Avoid the consultancy tax trap

first_imgThecontroversial IR35 legislation may be here to stay, but it needn’t preventfirms buying in skills from personal service companies. It just requires alittle more craft and cooperation, says David AndrewsManybusinesses have traditionally sourced skilled workers by engaging them throughpersonal service companies operated by consultants. This arrangement minimisesthe risk of the consultants obtaining employment law rights against therelevant business. It also reduces the overall labour costs involved insourcing skilled workers, because the relevant business does not pay employer’sNational Insurance Contributions (NICs), the consultants are not given employeebenefits (such as pensions contributions or private medical expenses cover),and they are usually excluded from participating in any share option schemes.Untilrecently, this arrangement was also beneficial to consultants as they were ableto reduce their tax and NIC liabilities by means of their service companiesoff-setting operating costs against the fees they generated, paying a salary totheir spouses (in order to take advantage of the spouse’s lower-rate tax bands)and distributing part or all of the fees generated by paying dividends (whichdo not attract NICs) to the consultant as the owner of the service company.  However,controversial new tax legislation, generally referred to as IR35, hassignificantly reduced the tax advantages for consultants providing theirservices through a personal service company. A judicial review challenging theGovernment’s implementation of IR35 recently failed and many consultants arenow abandoning this method of operating. The scope of the legislation isfar-reaching, but it is still possible to engage consultants through personalservice companies, provided you take certain practical steps.Thescope of IR35IR35is the reference number of the press release issued by the Inland Revenue on 9March 1999 announcing the intention to change the tax laws. The legislationcame into force on 6 April 2000 and applies to a particular engagement whereeither: –The consultant, alone or with any associates (family and unmarried partners),has a “material interest” in the service company, meaning ownershipof more than 5 per cent of the issued ordinary share capital of the servicecompany, an entitlement to more than 5 per cent of the dividends declared bythe service company or (in the case of a closed company) to more than 5 percent of the assets on the winding up of the service company or–The consultant receives a payment from the service company, which is nottaxable under Schedule E, that could reasonably be taken to represent paymentfor services provided by the consultant to a client; and the consultant would,under the normal common-law test of employment status, be deemed an employee ofthe client if he or she carried out the work directly for the client and notthrough the service company.Helpingconsultants avoid legislationAnybusiness that wishes to continue to benefit from engaging consultants throughpersonal service companies will need to provide their consultants withassistance in trying to avoid the IR35 legislation. There are in effect twomethods of doing this.Theservice company through which the services are provided should be set up so thatIR35 does not apply. For example, if the business engages 21 or moreconsultants, the consultants could group together and provide their servicesthrough one service company. Provided each consultant takes an equalshareholding in the company, none of the consultants would own 5 per cent ofthe shares in the company or be entitled to 5 per cent of the dividends of thecompany. Aslong as the consultants do not receive a payment from the service company(which is not taxable under Schedule E) that could reasonably be taken torepresent payment for services provided by the respective consultant to hisclients, IR35 will not apply. One way around this is for the consultants toagree to take low basic salaries and pay out as much of the profit of thecompany as possible by way of dividends to each consultant as a shareholder ofthe service company.Thisproposal may not be attractive to consultants where there is a significantdifference in fee generation from consultant to consultant, as the only methodof reflecting the difference in fees generated by each consultant would bethrough payments taxable under Schedule E, such as additional salary,commission or bonuses. Makingsuch balancing payments reduces the scope for maximising the tax benefits ofoperating through a service company and therefore this type of scheme will onlywork well where the fee generation of each consultant is similar.Thealternative is to ensure, for each engagement-the consultant undertakes, thatthe common law test of employment status would not point towards employment ifit were not for the consultant acting through the service company. In order tominimise the chance that the test points towards employment, the businessshould be willing to agree with the consultant, to the extent it deems iscommercially acceptable, that:–The contract between the service company and the business does not include anymutuality of obligations requiring the service company (or, even worse, theconsultant) to perform any additional services that the business may requireand forcing the business to instruct the service company in relation to anysuch additional services the business may require–The consultant is free to determine when to provide the services (subject to anagreed delivery date for a project), where to undertake the services and howthe services should be approached to complete the project successfully–The engagement relates to the completion of a particular project, each projectcan be completed in a relatively short period (ideally no more than threemonths) and the consultant does not work for the business in relation toseveral projects back to back which continue for a long period in total–The terms of payment are based on a fixed sum for completion of a project(not  on an hourly or daily rate) sothat the service company can maximise profitability through the efficient andtimely completion of projects–The service company does not have to provide a particular consultant to performthe services and has the right to substitute any qualified person who isemployed or engaged by the service company–The service company has its own offices or place of work and providestransport, tools and equipment for the consultant-Theconsultant provides his services (through the service company) to severalclients, being instructed by different clients either at the same time, beforeor after the project undertaken for the business–The consultant does not receive any benefits (such as sick pay, pension,private medical expenses insurance or life assurance) from the business and thecost of providing such benefits is not expressly charged back to the businessby the service company–The consultant is not integrated into the workforce employed by the businessand does not undertake the same work as an employee of the business at aneighbouring workstation–The contractual documentation clearly states that the parties regard therelationship as one of self-employment and–If contracting through an agency, the terms of engagement between the agencyand the business and between the service company and the agency are consistentwith the above points.Ideally,a business should aim to build up a pool of consultants, any of whom they arehappy to engage. Consultants should then be engaged from the pool in relationto short projects, noting the points above, and the business should vary theconsultant engaged on back-to-back projects.FacingrealityTheInland Revenue will apply the IR35 legislation wherever possible to maximisethe collection of taxes through the PAYE system and so many consultantsoperating through service companies will be caught. If a business wishes tocontinue to benefit from self-employed consultants, it should do all that iscommercially reasonable to engage consultants in a manner and on terms thatwill permit them to operate outside the scope of the IR35 legislation.      DavidAndrews is an employment lawyer at Brobeck Hale and Dorr Comments are closed. Avoid the consultancy tax trapOn 1 Sep 2001 in Personnel Today Previous Article Next Article Related posts:No related photos.last_img read more