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SMALL BUSINESS:

Contractors - An Accounting & Tax Guide



As a contractor providing your own services through a limited company you have a number of distinct responsibilities that you need to manage.

As a Director of a limited company you are required to prepare and submit a corporation tax return and financial statements for your company. You are responsible for calculating your companys corporation tax liability and paying any corporation tax due 9 months after the end of your companys accounting period. A corporation tax return then needs to be submitted electronically (together with supporting financial statements) to HMRC within 12 months of the end of your accounting period. You will need to file your financial statements with Companies House within 12 months from the end of your accounting period and can claim a exemption from the need to have an audit if you meet the small companies limit.

As a person engaging in trading activites you will need to review your obligations wih regard to registering for VAT – whether you are required to be registered and, if not, whether it is advisable. See our VAT Guide for further information.

You will need to determine whether your company is deemed a personal service (IR35) or managed service company because that will have a big impact on the way you account for taxes. See the sections below for further information on these issues.

It may be necessary for you to account for PAYE taxes on any employment income you receive or are entitled to from the company. HMRC’s current Real Time Information system requires you to submit certain payroll information to HMRC ‘on or before’ payments are made to employees. See our Employment Guide for further information.

One of the main perceived advantages to operating through a company structure is the flexibility you have as a director and shareholder to optimise the payments you receive from the company between salary and dividends to reduce the amount of tax you pay. The PSC and MSC provisions, if they apply, substantially reduce the flexibility you will have here.

In terms of your responsibilites as a taxable individual (income tax) you may also have to account directly to HMRC for all of the income you receive from your business (employment, dividend, interest etc) and elsewhere (dividends, interest, rental income, capital gains etc).

Do the IR35 or managed service company provisions apply to me?
There are specific rules regarding personal service or managed service companies which the tax legislation regards as ‘disguised employment’ and looks through the legal status to treat the individuals as employees from the perspective of administering income tax and NIC. Determining the treatment from the perspective of income tax and NIC does not determine the treatment for VAT purposes.

Factors pointing to employment include: the person carrying out the work personally; taking orders as to how, when and where to do the work; set hours; paid a regular salary including pay for sickness, overtime and holiday.

Factors pointing to self employment include: risking their own capital; carrying the cost of rework; freedom to appoint others to carry out the work; controlling where, when and how to do the work; providing their own equipment; regularly working for a number of different people.

HMRC have a online ‘Employment Status Indicator’ tool which can be used in ‘all but the most complex cases’, to signal employment status. They also publish many guides providing general advice and advice specific to a number of professions where these issues tend to occur. The section below provides further explanation on these 'Employment Status Factors'.

Personal service companies

The rules that govern the tax treatment of individuals providing their services through a personal service company are known as the IR35 rules. They cover situations in which a worker provides services to a client through an intermediary company or partnership and the income would have been treated as employment income if the worker had contracted directly. HMRC is in the process, following judicial criticism, of improving its guidance on which situations the IR35 provisions apply to and in providing a greater level of pre-transaction certainty as to whether the IR35 rules apply.

In terms of pre-transaction confirmation, HMRC provide helplines for one-off queries and a contract review service that can provide a certificate confirming that IR35 provisions do not need to be applied.

A company is within the IR35 provisions if the worker (alone or together with his associates) has a ‘material’ interest in the company.

Further information can be found at: HMRC/ir35

Managed Service Companies

The managed service company rules are similar to those for personal service companies but are for situations in which an outside business controls the administration and financial management of the intermediary company. MSC’s are concerned with providing the services of a worker to a client where the worker: receives most or all of the payment for his services; receives a greater amount (net) than he would have if employed directly and an MSC provider is involved with the MSC. The MSC rules require that payments for services, if not already treated as employment income, are treated as a deemed employment payment by the MSC.
What impact does IR35 or MSC status have on my company?

IR35 companies are required, at the end of the tax year, to treat the ‘profit’ generated by the company as a ‘deemed employment payment’ on the last day of the tax year (5 April) from which tax and NIC must be paid to HMRC by 19 April. There are specific rules that govern the calculation of the deemed employment payment in terms of the business expenses that can be deducted from the income. Expenses that can be deducted in arriving at the the deemed employment payment:
  • Flat rate expenses at 5% of income from client (net of VAT);
  • Expenses paid that would have been allowable if the worker was an employee;
  • Capital allowances that could have been claimed;
  • Employer pension contributions and Class 1 and 1A NIC; and
  • Actual salary payments made to the worker.
Similar provisions apply to partnerships.

The deemed employment payment and NIC are allowable deductions in calculating the intermediaries taxable profit. The payment of the tax on the deemed employment payment does not create a tax free sum of cash in the company that can actually be paid to the worker. The deemed employment payment should be paid as a dividend and an application will need to be made to avoid the tax due on the dividend payment which would otherwise represent a double tax charge. The deemed employment payment is also not considered as wages for the purposes of determining the wage level under the national minimum wage.

The Managed Service Company rules require that payments for services, if not already treated as employment income, to be treated as a deemed employment payment by the MSC.
What expenses can I claim?

For companies deemed to be a MSC or PSC please see the section above.

The general rule that applies across all incorporated and unincorporated businesses is that expenses must be incurredwholly and exclusively for the purposes of the trade.

Part of mixed expenses can be deducted, for example the business element of line rental and call charges and mixed living expenses where the business and private expenses can be accurately split. Reasonable expenses can be claimed for business travel.

Where an employee of a business (incorporated or unincorporated) gains a personal benefit from business expenditure the normal treatment is for the expense to be tax deductible in the businesses profits but it is taxed as a taxable earnings on the employee.

Accountancy expenses in relation to calculating profits and calculating the tax on those profits are generally held to be deductible although costs incurred preparing a traders tax return ( and capital gains) are not allowed and a distinction needs to be recognised when preparing the directors own personal tax return as opposed to the companys tax returns.

Capital or Revenue expenditure: capital expenditure cannot be deducted in arriving at taxable profits. Relief is given on capital expenditure through capital allowances. Items are capital in nature if they acquired ‘for the enduring benefit of the trade’. The nature of capital items versus revenue items will thus depend on the nature of a trade. For example, cars used by traders will be capital items but cars held for sale by a motor dealer are trading stock. Similar issues arise in determining trading income from capital profit.

Provision for future liabilities: allowable deductions provided they follow accepted accounting practice.

Business entertaining and business gifts are generally not allowable, although expenditure on entertaining staff is allowable but the VAT treatment of entertaining expenses differs.

Bad and doubtful debts specific provisions for bad or doubtul debts is deductible but not general provisions. The recovery of previously written off debts must be included in calculating taxable profits.

Interest paid wholly and exclusively for the purpose of the business is deductible.

Leasing of cars have a number of restrictions in terms of the tax deduction allowable including the level of CO2 omissions.

Private use of good and services goods taken for private use are valued at saleable value. Services are valued at cost and therefore do not introduce a profit element. Directors of a limited company taking goods or services are charged under the benefits rules and the cost of the goods or services is an allowable deduction for the company.

VAT - generally businesses registered for VAT will pay over the VAT they have raised on their customers and reclaim the VAT they have incurred on their supplies and thus VAT will not feature in the calculation of their profits. There are general restrictions in place regarding the input VAT claimed and output VAT charged on private use goods, services, and assets. Businesses not registered for VAT are entitled to include the input VAT as a business cost along with expenses that are deductible and also include the non recoverable VAT on the purchase cost of assets for calculating capital allowances. Adjustments to reported turnover and costs need to be made where the VAT flat rate scheme is used.

National insurance contributions – employers Class 1, Class 1A and Class 1B are all deductible.

Employment Status Factors

Unfortunately there is no simple and straightforward test for determining whether your company is caught by the IR35 rules. The fundamental question is whether the underlying contract you have with the client is one of employment or not. This is a matter that has been addressed, over many decades, by the courts, for a variety of reasons. This has lead to a number of factors being established which either point to an employment relationship or a self-employment relationship. HMRC did establish, in 2012, the business entity tests as an attempt to provide a clear indicator of the risk of IR35 applying to a specific contract. These test have been mush criticised on the basis that it is, in practice, very difficult for a contract to be classified as being low risk of IR35 applying. It has also been claimed that the weighting that the test applies to certain factors does not align with the weighting that has been applied by the courts. The BET’s are being withdrawn in April 2015 and there are no plans to replace them.
The process, therefore, for reviewing whether IR35 applies to you is to review the employment status factors, as defined by the courts, to establish whether your contract is effectively a form of employment or not. An overview of these factors is provided below. The factors that carry the most weight are the control, substitution and mutuality of obligation factors. Unfortunately, it can be a very subjective assessment and one that has, for certain cases, lead to challenges and appeals all the way to the House of Lords. The benefit of carrying out such a review is not only to understand the current and historical IR35 status but also to understand the specific contactual issue that may be creating an IR35 risk if you had not intended to be caught by IR35. This will allow you to review and amend the contract with your client.
Employment Status Factors
1. Control & Direction
Employees are generally under more control and receive more direction in terms of how, when and where to do the work than the self employed. The self-employed generally complete their work in line with specific milestones and objectives rather than being presented with a list of tasks and activities to complete, and have substantially more autonomy than the employee. Control factors that point to employment include:
  • Supervision and management by an employee
  • Having prescribed work start and end times, and even break times prescribed in the contract
  • Availability of employee perks such as provision for holiday and sick leave
  • Specific contractual rights prescribing control over the contractor
As with all of these indicators evidence world need to be provided both in the form of a written contract and by reference to actual working practices.
2. Right of Substitution
Generally an employee will provide their personal services to their employer whereas an independent business will provide its services to the business rather than the exclusive services of an individual.
A contract that contains a genuine right to provide a substitute if the contracted worker is unavailable is a strong indicator that the IR35 rules do not apply. An unfettered right provides an even stronger indicator and the actual use of a substitute the ultimate evidence of an independent business. Also, a business would pay for the costs of any substitute used and deal with any training that may be required and any client specific initiation.
3. Mutuality of Obligation
In an employment relationship a mutuality of obligation exists between the employer and the employee whereby the employee expects the employer to provide paid work for the employee and the employer expects the employee to undertake work when asked to do so.
The mutuality of obligation is evidenced when a contract expires and the nature and length of time over which new contracts are provided. HMRC argues that “where work is regularly offered and accepted over a period of time a continuous contract of employment may be created.”
Contracts that are fixed term, rather than rolling, and where the client can terminate immediately, rather than by providing notice, point towards a non-employment engagement.
4. Provision of Equipment
Employees tend to use equipment provided by their employer whereas independent businesses tend to provide their own.
5. Financial Risk & Reward
Employers tend to bear the financial risk associated with the services of their employees and tend to bear the cost of any associated rework that may be required. Employees also do not tend to be able to benefit financially as as result of their own efficiency, for example, by finishing a piece of work more quickly than anticipated. An independent business working to a fixed price contract would bear the cost of any work they had not anticipated but would also benefit financially if they were able to complete the work in a shorter time than anticipated, for example.
6. Basis of Payment
A fixed hourly/daily rate tends to indicate employment whereas payment on a per job/contract basis tends to indicate self-employment.
7. Part & Parcel
Employees tend to be more fully integrated into the day-to-day operations of the business than an independent business would be in terms of attending staff meetings, social events and by using staff facilities and receiving staff benefits.
8. Number of Clients
Independent businesses will tend to work for a larger number of independent clients over a period of time than an employee.
9. Intention of the Parties
The service contract will normally set out the formal intention of the parties with regard to employment or self-employment. If no contract exists then other means will be used to establish whether the parties intended the service contract to be one of employment or self-employment.
10. Set-up of Business
There are a number of other factors that can indicate whether a business is operating in its own right:
  • Office - does the business have its own office space?
  • Advertising - does the business advertise to attract clients?
  • Professional Indemnity Insurance - is the business required to have PII?
  • Website, email, stationery - does the business have and maintain an independent presence?
  • Employees - does the business employ people?
  • Bank account - does the business have its own bank account?
HMRC have an online ‘Employment Status Indicator’ tool which can be used in ‘all but the most complex cases’, to signal employment status. They also publish many guides providing general advice and advice specific to a number of professions where these issues tend to occur.
Tax Points
  • The mixing of private and business expenses should be avoided and the private use of a businesses goods should be avoided to prevent the creation of a taxable profit on the private use.
  • Wages paid after the end of the accounting period, for the accruals basis, must be paid within 9 months of the end of the accounting period to qualify for tax relief. Bonus payments after the end of the accounting period in relation to the accounting period will only be allowable where sufficient evidence exists before the end of the accounting period of the obligation to pay the bonus, such as recording the intention in the minutes of a board meeting.
  • All business records relating to tax affairs must be kept for 5 years 10 months after the end of the tax year.
Next Steps
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