Can contractors avoid IR35 investigation by closing down their limited company?

Posted on 12 November 2009. Tags: closing a company, hmrc, IR35, ir35 enquiry

Choose a Name: The name has to be unique, obviously, and not likely to be confused for someone else’s existing name. The best reference point is the Companies House website – www.companieshouse.gov.uk – which has a simple search facility so you can check your chosen version. Also, try to avoid names that are specifically related to your line of work, just in case you want to change careers later: imagine selling cars though a company called Al’s Bakery.

Decide on Share Ownership: Is this just you, or you and your spouse, or you and two or three other people? This is important, because it defines how to allocate the Ordinary Shares In the company. Dividends are paid in direct proportion to numbers of shares held. A husband and wife typically have 50% each, for example, but if one is already earning money, be aware of the impact of the share income on their tax position. Share allocation can be changed after the event. There are several variations on share management; but for anything other than a simple allocation of ordinary shares, get expert advice.

Register at Companies House: There is an online system you use to set up your company and pay the registration fee. It is fairly simple to use. One question it will ask is who the directors are. For a typical small contractor company you only need one but there’s no reason not to have more. Although not strictly necessary any more, it also helps to nominate a Company Secretary: this could be the same person, but it’s more sensible to have someone else, a partner or relative for example.

Register a Memorandum of Association: Something else to do while you are at Companies House. At its simplest this is a document describing what your company is for and how you wish to run it. You can do it yourself, but the document can have legal implications in a tax investigation so do some online research for a suitable template from sites such as www.simply-docs.co.uk or www.clickdocs.co.uk.

Set up a Bank Account: This has to be a business bank account. Banks are increasingly wary of new business accounts, so you will have to answer some detailed questions and it will help if you have some professional references and a signed contact to demonstrate you actually will have an income.

Register for VAT: You have to do this if your annual income is in excess of a set amount (currently £67,000 pa) but it Is advantageous to register anyway. VAT and the Flat Rate Scheme are discussed in more detail elsewhere.

And that’s it. It sounds complicated but is in fact quite straightforward. You can also take the easy way out; either use a company formation agent, or there are several accountants who specialise in contractors who will set up all if the above for you for a small fee, or even for free, as well as providing expert support. Finally keep track of all your various expenses setting the company up, since you can reclaim these once you start trading.

It is often heard that contractors routinely close down their companies in order to avoid IR35 investigations: the logic is that if the company no longer exists, it can’t be investigated. Sadly, perhaps, this is not actually the case.

Firstly, HMRC have the right to restore a closed (or dormant) company if they have reason to believe that the amount of tax owed makes it worthwhile doing so. Closing a company requires that you submit a final return and that can be investigated for PAYE compliance – which may easily turn into an IR35 case – up to 12 months after the actual closure date.

Secondly, should HMRC suspect incorrect information has been provided they have up to six years to investigate a company’s records If they suspect actual fraud or negligence, this extends to 20 years. So simply closing the company does not mean you won’t be investigated.

Although they have a fairly modest record of winning IR35 cases, should they succeed then a significant amount of money may need to be repaid. This will certainly be the unpaid taxes plus interest from the start of the investigated period. Under the provisions of Regulation 72, if HMRC conclude that you had deliberately misstated your PAYE position, as opposed to simply making a mistake over it, they can also impose penalties of up to 100% of the unpaid tax.

More importantly, Regulation 72 allows HMRC to pursue the director of the company personally for any outstanding debts provided they have firm evidence that said director was in a position to exercise some control over the affairs of the company. In other words, you are not protected from personally from having to pay the total debt.

But why would HMRC start such an investigation? To be fair, for most small freelance companies the effort is probably not worthwhile, but one trigger would be to notice that a director routinely closes and open companies in the same line of work for no obvious business reason. They may suspect “Phoenixing”, the practice of closing a company and opening a new one to avoid outstanding debts from the old company. Or the ex-Director may be the subject of an entirely separate investigation and HMRC decide to check his history.

The chances of a closed company being investigated may be small, but they are real. Closing the company does not offer any protection from IR35.

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The Lazy Man’s Summary of IR35

Posted on 03 November 2009. Tags: hmrc, IR35, ir35 enquiry

IR35, more properly known as the Intermediaries Legislation, at its very simplest is a taxation treatment intended to ensure that two workers doing the same job pay the same amount of taxes.

I t was announced by the then Chancellor, Gordon Brown, in the 1999 budget and enacted in April 2000. It wasn’t mentioned in Brown’s budget speech, but in a press release after the event. This release was numbered IR35, hence the name.

It is a remarkably imprecise piece of legislation, but its stated intention is to prevent a worker who operates through an intermediary company, such as a micro-business or limited liability partnership, avoiding paying some NICs by taking payments in dividends rather than as salary. Dividends are essentially free of NICs, so the worker can save a significant amount of tax.

IR35 prevents this saving by deeming the worker’s salary to be 95% of their gross income and demands PAYE and NICs accordingly. The 5% is to cover the administrative cost of the company itself.

Dawn Primarola, the PMG at the time, announced that IR35 was not intended to apply to people who are in business on their own account. Sadly, IR35 does not – and probably could not – define the boundary between these workers and a jobbing contractor. Instead it tries to differentiate between a personal Contract of Service, which would be inside IR35 and a Contract for Services, which would not. To do this it falls back on long-standing tests of employment. Very briefly these are:

• Direction and Control: is the worker under the Direction of their client and does the client exercise control over how they perform the work

• Mutuality of Obligation: essentially does the client have to provide work and pay for work done, and is the worker required to accept work offered

• Right of Substitution: can the worker send a substitute to perform the work

As case law has evolved it is now clear that these three tests hold firm. They must actually exist in practice as well as in the contract and the totality of the arrangement is taken into consideration as much as the precise contractual detail. As a result, most judgements on IR35 status are largely subjective. Accordingly there is significant uncertainty over any contract’s liability to IR35 and it is this that causes the problems.

There is an enormous body of work on IR35 and how to manage it, much of it stemming from an original analysis by Dave Smith of Accountax. However, the PCG (www.pcg.org.uk) was originally set up to combat IR35 and they remain the prime source of information. There has also been a recent analysis of Ten Years of IR35 by Contractor Calculator (www.contractorcalculator.co.uk) that provides much useful background.

IR35, more properly known as the Intermediaries Legislation, at its very simplest is a taxation treatment intended to ensure that two workers doing the same job pay the same amount of taxes.