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 (very) brief, a ruling that states if you can be considered 'employed' by the company you are contracting your services to, then you are liable to pay tax and NI contributions as is 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 the Umbrella Company.

An umbrella company acts as your employer for tax purposes when undertaking a contract with either a client or 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 choose to hire an accountant or bookkeeper to take care of such things as your VAT returns, monthly accounts and 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.