From the beginning of contractors providing services there have been options for how a contractor performs the tasks of meeting legal obligations while working for themselves. Whether it was through an umbrella company, a limited company or through sole trader status or partnerships, there have been a variety of beneficial reasons to choose each as well as a few differentiations between the choices which make certain options stand out over the rest.

 

Earning retention schemes are not new either – traditionally there has been an array of options for contractors to try to retain as much of their earnings as possible. Different tax vehicles laid promises of high returns such as the Employee Benefits Trust and the Offshore Intermediaries, until HMRC stepped in and shut them down. When that happened contractors were left open to a review and to essentially paying back taxes on the amounts that they thought they gained.

 

 

The Managed Service Company was arguably the most successful of these schemes. Also known as Composite Companies, Managed Service Companies were a type of company structure that grouped contractors together under the auspices of a corporation which was managed and owned by a service provider. The Managed Service Company would then go on to avail of tax advantages for the contractors in line with working for a limited company while at the same time reducing time spent and responsibility for same. By this standard a contractor would be seen to provide their typical service to their typical clients through the Managed Service Company but they did not retain any control over the company. This idea did not take long to raise eyebrows over at HMRC, who duly investigated.

 

Considering what HMRC found, legislation was immediately passed prohibiting companies from using this form of circumventing maneuver. The legislation, aptly titled ‘Tackling Managed Service Companies’ targeted companies that could be seen to be to be setting up composite structures in order to evade PAYE and NIC contributions and payments. The treasury determined that any contractor working in this way would have their tax credits automatically adjusted to show their true status.

 

 

The legislation took effect in 2006 and was clearly outlined, income received by contractors working under an MSC would be liable for PAYE and Class 1 NICs on that inome, as well as tax expenses being put in line with any employed worker. The legislation allowed for recovery of debts to third parties from contractors who had used this method previously and continues to remain in effect. HMRC believed this would level the playing field and gain a level set of compliance from both workers and businesses alike.

 

 

 

The legislation was ratified in 2007 and became law – from then on, if a contractor was able to prove that they were their own boss they would become liable so that all income paid to their company would come by way of a salary and contribute PAYE and NIC accordingly.

 

 

Was This Legislation Really Necessary?

 

 

HMRC felt that the legislation was necessary as it became evident that many contractors were abusing the rules and evading taxes, trying to evade IR35 legislation. Managed Service Companies would be seen to ‘employ’ 20 or more contractors who were all considered no-director shareholders, with the company managed by a service or scheme provider. The benefit in that method was that contractors could be paid extremely low salaries while gaining above average exemptions while the rest of their salary could be paid as a dividend. This would have appeared to be an efficient means of working by the contractor, who would not be blamed for being confused as to the legality of their approach since it was being recommended by existing companies. In truth, through looking at the IR35 legislation it was clear that this should not be happening.

 

These composite structures saw a steep rise in use and implementation leading up to 2007, while HMRC found a great loss in their tax retention and payment rates. The MSC’s did not have assets to be seized, so by default HMRC noticed  quickly that something was amiss as it became nearly impossible to collect on losses. The MSC’s also shut down and stopped trading as fast as they were created, by creating a new MSC and continuing on.

 

 

How The Legislation Works In Practice

 

The accepted definition of a Managed Service Company, as given by HMRC, became a company that provided services of individual contractors to third parties and whom were also involved in the provision of the services or the control of the services which were paid for. This proved that the contractor was not a business in their own right and did not have full control or responsibility over their employment affairs.

 

The Managed Service Company is described by HMRC a ‘person who carries on a business of promoting or facilitating the use of companies to provide the services of individuals.’  However, for the MSC legislation to be applicable the service provider of the scheme must not only fulfil that definition of a provider but also be involved with the client companies. HMRC noted that regardless of whether a tax advisor or accountant held any professional qualifications to provide client advice to service companies were not MSC providers based on only their client base. The determination as to whether or not a contractor is carrying on as a business lied in the promotion or facilitation of a company to provide such services.

 

Due to the structure involved any collection of liability became incredibly difficult. With the new legislation HMRC is able to collect from third parties who were in the scope of recovering debt. The legislation define appropriate third party debt recovery agencies are ones who encourage, facilitate, or otherwise actively be involved in the MSC provision of the worker. This equated to MSC providers becoming responsible for debts as well as the MSC directors. Workers also fell into these debt transfer regulations and became liable if it could be proven that they knew they were working under an MSC. Third parties knowingly dealing with MSC who could be determined to know that fact would also become liable for the debt in any circumstance where the debt could not be taken from the MSC, directors or office workers.

 

 

What Was The Effect of the Legislation?

 

HMRC considered the legislation very successful and worked in decreasing tax avoidance by contractors. The legislation was intended to address MSC’s that set up in order to facilitate the contractor’s tax evasion. Outstanding monies were collected by HMRC based on this calculation and contractors were accordingly labelled employees and charged the correct amount of PAYE and NIC. This meant that IR35 became an issue for MSC’s operating for this reason and many dissolved their business based on this. It did not even matter where the MSC was located, within or outside the UK, if they were helping UK residents evade tax they became susceptible to the legislation.

 

 

What About Umbrella Companies?

 

HMRC clarified from the outset that umbrella companies did not fall into this legislation as it could only apply where a company has contractors as shareholders and received their income in the form of a dividend. By virtue of the fact that umbrella companies always pay the correct amount of PAYE and NIC they were not considered at odds with the rules. The legislation defined who was affected and that was individuals who worked through a Personal Service Company that were not within the new MSC definition and individuals working through umbrella companies. It went on to state that if an umbrella company worker is treated as an employee of the umbrella company and the company paid all taxes they could not be considered as a MSC.

 

 

What Does The Legislation Mean Today?

 

The legislation worked alongside IR35 and resulted in tax loopholes and tax vehicles being shut down as well as new anti-avoidance rules that contractors must be aware of and avoid. This resulted in very few operating MSC’s and an influx of workers choosing umbrella companies as they were the only tax vehicle left that offered security of knowledge of full legal and tax compliance.