identifying Managed Service Companies
Managed Service Companies (MSCs) are also intermediary companies through which the services of a worker are provided to an end client. These are often known as "composites" or "managed personal service companies". In contrast to PSCs, the worker in an MSC is almost invariably not in business on his own account and is not exercising control over the business. This control lies with the provider of the MSC, known as the "scheme provider".
The existence of a scheme provider is a key feature of MSCs. MSC scheme providers are businesses (usually companies) which provide these generic company structures and then administer the schemes.
MSC scheme providers range from those who specialise in the provision of MSC schemes, often in a particular sector, to larger concerns which operate MSC schemes as one part of a wider business. Some employment agencies have set up separate MSC scheme providers.
In an MSC scheme, the worker obtains work engagements, usually via an agency, in the normal way. The worker supplying services usually takes no part in the on-going management or financial control of his MSC and is typically a worker-shareholder of the company, not a director. The MSC scheme provider handles payments between the agency and the MSC, deducting a fee for the work it carries out and arranging for the payment of the worker. The worker is often unaware of the details of the arrangement or its implications.
The marketing of MSCs schemes emphasises that the worker will not be involved in running the company - they simply receive payments for their services. Examples from the websites of MSC scheme providers include:
- "In a nutshell - we handle the boring administration that helps you keep more of your earnings and keep your free time for the things you enjoy."
- "We will also carry out all the administration and payroll, so that you can enjoy all the benefits of being an employee and a shareholder of your own limited company, without the hassle."
"…Hassle free without any of the usual headaches and costs associated with owning your own limited company."
- "You can choose to be paid monthly or weekly"
- "You agree with your agency whether you will be paid weekly, two-weekly or four-weekly and tell us which pay frequency you have agreed."
- "[We perform] all administration and management of each company."
Two types of Managed Service Companies
The specific arrangements of MSC schemes vary, but two common structures through which MSC schemes operate are "composite companies" and "managed personal service companies".
In a Composite Company scheme several, typically ten to twenty, otherwise unrelated workers are made worker-shareholders of a company. The size of the Composite Company is restricted to ensure that profits do not exceed the threshold for the small companies' rate of corporation tax. Each worker usually holds a different class of share in the company. This enables the Composite Company to pay different rates of dividend to each worker and, in practice, the dividend received will be directly related to the company's income from the end client for work undertaken by that worker. The MSC scheme provider, or a person associated with the MSC scheme provider, may be a director of the Composite Company and exercise full financial and management control of the MSC.
In contrast, in a Managed Personal Service Company (MPSC) scheme, there is only one worker per company structure. The MSC scheme provider performs similar functions for MPSCs as for Composite Companies, usually providing a director and exercising financial and management control of the company, typically performing this function for many MPSCs.
How Managed Service Companies operate
In practical terms, the day-to-day operation of MSCs is similar whether they are Composite Companies or MPSCs. There is generally an agency between the MSC and the end client and, in fact, some agencies have themselves set up associated MSC scheme providers. The mechanics of an engagement with an end client tends to work as follows:
- a worker agrees to undertake an assignment for an agency
- the worker joins the MSC, sometimes at the suggestion of the agency
- the MSC scheme provider provides the worker with the company name, share certificate and employment contract, and undertakes to carry out the company administration
- details of the agreed assignment are provided to the scheme provider, which puts in place contracts for the work to be provided through the MSC. The contracts contain the terms under which the worker will be provided. They are usually in standard form, altered only for assignment-specific matters such as hourly rate or location of work.
- the individual (or the agency) then informs the MSC scheme provider on a regular basis how many hours have been worked. These are then invoiced to the end client by the MSC scheme provider. Finally, the end client pays the scheme provider or MSC via the agency.
- when funds are received, the MSC scheme provider deducts an administration fee, retains an amount to cover tax and NICs and pays the balance into the worker's bank account - usually as a mix of salary, dividends and expenses reimbursements. All the calculations relating to these payments are carried out by the MSC scheme provider.
- the MSC itself often does not move with the worker from one assignment to the next - indeed the scheme provider may place another worker in the vacated MSC. This is in contrast to PSCs where the company is clearly associated with its owner-manager (the worker).
Non-compliance with IR35 rules
In contrast to PSCs, workers are almost invariably not in business on their own account and the underlying nature of the contracts in which they are involved is one of employment. The Intermediaries legislation should ensure that employed levels of tax and NICs are paid but HMRC's compliance activity suggests that in the vast majority of cases MSC schemes are not complying with this legislation.
- Workers in an MSC are usually paid a salary at the National Minimum Wage and the rest of their remuneration is paid in the combination of reimbursed expenses and dividends to minimise the tax and NICs paid.
- MSCs often use the rules on tax relief for employee travel to reduce the tax and NICs liability of individual workers. Workers in MSCs are treated as having one employment (with the MSC). This allows each location they work at to be treated as a temporary workplace (unless the period of continuing work at that place lasts, or it is reasonable to assume it will last, more than 24 months). This means that workers are able to get tax relief on the cost of travel from home to what would otherwise have been their permanent workplace. They are also able to get relief for the cost of overnight accommodation and subsistence.
- HMRC compliance activity has also found instances of MSCs paying travel expenses free of tax and NICs even where no relief is due.
- MSC scheme providers are aware that the Intermediaries legislation may deter workers from entering schemes and so some offer workers "IR35 proof contracts" and "IR35 insurance".
There are currently around 150 scheme providers operating in the UK, with about ten large ones providing the vast majority of workers in MSCs and HMRC estimates that the number of workers in MSCs has grown to at least 240,000 in 2005/06. While information on the range of sectors in which MSCs operate is limited, they have a significant presence in construction, information and telecommunications sectors and engineering. There is also increasing evidence of their use in healthcare and teaching, where there is intensive advertising to mobile professionals from overseas to encourage them to join MSCs when they sign up with agencies for temporary work in the UK. There is no restriction on the sectors in which MSCs can operate and some MSC scheme providers appear to be specialising in sectors such as contract cleaning, transport and the oil and nuclear industries.
Proposals for new PAYE and NICs procedures
The Government seeks to ensure that, where the underlying nature of an individual's contract is one of employment, tax and NICs should be paid at employed levels, even if the individual is working through a company.
Workers in MSCs are almost invariably not in business on their own account and the underlying nature of the contracts in which they are involved is one of employment and so they are within the Intermediaries legislation. However these rules are, in the vast majority of cases, not being followed by MSCs - and this regime was never intended to deal with widespread non-compliance on the scale displayed by MSCs. The Government will therefore remove MSCs from the scope of the Intermediaries legislation and will apply employed levels of tax and NICs to income received by workers in respect of services provided through MSCs.
The Government proposes to introduce legislation in Finance Bill 2007 to:
- oblige the MSC to operate PAYE on the income received by workers in the MSC in relation to their services provided through the MSC, with the NICs obligations arising by virtue of regulations to be laid immediately after the Finance Act receives Royal Assent
- apply rules for tax relief for travel expenses to put MSC workers in the same position as other employed workers by treating each of their engagements with an end client as if it was a separate employment with the end client, carried out at a permanent workplace
- address the problem of MSCs escaping payment of tax and NICs due by allowing the recovery of these debts from appropriate third parties where the MSC does not pay.
The new legislation will mean that the existing Intermediaries legislation no longer applies to MSCs and those working through them. Instead, where workers providing their services through an MSC receive payment for those services, the MSC is treated as making a payment of employment income to the worker. The MSC will be obliged to operate PAYE and pay NICs in the usual way.
It will not matter whether the worker receives payment:
- directly from the MSC or via a third party
- in person or to an associate of the worker (for example, the worker's spouse)
- in cash or non cash form, or
- described as a "dividend" or some other type of income.
The MSC is still treated as making a payment of employment income to the worker, and the worker is treated as having received it.
PAYE tax and NICs will be calculated on the amount of each worker's "deemed employment payment", i.e. the amount received for the worker's services, less allowable expenses, less the amount of employer's NICs payable. The MSC will be responsible for paying the tax and NICs calculated to HMRC.
Under this new tax treatment, in deciding what expenses can be deducted in arriving at the amount to which tax and NICs apply, the cost of travel between the worker's home and the place at which work is performed for the end client is not an allowable expense. This is because, in determining what, if any, expenses are deductible, the worker is treated as an employee of the end client. The cost of travel to each engagement is therefore not allowable. This puts a worker in the same position as they would have been had they worked directly for the end client.
Payments of dividends by the MSC are, under these new provisions, treated as part of the employment income of the worker. The legislation provides for relief to be given to avoid a double charge to tax.
In calculating the profits on which the MSC has to pay either corporation tax (as a company) or income tax (as a partnership), account needs to be taken of this new treatment of sums received by the worker. In respect of those sums, the company, or partnership, is only allowed to deduct, in working out its profits:
- the amounts paid out to the worker in the form of employment income,
- the amounts treated as employment income of the worker by these new provisions,
- the employer's NICs on both of those, and
- the expenses paid out to the worker (which the worker is entitled to deduct from taxable earnings).
All of the Governments proposals are subject to a consultation period that will run until 2 March 2007. The document includes the draft legislation for the taxation of the deemed employment payment (to be added to the Income Tax (Earnings and Pensions) Act 2003) and for the calculation of the profits of managed service companies (to be added to the Income Tax (Trading and Other Income) Act 2005).
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Further information:
Tackling Managed Service Companies
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