The aim of the HMRC is to remove the tax advantages from contractors who are selling their services via partnerships, under umbrella or managed service companies. The view of those very generous people at the Revenue is that contractors are, in effect, full time employees and should be taxed accordingly. Contractors, unsurprisingly, do not agree.
The legislation that governs this often fraught relationship is IR35. IR35, in short, is a ruling that states if you can be considered 'employed' by the company you are contracting your services to, then you become liable to pay tax and NI contributions as if you were directly employed by that company.
Some of the indicators that a contractor falls under the IR35 legislation are as follows :
1)The contractor has no financial risk from working on the project in question.
2) The contractor does not use his own materials and/or equipment on the project.
3) The contractor has set hours, as would a normal 'employee'.
4) The contractor works soley for a single client and does not have several clients.
Contractors looking to maximize their income would be well advised to be aware of IR35 before signing any contracts. Avoiding IR35 can make a very significant difference to the income of a contractor.
Even better, they should, at the very least, speak to an accountant who has significant experience in dealing with contractors.
In essence, contractors falling outside IR35 have two basic choices, now that Managed Service Companies have effectively been outlawed by recent changes in legislation.
The first choice is an Umbrella Company.
An umbrella company is, in effect, your employer for tax purposes when undertaking a contract with either a client or an employment agency.
Umbrella companies raise invoices on your behalf and pay you once they have received the funds. Many umbrella companies pay you the same day they receive the funds, but some will pay you only once a month.
What you will receive from an umbrella company is a payslip detailing not only your tax and NI contributions (both employee and employer contributions), your umbrella company's fees and any expenses claimed.
Umbrella companies have a special dispensation that means that they can process some expenses without having to record them on a P11D. This does not mean that, if investigated, you don't have to produce receipts for all expenses. You do.
However, all expenses are processed by your umbrella company, making things very much simpler for you. Expenses that can be charged to your employment agency or to your client will be refunded to you in full, while those expenses which are not are processed as a tax benefit.
The second option available to UK contractors is setting up a limited company, where you, the contractor, become a shareholder and director in the company.
Usually, a limited company is the most tax efficient option for a contractor.
This is because, as a limited company, a wider range of expenses can be claimed back and the legislation governing such things as capital allowances is far more detailed for limited companies. Accountancy fees, capital expenses such as machinery, research and development costs - all these things can be claimed back.
In practice, there isn't really that much paperwork involved, particularly if you decide to employ an accountant or bookkeeper to take care of things like VAT returns, monthly accounts & payroll.
The limited company offers a greater scope for reducing tax liability of contractors than does an umbrella company. One of the reasons is that, as a shareholder and directory of your company, you can choose to pay yourself a small wage but take the bulk of your income as dividends, thereby attracting smaller national insurance and tax liability.
Taking advice from accountants experienced in dealing with contractors should be your first step in ensuring you minimise your tax bill and maximise your earnings. At the very least, you will get to understand the issues and, perhaps more importantly, how much paperwork is involved in each of the options available to you.
First examine the facts as they exist in the current financial year 2007-08. The current approved mileage allowances were set five years ago in the financial year 2002-03 and while the current rates in no way reflect the increases in fuel costs in recent years that all businesses including small business. The Inland Revenue is actually considering a revised scale of tax allowances that may even lower the overall amount that can be claimed which will be detrimental to small business.
The approved mileage allowance for cars and vans is 40p per mile for the first 10,000 business miles and 25p per mile for each business mile over 10,000 miles in each tax year. The approved mileage allowance for motor cycles is 24p per mile for the first 10,000 business miles and 24p per mile for each business mile over 10,000 miles in each tax year. The approved mileage allowance for bicycles is 20p per mile for the first 10,000 business miles and 20p per mile for each business mile over 10,000 miles in each tax year.
These approved mileage allowances demonstrate complete irrelevance to the actual costs incurred in performing the business journey. The purchase price of a new motor vehicle would not be unusually 100 times the price of a bicycle, plus vehicle maintenance costs, vehicle insurance, licence fees and substantial fuel charges in operating the motor vehicle compared with zero costs for a bicycle. Few small businesses claim tax allowances for bicycle business journeys in their small business accounts.
The startling anomaly is that vehicle allowances are only twice the bicycle rate on the first 10,000 miles and only 25% more over 10,000 miles. Not that many people are likely to use a bicycle and cover in excess of 10,000 business miles in a single tax year.
In addition to the approved mileage allowances an additional 5p per business mile may also be claimed as a tax free expense if a fellow passenger is also carried on the business journey in the small business accounting records. That fellow passenger must also be on a work journey to enable the mileage allowance to be claimed in the small business accounts
Generally there are specific rules on justifying a business journey and the information that must be supplied to support the claim for a tax free mileage allowance. In practise the Inland Revenue often take a reasonable view of any claims provided the information provided in the small business accounts indicates that the claim is valid and has been incurred for real business journeys as opposed to an invention by the claimant.
When claiming a mileage allowance the essential information to provide is the date of the journey, the reason for that journey, the place visited and the actual mileage covered. Small businesses who claim this tax free allowance should maintain detailed records as part of the small business accounting to substantiate their expense claim should it later be challenged by the tax authority. Devising an expense sheet and submitting this sheet to the business is one way of ensuring sufficient documentation exists within the small business accounts.
Another way a small business can substantiate a mileage allowance expense claim is to enter each journey directly into the accounts for small businesses, perhaps recording the mileage against either sales invoices to customers or against purchase invoices from suppliers. With these transactions having already been recorded in the small business accounting records with a date, the location also stated on the invoice and the purpose of the journey being obvious the rules on supporting information are covered.
That is the easy part of making a valid claim but for many small businesses making such claims would seriously understate the true level of business journeys. Therefore also include in the small business accounts all other business journeys undertaken which may or may not have resulted in a specific purchase or a specific sale.
So what other journeys can the small business accounting system claim as a deductible expense against the taxable profit. The answer is basically any business journey and that should include all incidental journeys, perhaps visiting a supplier or a customer, visiting customers to quote for work, attending a business meeting, taking money to the bank.
Mileage allowances cannot be claimed for a business vehicle where the running costs of that vehicle are being claimed as a deduction from net taxable profits. Vehicle running costs include the capital tax allowances, licence fees, insurance, repairs and maintenance, membership of breakdown services and fuel costs.
Many small businesses may find that more than one vehicle is used for business journeys. The business vehicle running costs may be claimed for a specific business vehicle on which mileage allowances are not claimed this tax allowances may be claimed for the use of a private vehicle in the small business accounts.
Perhaps the small business runs a van for its main business and the running costs exceed the potential mileage allowance in which case the business should claim the vehicle running costs. If a different private vehicle is also used for some business journeys, perhaps even a spouse taking cheques to the bank, then mileage allowances could be claimed for that journey.
Each business should examine their tax allowance practises to ensure the maximum tax free allowance is claimed and supported with the required documentation to lower the tax burden when preparing the small business accounts.
Terry Cartwright has sinced written about articles on various topics from Payroll Accounting, Tax Software and tax. Terry Cartwright, qualified accountant in the UK designs providing complete. Terry Cartwright's top article generates over 90500 views. to your Favourites.