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Over eight years ago, in April 2000, the government introduced the “IR35” rules, provisions aimed at preventing tax avoidance by means of “intermediary” personal service companies, set up by individuals to minimise employment tax and NICs liabilities.

This was followed, in April 2007, by the introduction of new and different measures aimed at preventing tax avoidance by the use of “managed service companies” to get around the IR35 rules.

HM Treasury is now consulting on yet further measures to block the use the “overarching employment contracts” to avoid paying tax and NICs on the payment of travelling expenses to temporary workers.

The consultation document, published in July 2008, is entitled Tax relief for travel expenses: temporary workers and overarching employment contracts. In introducing the proposals, the government states:

“Umbrella companies and some employment agencies make use of overarching employment contracts which enable some temporary workers to gain tax relief for travel expenses not available to others working in similar circumstances. There is also evidence of widespread abuse of the travel expenses rules by these structures. Non-compliance and the use of these structures to pay less income tax and national insurance contributions (NICs) lead to a loss to the Exchequer, as well as further problems.”

The following notes explain the issues that the government seeks to address and, at the same time, endeavours to clarify the different employment arrangements that are addressed by the existing “personal service” and “managed service” legislation and the proposed new measures that are likely to be introduced from April 2009.

Employment
In simple terms, “employment” describes the relationship between an employee and an employer. Where an employment contract exists, the employer’s payments are subject to PAYE tax and both employer and employee are required to pay Class 1 NICs on the payments. Other rules apply to the tax and NICs due on the provision of benefits and the payment of expenses and, with reference to travelling expenses, the legislation defines which expenses are taxable and which are not.

For comparison purposes with the other arrangements described below, the following chart uses the term “end client” instead of “employer”, and “worker” instead of “employee”.

To bring the employment contract to an end normally requires one of the parties to give notice and, if the employer gives notice, there are “unfair dismissal” issues to consider and various payment obligations to meet. Employment does not, therefore, provide the flexibility that many businesses and individuals prefer. As a result, employers and workers have sought more flexible working arrangements, including the use of fixed-term employment, where the contract between the employer and employee ends after a defined period or when a specified event occurs, and agency work.

Agency work
Although there are some variations, agency work is an arrangement between three parties – a worker, an agency and an end client. There are two contracts,

• an “agency contract” between the agency and the worker, which is usually not an employment contract, and
• another contract, between the agency and the end client, to provide the services of the worker to the end client.

The end client pays the agency for the worker’s services, and the agency, after deducting its fee, pays the worker.

The factors in this arrangement that provide flexibility are

• the end client can dispense with the worker’s services at any time,
• the worker can choose when to work
• the agency does not have to guarantee the provision of work.

Although the contract between the agency and the worker is not an employment contract, if the worker is subject to control over how the services are provided, the agency is treated as the employer and the worker as an employee for both PAYE tax and Class 1 NICs purposes.

Intermediary companies
With the objective of avoiding the levels of tax and NICs imposed on workers in the employment and agency arrangements described above, a number of models have been developed that involve “intermediary” companies. There are three different models, the first two of which are, or were, designed to create a working relationship that avoids the tax and NICs obligations of employment, and the deemed tax and NICs obligations of agency work.

The three models are

• personal service companies (PSCs),
• managed service companies (MSCs), and
• umbrella companies.

Personal service companies
The so-called “IR35” legislation takes its name from the number of the 1999 press release that announced the government’s intention to address the issue of workers avoiding the levels of tax and NICs that they would pay if they were in employment. The IR35 rules apply where a worker sets up an “intermediary”, i.e. a limited company (sometimes a partnership), to supply services to a client. The worker is a director and shareholder of the company. The company or partnership is known as a “Personal Service Company” (PSC). Some PSCs contract directly with the end client to provide the worker’s services; others contract with an agency. In this latter situation, the end client pays the agency, which deducts its fee, and the agency then pays the PSC for the services of the worker. The PSC then pays the worker (1) a salary, often at the national minimum wage, and (2) dividend payments, which are tax free to basic rate taxpayers.

Where the PSC contracts with the end client, there is no employment contract. Where the agency contracts with the end client, there is no agency contract with the worker. In both cases, there are no PAYE tax or Class 1 NICs obligations. Instead, the IR35 rules require the PSC to consider whether, for each engagement, the nature of the work for the client is such that, if the contract were made between the worker and the end client directly, the end client would have had to treat the worker as an employer, deducting PAYE tax and Class 1 NICs. If so, the IR35 legislation requires the PSC to pay employed levels of tax and NICs on that part of the income from the contract that has not already been subjected to tax and NICs.

Managed service companies
Managed Service Companies (MSCs) are also intermediary companies through which the services of a worker are provided to an end client. In structural terms, they may be “composite companies”, where up to 20 workers become shareholders in the same limited company, or “managed personal service companies”, where there is just one worker per company, as with PSCs. The key difference from PSCs is that the worker in an MSC is usually not in business on his own account and does not exercise control over the business. This control lies with a separate business, known as the “managed service scheme provider”, which sets up and administers the MSC on behalf of the worker.

In principle, MSCs fell within the IR35 legislation. However, due to widespread non-compliance by MSCs and their failure to tax all travel, accommodation and subsistence expenses, the government decided to remove MSCs from the scope of the IR35 legislation. Since April 2007, MSCs have had to treat payments made to workers, including expenses payments for commuting journeys and related accommodation and subsistence, as employment income and deduct PAYE tax and Class 1 NICs as if they were employees of the MSC. The number of MSCs in operation has decreased substantially.

Umbrella companies
The Treasury’s latest consultation document addresses a more recent attempt to minimise workers’ tax and NICs liabilities. Umbrella companies are not new but they have grown in popularity since the MSC rules were introduced in April 2007.

The umbrella company is a limited company and the workers, any number of them, are contracted to the company as employees. They are not directors or shareholders. The employment contract is known as an “overarching” employment contract as it relates to the services that the worker provides for a number of end clients. The worker performs no work directly for the umbrella company.

The workers are paid a salary and expenses and the umbrella company, as the employer, deducts PAYE tax and Class 1 NICs. Each worker may source engagements directly with end clients, or may use an agency to source engagements. The contract for the worker’s services is between the end client and the umbrella company or the agency, as appropriate. The umbrella company’s sole source of income, therefore, is from contracts with a number of end clients and/or a number of agencies. From the payments received under those contracts, the umbrella company deducts administration fees and sums towards future holiday pay before paying the worker’s salary and deducting tax and NICs.

The first key difference between umbrella companies and PSCs/MSCs is that all of the workers in an umbrella company are employees and are, therefore, for the full range of employment rights. There is no attempt to avoid PAYE tax and NICs on salary payments. However, the government’s area of concern relates to what it sees as serious exploitation of the travel and subsistence expenses legislation. The “overarching” contract allows each end client’s workplace to be treated as a temporary place of work, thus allowing the worker to claim tax relief on the travel, accommodation and subsistence expenses incurred when working at those workplaces. Under the recent MSC legislation, all such workplaces are treated as permanent places of work and, as such, no tax relief is allowed.

Some of the related practices that are of concern to the Treasury are:

• payment of travel expenses under a salary sacrifice arrangement – a proportion of salary is sacrificed and paid instead as travel expenses, thereby reducing the worker’s tax and NICs, and the umbrella company’s NICs.
• the use of dispensations to agree scale rates for subsistence expenses, and encouraging workers to claim the scale rate whether or not an expense was actually incurred
• the unfair competition this creates, putting compliant companies at a financial disadvantage
• encouraging employment in an umbrella company by advertising the tax savings be means of expenses claims
• agencies encouraging or requiring workers to use umbrella companies because the agencies do not have to operate PAYE or deduct NICs
• anecdotally, agencies or agency staff receiving payments from umbrella companies for each worker referred to them
• the increasing use of overarching contracts by agencies themselves for the same reasons as umbrella companies
• if HMRC identifies specific abuse of the tax relief provisions, it may not be possible to collect the tax and NICs owed as umbrella companies have few or no assets and simply wind up the business and move the workers to a new company.

The consultation document puts forward two options to address these issues:

1. allowing the existing arrangements to continue but introduce legislation to tackle non-compliance, or
2. removing entitlement to tax relief for travel expenses for umbrella companies and employment agencies using overarching employment contracts.

Interested parties are invited to submit their views and comments on the issues and proposals included in the consultation document. The deadline for responses is 13 October 2008.

Further information:
Tax relief for travel expenses: temporary workers and overarching contracts
Tax relief for travel expenses: temporary workers and overarching employment contracts

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The UK Payroll News is sponsored by HRD & Payroll Solutions

Written by Ian Congreave -

Filed under: Compliance on August 11th, 2008

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