In response to a global downward drift in corporation tax, accelerated in the UK by Parliament’s aim to use low corporation tax rates as a means of attracting international business to the UK, there is now a significant mismatch between the tax rates applicable to the different business arrangements which might be used for what are essentially the same business activities.
Over the years, as corporation tax rates have continued to decline, income tax rates have remained high relative to these, with the NIC burden increasing. Personal service companies have therefore become popular businesses structures for independent contractors who wish to reduce the overall burden of tax and National Insurance.
As a result, HMRC finds itself having to police tax boundaries to ensure that taxable income does not seep from a high-tax regime (employment) to a low-tax regime (personal service companies). This is not a recent problem.
Legislation
In April 2000, new intermediaries legislation came into force. Using its powers under what became known as IR 35, HMRC was able to look through the contractual arrangements between the personal service company and the client company. If HMRC could successfully contend that the worker was in fact a disguised employee, then the fees paid to the personal service company would be taxed as salary. In consequence, the net income available to the worker reflected deductions for employer’s NIC as well as employee NIC and income tax under PAYE.
IR 35 does not only apply to personal service companies. It may also apply to self-employed contractors working direct for the client company. If the terms of the engagement are such that HMRC categorises the individual as an employee of the company, then the client company must operate PAYE.
HMRC has been reluctant to provide detailed figures demonstrating the effectiveness of IR 35, but the relatively low tax yield derived from it suggests that the deterrent effect has been enormous.
So if you have a successful personal service company and have satisfied HMRC that IR35 does not apply, how do you go about extracting profits from the company?
As a starting point, it's worth remembering that taxable profits can be retained in the company at a tax rate of 19 per cent. As taking profits out of the company, however that is done, will give rise to an additional tax charge, for most people there will be little point in withdrawing more money than they need. The biggest and most frequent exception to this approach is to remove undistributed profits from the company so that they are no longer exposed to business risk.
