Off-payroll working rules from April 2021 require private sector end users to determine employment status of contractors who use an intermediary. If there is deemed employment, the intermediary receives payment net of deductions. This builds on legislation for public sector engagers effective from 2017. Existing IR35 rules continue to apply where the end user is small. Rebecca Benneyworth provides guidance on how to account for off-payroll transactions.
This TAXguide has been written by Rebecca Benneyworth and edited by Philippa Vishnyakov.
Off-payroll working – an overview of 2021 changes
Section 7 and Schedule 1 were introduced late into the Finance Bill 2020. Section 7 merely introduces the Schedule which is 14 pages long.
The existing IR35 legislation in Chapter 8 of Part 2 of Income Tax (Earnings and Pensions) Act 2003 (ITEPA 2003) is re-named by para 2 as follows: “Workers’ services provided through intermediaries to small clients”, meaning that when a worker is engaged by a small end user client they fall within the “old” IR35 rules, and any risk of underpayment of tax falls on the worker’s personal service company. The scope of Chapter 8 is then amended to focus on services provided to a customer who is not a public authority, but either
- qualifies as small for a tax year, or
- does not have a UK connection for a tax year.
Small end users
Small end users do not need to operate the off-payroll working rules. Instead the contractor (and their intermediary – usually a personal service company (PSC)) are covered by the original IR35 rules. This means that the contractor is at financial risk if the rules of IR35, including accounting for a deemed salary, are not applied correctly.
A brief summary of the definition of “small” in the new legislation follows. In all cases, the turnover of connected persons is added to that of the entity under consideration.
A company is to be regarded as small for a tax year if during the last financial year relevant to the tax year, the company was small with regard to the Companies Act 2006. A financial year is “relevant to” a tax year if the Companies Act 2006 due filing date falls before that tax year. A company is also small if the first financial year is not relevant to the tax year. Where a company is a member of a group (but not the parent company) then the parent company must qualify as small for the subsidiary to be regarded as small. As is usual in the company law test, a company does not become non-small in the first year in which the limits are exceeded.
Where a company is a joint venture company, then it is to be regarded as a parent company of a group with the joint venture owners.
The test for a “relevant undertaking” is identical to the tests applying to companies. A relevant undertaking is a Limited Liability Partnership, an unregistered company (s1043, Companies Act 2006) or an overseas company (s1049, Companies Act 2006).
An undertaking that is not a company nor a relevant undertaking is small if the turnover for the last financial year that is relevant to the tax year is not more than the turnover limit in s382(3), Companies Act 2006. This limit is currently £10.2m. Here, a financial year relevant to the tax year is one ending at least nine months before the beginning of the tax year. It is likely that traditional partnerships will be covered by this provision.
A person who is not a company nor an undertaking is regarded as small if their turnover for the calendar year before the tax year starts does not exceed the Companies Act 2006 limit which is currently £10.2m.
1.3 Request for confirmation of small status
Given the financial risk and implications, contractors and agencies are entitled to ask for confirmation that an end user is small for the purposes of this legislation. The legislation places a responsibility on a “client” end user to respond to a request from either the worker or the agent involved in the arrangement with confirmation that they are small (or not) within a statutory time limit. The time limit is the later of 45 days from the request, or 45 days before the start of the tax year concerned.
A UK connection for a tax year
An end user with no UK connection for a tax year is outside the scope of the new rules, and a worker will be subject instead to IR35. A UK connection is defined by the legislation as follows.
- A person has a UK connection if and only if immediately before the beginning of the tax year they are either UK resident or have a permanent establishment in the UK.
Status determination statement
The existing off-payroll working rules require public sector end users to inform the worker and any agency that they deal with of the worker’s status for tax purposes. Finance Act 2020 formalises this, and calls the statement a status determination statement (SDS). A SDS states whether or not the employment status test indicates that the worker is to be regarded as an employee for tax purposes, and the reasons why this conclusion has been reached. A statement only qualifies as such if the client has taken reasonable care to arrive at the conclusion.
In the absence of a statement being provided to the worker in the case of deemed employment, the client is liable for any tax and NI that would arise. Once the statement has been correctly passed on, the fee payer is liable. The fee payer (deemed employer) is the last person in the chain before the intermediary, and so is the same as the end user client where there are no agencies involved.
Disputes about status
Both the worker and the deemed employer have a right to notify the client if they believe that the status has been incorrectly determined. They must do so before that engagement comes to an end (by virtue of the final payment having been made). The response by the client must be either to confirm the status determination or to withdraw it and replace it, with reasons. If the status determination is reversed, the replacement must state from which date the new status became correct.
The client has 45 days to provide this response, after which they become liable for the tax and NIC which might become due.
Worked example 1 – Rachel
This example illustrates the likely practical and financial impact of these measures on both the individual worker and the personal service company where 100% of the business of the company is covered by the off-payroll working rules. There is also consideration of the practical issues for the client company. This example does not include the use of an agency, for the sake of simplicity. The example is based on 2020/21 rates and allowances.
Rachel works in IT through her own limited company RP Consulting Limited. She owns 100% of the shares in the company and has historically drawn a salary of around £8,400 and then sufficient dividends to bring her income to £50,000. Given the status of the company, it is not regarded as an employer for the purposes of auto-enrolment. During COVID-19 Rachel has had to draw any remaining retained profits as she was between contracts and unable to obtain new work. The company’s year end is 31 March.
On 1 April 2021 Rachel signs a contract (for an initial period of 12 months) with Big Data plc under which she commences work on 6 April 2021. She is issued with a SDS on 6 April 2021 informing her that Big Data plc believes that she is an employee for tax purposes under the off-payroll working rules, and accordingly Big Data plc withholds tax and NIC from the payments to RP Consulting Limited.
Each month, Rachel raises an invoice from RP Consulting Limited for £6,000 plus VAT, the agreed contract rate. This is emailed to Big Data plc from Rachel’s cloud accounting software.
Big Data plc accounting issues
Big Data plc has normally received invoices from contractors into the purchase ledger department, where they are processed, the input tax reclaimed and the payment raised. However, in view of the changes, the invoices from RP Consulting Limited are forwarded to the payroll department.
The payroll department obtains the starter information from Rachel on 6 April, and set Rachel up as a ‘deemed employee’ on the payroll. In accordance with HMRC’s guidance Rachel was issued with a starter checklist, and is set up with tax code BR. Each month the invoices are processed by including the fee of £6,000 as an employment payment, and adding a non-taxable addition of £1,200 representing the VAT on the invoice. No tax or NIC applies to this element of pay.
Tax and NIC are then calculated as normal, and RP Consulting Limited is paid the net amount after deductions.
Big Data plc also raises a new accounting process to deal with the input tax, which is to list the individual amounts of VAT and the net of VAT fee (but before payroll deductions) on a report and for this data to be accessed by the VAT reporting systems, to comply with Making Tax Digital (MTD) for VAT record keeping requirements. (It would not be sufficient to simply pass the total amount of VAT each month to recover to accounts as each individual transaction must be recorded.)
This has entailed writing a report run through the payroll systems detailing each gross payment made to deemed employees in a VAT period and the amount of the non-taxable addition in respect of each payment processed. The data is exported as a comma separated value report and then uploaded to the VAT system in order to both recover the input tax and comply with MTD requirements on record keeping and digital links. Flagging the entries as included in a VAT return has proved problematical and Big Data plc is aware that there is some degree of risk of misstatement on the VAT returns. This issue is being kept under review.
RP Consulting Limited accounts 31 March 2022
Rachel’s company has recorded sales of £72,000. It has paid over output tax on this amount totalling £14,400. A modest amount of input tax has also been recovered.
The debtor’s ledger shows debit entries to the account of Big Data plc totalling £86,400. The amounts paid towards this each month have been as follows:
|Tax at Basic rate||1,200|
So there is a credit entry on the debtor account of £66,696 (12 x £5,558), leaving an outstanding balance of £19,704 equating to the deductions suffered (12 x £1,642).
Rachel has drawn a salary of £700 per month, which was reported through RTI. She has also drawn the same cash amounts as she took as dividends in past years to make her income up to £50,000, (ie, £41,600). The company has expenses of £2,462 on software and other IT costs (including accounting software), £288 paid in homeworking allowance to Rachel tax free and an accrual of £1,400 in accountancy fees for accounts, payroll and company tax services.
The balance on the VAT control account represents the output tax for the quarter (£1,200 x 3) less an amount of input tax on expenses of £150.
The trial balance at 31 March 2022 looks like this:
|Director’s loan account (cash drawings)
|VAT control account (quarter 4)||3,450|
|Sales ledger debtor (see above)||19,704|
|Software and IT costs
Journal entries needed
In order to prepare the accounts, it is necessary to process a journal to remove the debtor, which is really the deductions made by Big Data plc. This is treated for accounting purposes as an employment cost. The journal entry is dated 31 March 2022.
|Credit||Sales ledger control
– customer Big Data plc
It is also necessary to deal with the debit balance on Rachel’s loan account. Normally, when the accounts are prepared an interim dividend is declared to reduce the loan account to zero. Rachel has continued to draw at the same rate as previously to bring her total income drawn to £50,000.
However, the profit and loss account for the company looks like this:
|Other employment costs
|Profit before tax
* RP Consulting Limited will not bear any corporation tax, as all of the income of the company has already been taxed under the off-payroll working rules. Section 141A of Corporation Tax Act 2009 (CTA 2009) requires that payments which have been subject to the off-payroll working rules are not brought into account in calculating the profits of the trade. There is therefore a loss for corporation tax purposes of £4,150 (accountancy fees of £1,400 and other expenses of £2,750).
Clearly, there is insufficient profit to cover the director’s loan account, and as there are minimal retained profits brought forward, Rachel’s loan account cannot be cleared in full. The necessary minutes are prepared, and the entry dated the same date.
||Director’s loan account
Although the director’s loan account will still appear in the company accounts for the year ended 31 March 2022, most of the balance will be cleared before the due date for corporation tax. The balance of £1,854 will be subject to a s455 charge unless it can be cleared by 31 December 2022. The liability would be £603.
The draft balance sheet therefore looks like this on 31 March 2022 (without comparative figures).
|Liabilities due within 12 months
|Net current Assets = Net Assets||39,850
|Total Shareholders’ Funds
Note also that the company is technically insolvent, as there are insufficient funds in the bank to cover the current liabilities. Rachel needs advice urgently to prevent this situation becoming worse.
An alternative solution
The company could alternatively have decided to pay the “net pay” received from Big Data plc to Rachel as salary. In this case, it would not have been liable to tax and NIC, but in processing it through RTI, the company would have to deal with any student loan deductions for which Rachel is liable, as these cannot be dealt with through the off-payroll working regime. However, at present it will not be possible to make student loan deductions through payroll as the deductions are based on pay which is subject to NIC, which is zero. Student loan liabilities will therefore be calculated and collected through self assessment.
The company profit and loss account would then look like this:
|Loss before tax||(4,150)
It is possible that in the first year of the new rules the loss arising could be carried back and set off against the profits of a previous year, although that is unlikely to benefit RP Consulting Limited in view of the lack of work in the preceding year.
The impact on Rachel
Historically Rachel would have received gross taxable income of £50,000 a year and a tax liability of £2,663 would have been payable each year (dividend tax on £35,500), so her net income would be £47,337. In addition (using the expenses above, and after corporation tax) there would be £6,554 of retained profits in the company each year to provide for unexpected expenses (either personal or business).
Under the off-payroll working regime there are a number of consequences for Rachel.
The first issue is that using a tax code of BR, Rachel has accumulated a tax liability on her deemed salary, as no higher rate tax has been deducted. In Rachel’s case her total tax liability on the deemed salary would be £16,300, but only £14,400 has been deducted by Big Data plc, so she will be required to pay £1,900 in tax under self assessment. She will report employment income on her tax return of £72,000 and tax deducted of £14,400, naming her employer as Big Data plc (who will be required to provide her with a P60, but not necessarily payslips each month).
Her net income (cash extracted) assuming that a dividend has been paid with the profits would be £39,746 plus remuneration of £8,400. These amounts would bear no tax, but student loan deductions on £72,000 would arise under self assessment – total £4,088, which after accounting for her additional tax liability would leave her with net income of £42,158 per annum – a reduction of £5,179. And of course there are no retained profits in RP Consulting Limited to provide a financial safety net.
If the net amounts received had been paid out as salary rather than dividend, the net income paid out would be £52,296. The liability of £1,900 due on her deemed salary would be payable, as would the student loan liability of £4,088 and in essence, Rachel would have to return funds to the company in order to be able to pay the liabilities. Repaying the loss of £4,150 would leave Rachel with £42,158, a reduction in net income of £5,179. Again the loss of a financial safety net may leave Rachel in a precarious financial position.
Summary – Rachel’s position
The above illustration shows that small business clients who are affected by the off-payroll working rules from 6 April 2021 will need advice and support from that date (rather than at the end of the year) if they are to avoid serious financial complications.
Worked example 2 – Christopher
This example illustrates the issues when the intermediary has a mixture of income, some regarded as within the off-payroll working rules and some not. There is no further consideration of the impact on the client company, as these were covered in Example 1 at paragraph 2.2. This includes an agency in the contract chain for an illustration of how the rules work in those cases.
Christopher has just started contracting work and has obtained work through an agency, Staffing Solutions Limited. He starts work through his limited company in July 2021 and does a six-month engagement at ABC Logistics Plc, which finishes in December 2021. He then starts a new contract in February 2022 which is expected to run for at least nine months; his new client is Davis & Pendlebury, a large firm of lawyers for whom he is writing a new management information system. Christopher owns 100% of the shares in his company, Cobalt Consulting Limited. Given the status of the company, it is not regarded as an employer for the purposes of auto-enrolment. Christopher’s accountant has notified Companies House that the first period of account will be the period ended 30 June 2022.
ABC Logistics Plc issues a SDS in July 2021 to Christopher and Staffing Solutions Limited informing them that he is regarded as an employee for tax purposes. The agreed contract rate for the job is £2,500 per week, and the contract runs for 24 weeks in all, so a total contract price of £60,000 plus VAT. Christopher invoices Staffing Solutions Limited, who make payments to Cobalt Consulting Limited net of PAYE and NIC.
Davis & Pendlebury have responded to Christopher’s request to confirm whether or not they are a small end user by stating that they are not small. After a short delay, they issue a SDS indicating that they do not regard Christopher as an employee for tax purposes, so payments under this contract will be made gross. The contract price is £90,000 plus VAT, and Christopher has invoiced £50,000 plus VAT by the end of June 2022, which reflects the work done to date.
Accounts for Cobalt Consulting Limited 30 June 2022
In March 2022, Christopher’s accountants process an annual payroll for the company showing Christopher’s director’s remuneration as £6,300 for the nine-month period. Christopher’s PAYE code number is equal to the personal allowance so no tax is due.
Cobalt Consulting Limited – Trial balance as at 30 June 2022
(after initial journals for accruals and depreciation)
|Director’s loan account||30,100|
|VAT control account (June quarter)||5,848|
|Sales ledger debtor (see below)||26,976|
|Software and IT consumables||1,433|
|Travel – ABC Logistics work
|Travel – Davis & Pendlebury||745|
|Computer equipment purchased||1,800|
|Provision for depreciation on computer
The Debtors are as follows:
Staffing Solutions Ltd in respect of work at:
|ABC Logistics Plc
|Davis & Pendlebury
The 24 payments by Staffing Solutions Ltd against invoices of £3,000 including VAT per week were as follows:
|Tax at Basic rate
So the total received against invoices of £72,000 is £57,024 (24 x £2,376), leaving a debtor on this job of £14,976 (24 x £624).
Finalising the accounts
As in example 1, we use a journal entry to deal with the non-existent debtor, transferring the balance to employment costs. To deal with the director’s loan account we need to establish the profit after tax to check it will support a dividend of this amount. The profit and loss account looks like this:
|Other employment costs||14,976|
|Profit before tax||82,778|
The tax computation works as follows:
|Profit before tax||82,778|
|Net income taxed to PAYE
(£60,000 - £14,976)
|Capital allowances – AIA
|Taxable total profits||36,554|
|Tax at 19%||6,945
The profit after tax is therefore £75,833, which is ample to provide for an interim dividend in the following year to cover the debit balance on Christopher’s director’s loan account.
Summary - Christopher
The significant difference between Christopher and Rachel is that Christopher has other income in the company not covered by the off-payroll working rules. This provides a tax deduction for the expenditure (including the expenses incurred in travelling for ABC Logistics work). Note that the company can declare a dividend of up to £45,024 – the net value of work that has been taxed to PAYE – which would not be taxable on Christopher, as it has suffered PAYE and NIC already; it would seem sensible to reduce this amount by the £6,300 salary that has already been processed. Christopher also has sufficient profits to make contributions into a pension scheme in future years, should he wish to.
Christopher will need to report employment income on two separate employment pages in his self assessment tax return. One page will show gross pay of £60,000 from Staffing Solutions Limited (ie, the deemed employment income on the ABC Logistics Plc contract) with tax deducted of £12,000. The other page will show remuneration of £6,300 from Cobalt Consulting Limited on which no tax has been deducted as it is below the personal allowance.
Note that although Christopher does not need immediate support to control his drawings as Rachel did, it will be necessary to keep a record of distributions made out of the net income of £45,024 to identify what income should be subject to tax and therefore included on Christopher’s self assessment return. This is a record that will run from year to year, carrying forward the deemed employment income which has been taxed under PAYE when paid to Cobalt Consulting Limited until it has all been utilised.