WA13

WA13 - Personal Service Companies - Face The Facts

You my have seen reference to this topic in the press under the title "IR35", which arises from the fact that the Inland Revenue's original Press Release on the subject bore that reference!

The Inland Revenue have for many years been concerned with the use of personal service companies to reduce the tax and national insurance liabilities of individuals. The particular circumstance causing most concern is where an individual is working for one client but has, through the use of a personal service company, effectively eliminated himself or herself from the client's payroll.

The new legislation to deal with this kind of situation took effect from 6 April 2000 and has the result of allowing the Inland Revenue to collect tax as if the individual received salary direct from the client, thus largely ignoring the existence of the intermediary service company.

This Memorandum considers the various ramification of the new rules. In certain circumstances, the legislation can apply to members of a partnership and similar principles will apply if a partner falls foul of the new rules.

Are you vulnerable?

If you carry out work for clients via a personal service company, it is necessary to consider carefully the reality of your relationship with the client. The Inland Revenue will analyse what actually happens, which may not be the same as the terms of any contract which you or your company may have with the client.

Each case will be different, and it is necessary to weigh up all relevant factors in order to determine whether you are "caught" by IR35.

Two factors will be particularly helpful in arguing that use of a service company is not a device to avoid tax and National Insurance Contributions ("NIC"):

• if you (or your company) are personally liable for negligence, failing to deliver on time, or for carrying out work in an unsatisfactory manner

• if your client permits you to substitute someone else when you are sick, on holiday or otherwise unavailable

Also, it will be easier to argue that IR35 does not apply if your company has a wide range of clients, rather than one or two who dominate.

Application for clearance

It is possible to send contracts to the Inland Revenue to seek their opinion as to whether or not IR35 will apply. It is important to bear in mind that the documentation should set out all relevant facts and it must reflect the reality of your relationship with the client. Thus, it is no good having a "substitution" clause in a contract if the reality is that the client would never, in practice, accept the services of a substitute.

In addition, if clearance is received, it is important to review the situation regularly to ensure that no significant changes have occurred which may affect the continued validity of the clearance

What happens if you are caught by the new rules?

The legislation is complex. If, for example, you operate via a "one person company" and distribute all the company's profits as a dividend to yourself, thus avoiding NIC, then, from 6 April 2000 onwards, this situation will be ignored by the Revenue and, for instance, any income received by the company from 6 April 2000 to 5 April 2001 will be treated as being received by you personally as earnings (with perhaps small deduction for expenses) on 5 April 2001. A similar situation will apply for later tax years. The company has to account for PAYE and NIC within 14 days of the end of
each tax year.

There are special rules to deal with the situation where the company has paid out some of the income to you during the year as salary rather than dividends.

The position will be particularly difficult to deal with if your company does not run its accounts to 31 March or 5 April, and/or if the company has a wide range of contracts with clients, some of which count as "self-employment" and some of which count as "employment".

You should note that the company itself may have a corporation tax liability under the new rules, even if you are directly taxed on all the company's income.

Expenses

The new legislation also gives rise to problems on the deducibility of expenses, since the rules for people who are employees or who are treated as employees are much stricter than the rules for companies and the self-employed. For example, there may be particular difficulties in obtaining tax relief for travelling expenses under the new rules.

However, the April 2002 Budget made a welcome change to the rules, whereby an employee of a personal service company can now be reimbursed for business mileage in his (or her) own car on a tax-free basis (subject to certain upper limits).
Alternatively, from 6 April 2002, the employee can claim tax relief for business mileage on a similar basis. These changes bring the treatment of employees of personal service companies into line with employees of other companies.

Pension contributions provide another potential problem area, since the tax treatment obviously depends on who actually makes the contribution and the amount of taxable earnings.

Why not adopt a "wait and see" approach?

It may be tempting to continue as before and to hope that there will be no investigation of your affairs by the Inland Revenue.

There are at least two serious problems with this strategy:-

• under self-assessment for companies and individuals, the onus is on the taxpayer to "get things right", not on the Inland Revenue.

• if the Inland Revenue do not investigate for, say, 6 years, all years from6 April 2000 onwards can be reassessed - potentially resulting in substantial liabilities for interest and penalties for you and your company for 6 years' incorrect returns. (In addition, the company's accounts will have been drawn up on the wrong basis!)

What next?

We believe that it is important to carry out a full review of your situation if you believe that the new rules could affect you.

We shall be happy to look at your current position and to advise you on the best strategy for the future, as well as how to deal with the past.

FOR GENERAL INFORMATION ONLY

Please note that this Memorandum is not intended to give specific technical advice and it should not be construed as doing so. It is designed to merely alert clients to some of the issues. It is not intended to give exhaustive coverage of the topic.

Professional advice should always be sought before action is either taken or refrained from as a result of information contained herein.

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