Personal Service Company and tax implications
How many of you aspire having your own business? I'm sure most of you do. We all think about all the positives : No more bound by another employer's rules, more money perhaps, being one's own boss is a dream.
Maybe you have seen or read about someone who has done it and is now the boss of his/hers own company or companies. Some are still on the way to get there.
For those who are already there or who want to get there here are some advice on important points regarding tax implications for yourself and your company.
Many businesses are 'uni-personal Limited' rather than 'self employed' or 'employed'.
Many big corporations are looking for 'contractors' who own a 'Limited company' because these comapnies wants to "employ" contractors under the 'umbrella'.
Do you know why a higher percentage of the UK contracting market prefers to creat a limited company to represent them? That is because:
- taxes for a limited company are lower (a flat rate of 20%) compared to a self employed or employed person (from 20% to 45% + NIC 13% / Employer NIC 13.8%)
- the limited company pays only corporation tax and no NIC
- the client/employer avoid paying NIC class 1 secondary, on salary and class 1A on benefits
- companies generally would favour contracting for a big job, thereby shielding them from the risk of mistake by blaming responsibility on contractors rather than their own employees.
Therefore many businesses are in fact limited companies which provide different services because tax convenience.
What does Personal Service Company (PSC) means?
In 1999 Chancellor Gordon Brown introduced the legislation IR35 about PSC. However there is no clear definition in law about a personal service company. That's what makes it tricky. This lack of clarity allegedly provides the HMRC plenty of room for manoeuvre when it investigates the tax bill of contractors and Limited companies owned by one shareholder & director.
In the past 11 years I have represented many clients undergoing Tax investigation. Lack of appropriate information for tax purpose was always an issue, exploited expertly by HMRC officials who often gained the upper hand. Without a knowledgeable accountant, you are almost certain to lose.
The HMRC consider the follwoing set of criteria when concluding whether or not a business is a Personal Service Company:
Business premises test: does the company operate from premises which are neither the worker’s home nor the client’s premises?
Professional indemnity test: does the contractor need PII
Efficiency test: has the business had the opportunity in the last two years to increase income by working more efficiently?
Assistance test: does the company engage workers other than directors/shareholders/partners who bring in 25% or more of the turnover?
Advertising test: has more than £1,200 been spent on advertising in the last 12 months?
Previous PAYE test: has the client engaged the worker on PAYE employment terms within the 12 months ended on the last 31 March for the same work?
Business plan test: does the business have a business plan?
Repair at own expense test: would the company bear the cost of putting right any mistakes?
Client risk test: has the company been unable to recover payment for work done in the last 24 months?
Billing test: does the company invoice for work carried out before being paid and does the company negotiate payment terms?
Right of substitution test: can the company send a substitute?
Actual substitution: has the company used a substitute in the last two years?
If HMRC believes that you fail the 12 criteria it will assign a Personal Service Company status to you.
Now you may wonder: "so what?"
This is where the fun begins.... Let's see how taxes apply for a PSC and for the owner.
For illustration let's see that with a fictitious example:
Alexandra is the only director & shareholder of Anca Ltd.
Alexandra through Anca Lld provides services to various clients.
- has a turnover of £150,000/year
- pays gross salary to Alexandra £60,000/year
- pays employer NIC (60,000 - 8112)x13.8% = £7,161/year
- pays pension for Alexandra £4,000/year
- and other allowable expenses £2,000/year
- dividends £5,000/year
Here are the most common mistakes, wherever is voluntary or involuntary:
Most of you would think that Alexandra has nothing to pay on her tax return because she already pays her income tax via PAYE system. And she has no dividends tax to pay because £5,000 is tax free.
And for Anca Ltd they will calculate Corporation Tax in a very simple way as follows:
Employer NIC 13.8% (£7,153) - £3,000 free allowance doesn't apply for companies with only one employee
Other expenses (£2,000)
Taxable income: £76,847
Corporation Tax 20%: £15,369
So the tax that HMRC gets is on the salary of £60,000 which is
- employee income tax and employee NIC £17,533
- employer NIC £7,153
£0 tax on £5,000 Dividends
Corporation tax £15,369
Total of = £40,055
IF THAT'S WHAT YOU THINK SHOULD BE DONE, YOU ARE WRONG!
HMRC tends to associate Personal Service Company to "tax evasion". In fact if you follow the steps from above precisely, this is tax evasion and is illegal.
The legal and correct way to calculate tax for Alexandra and for Anca Ltd base on the legislation IR35 introduced in 1999, is as follows:
Alexandra has to pay extra tax on 'Deemed Salary':
Anca Ltd turnover £150,000
Statutory deduction (150,000x5%) (£7,500)
Alexandra's salary (£60,000)
Employer NIC paid (£7,153)
Deemed salary including employer NIC £71,347
Employer NIC (75,347x13.8/113.8) (£8,652)
Deemed salary taxable £62,695
Deemed salary is a taxable salary. Through there might not have been any cash transaction and is in effect non-cash, it is considered the opposite by HMRC as far as taxable income is calculated.
Therefore Alexandra's income tax is not only on the £60,000 salary but on the deemed salary too.
Total Income for Alexandra:
- salary £60,000
- deemed salary £62,695
- dividends are substituted by the deemed salary
Total taxable income £122,695 but £60,000 has already been taxed via PAYE system so the remaining tax to be paid is on £62,695 and has to be declared via personal tax return section IR35.
Anca Ltd corporation tax will be:
Employer NIC 13.8% (£7,153) - £3,000 allowance doesn't apply for companies with only one employee
Other expenses (£2,000)
Deemed salary (£62,695)
Employer NIC (£8,652)
Taxable income: £5,500
Corporation Tax 20%: £1,100
In this case the tax that goes to HMRC on the salary of £60,000 and the deemed salary of £62,695 is
- employee tax and employee NIC of £43,865
- employer NIC £15,812
Total of £59,677
No Dividends considered
Corporation tax £1,100
Total of = £60,777
If you compare the tax that HMRC receives in the first scenario (which I said was a tax evasion one) with the tax that it receives in the second scenario, the different is £20,722.
You probably understand better now why HMRC are sensitive with small businesses with one shareholder and director - this is a red flag for tax evasion.
Alexandra could have avoided the implications of IR35 by taking additional gross salary of £62,695.
Having an accountant that advice you correctly based on currect law and extensive experience is always good in order to avoid unpleasant situations with the Tax Man.