Pre budget report 6 December 2006: New managed service company legislation proposed

Background
The background to this is that, for many years, working via a limited liability company has offered a number of tax savings for individuals who regard themselves as self-employed. These individuals are often called contractors or limited company contractors and are very common in sectors like IT and engineering. They usually set themselves up via limited companies using the help of MSCs, who offer a range of contracting models including:

ï composite arrangements (where the contractor is a shareholder in the composite company, usually with several other contractors);

ï personal service company arrangements (where the contractor is the sole shareholder in the personal service company); and

ï umbrella company arrangements (where the contractor is an employee of, rather than shareholder in, the umbrella company).

The current tax position is set out in the legislation known as IR35. IR35 requires PAYE and NICs to be accounted for if, but for the existence of an intermediary in the contractual nexus between individual service provider and service recipient, the contractor would be an employee of the service recipient. Whether someone is an employee is determined by employment status case law going back hundreds of years. Provided the contractors fall outside IR35 (which they often claim they do), they are usually able to put a number of personal expenses through their companies and then draw down the balance of their gross remuneration as dividend (which reduces National Insurance Contributions).

The Treasury has been painfully aware for some time that contractor numbers have been growing (to perhaps more than 250,000), and that IR35 is not working because contractors can usually argue that they do not have any employee characteristics.

As a result, in January 2005, the Treasury said that it was aware of the increasing number of self-employed individuals adopting this corporate legal form for tax reasons rather than as a step to grow, often as marketed tax-avoidance schemes. More recently, in March 2006, the Chancellor stated that further evidence has emerged that employment income is being disguised as dividends in order to take advantage of the small companiesí tax rate, often encouraged by promoters of mass-marketed managed service company schemes. The Chancellor went on to say that he believes that all individuals and businesses must pay their fair share of NICs in tax, irrespective of legal form.... As the first stage of this review the Government will consult on action to tackle disguised employment through managed service company schemes.

Yesterdayís announcement follows a period of about nine months during which the Treasury has been drafting a technical note setting out proposals for new definitions of employment and self-employment for tax purposes. It is clear that they have found this drafting exercise more complex than they originally thought it would be ñ it is widely accepted by experts in this area that the tax status of contractors is not easy to deal with by new legislation.

What are the proposals?
The proposals, published yesterday in a 60 page document include draft legislation which will require MSCs to pay PAYE and deduct Class 1 NICs on all income received by individuals providing services through them.

Organisations which set up:

ï composite companies;
ï managed personal service companies; and
ï umbrella companies

for contractors are intended to fall within the proposed definition of managed service company.

Personal service companies or single member companies operating independently of a managed scheme appear not to be covered by the legislation, and IR35 considerations will continue to apply to these types of companies.
The legislation clarifies that the cost of travel between a service providerís home and place at which they work for the service recipient will not be an allowable expense.

The legislation also introduces a new right for HMRC to pursue debts from appropriate third parties in circumstances where the composite (or other managed service arrangement) becomes insolvent. Appropriate third parties will be those who have been directly involved in and benefited from the provision of managed services to the insolvent companies. Query whether this could include end users or staffing companies in certain cases?
The Government is inviting consultation on these issues between now and 2 March 2007.

We will be issuing a more detailed briefing in due course outlining:

ï the impact on users of contractors;
ï the impact on recruitment companies; and
ï contracting models which may not be affected by the new proposals.

Initial comments
In the meantime it appears to us that the proposals may have failed to take into account a number of important complicating factors including the following:

ï recent Court of Appeal decisions such as Cable and Wireless v Muscat 2006 suggest that in many cases contractors are the employees of the service recipient, and yesterdayís proposals support this view by saying that the underlying nature of the [relationships] is one of employment. If that is the case the obligation to deduct PAYE and NICs lies (per the PAYE regime) with the service recipient. How will the proposed new regime sit alongside that? Can HMRC recover tax twice (per the recent Demibourne case)?

ï the biggest user of contractors in the UK is the UK public sector. Indeed HMRC itself is a heavy user of IT contractors. If an additional tax burden is introduced into the supply chain will this push up the cost of using these contractors (especially the ones whose skills are in relatively high demand and who may expect the same take home pay as before)? Will the Chancellor end up having to pay out much of the increased tax revenue he collects in the form of higher staffing budgets for Government departments? Will skilled Australians and New Zealanders still want to come here unless their take home pay rates are preserved?

ï will contractors affected by this decide that if they are to be taxed as employees they might as well get the upside as well (i.e. employment rights)? Will the longer serving contractors start claiming that they should be given retrospective membership of pension schemes, saying that they have been discriminated against? Will contractors affected by offshoring claim unfair dismissal? Again, will this end up costing the Chancellor more in tribunal awards against the public sector than is gained in higher tax revenue?

ï the definition of MSC appears to rely on the fact that the contractor companiesí finances or general management are controlled by the scheme provider rather than the individuals supplied through the companies. What does control mean in this context? HMRC has taken the view in recent cases (and yesterdayís proposals repeat this view) that control should mean who controls in practice rather than who has voting rights etc. This may be an area of contention, with MSCs denying that the companies they operate are in practice controlled by the scheme provider and developing arrangements under which the individuals do in fact control how the companies are operated;

ï an assumption is made that the sole reason for incorporation by contractors is the avoidance of tax. However the writer of this briefing was taught on his first day at law school that the purpose of incorporation is to limit personal liability. Many contractors operate as contractors for this reason. Others incorporate because they like the idea of the status of being a consultant. Itís not all about tax and we think the Treasury would be wrong to assume that all contractors set out to be wicked under-payers of tax;

ï it seems likely that there will be confusion as to whether the services of chartered accountants and solicitors who often help set up and run companies for individuals will be caught by the legislation. There may be other innocent victims. What about payroll outsourcing companies? What about consultancies, many of whose workers are shareholders? Will small management or outsourcing consultancies whose key personnel are often shareholders and nearly always work on client sites be affected? Will franchise arrangements (which often involve financial management services being provided by franchisors to franchisees) be affected?

ï how will this new regime interplay with the new Construction Industry Scheme?

ï paragraph 5.14 of yesterdayís announcement states that labour market flexibility in the UK will be unaffected. This remains to be seen. No doubt some key workers will consider working overseas, and the cost of engaging them in the UK may rise, forcing some major companies to be more attracted to offshore the sorts of projects (e.g. IT development) reliant on such workers. Many key workers from overseas may be less inclined to work in the UK.
These comments are very much early stage comments, based on a very quick review of parts of yesterdayís announcement. Obviously a proper review of the proposed legislation will be carried out by us over the next few weeks.