Dear Contractor Doctor,
I’m an IT contractor and I’ve been working in the financial sector for just over five years, trading via my own limited company.
A contract has just come up directly with a small bank and because there’s no agency in the loop, I’ve been offered a higher rate. But the client says I have to submit invoices without VAT, and that in the past contractors working for the bank have started a separate, non-VAT-registered limited company for this purpose.
Can I run my contracting business through two different companies?
Contractor Doctor says:
“The short answer to Joe’s question is yes, contractors can trade through more than one limited company which they own,” explains James Abbott, owner and head of tax at contractor accountant Abbott Moore LLP. “However, there are taxation, cost and commercial implications contractors should take into account when choosing to incorporate a new company.”
Abbott also warns contractors against using two companies purely to avoid tax: “HMRC has been known to use disaggregation rules to prevent splitting a business in two purely to evade VAT when in reality it is a single business. ”
But he adds that in some scenarios there are distinct advantages to running two limited companies: “When a contractor makes exempt supplies, such as in a property company, there can be a benefit to having two or more limited companies.”
Two companies: the commercial implications
According to Abbott, because each of the contractor’s companies is a separate entity, it is unlikely that the creditors of one company can access the assets of the other company. This can be a benefit particularly because if one company is experiencing difficult trading conditions, it shouldn’t impact on the company that is doing well.
But there are additional costs associated with two companies, as Abbott explains: “Two limited companies means two sets of compliance costs. Two sets of accounts, two sets of filing fees with Companies House and so on.”
If the contractor is concerned about several different income streams, Abbott says it is no problem to run two trades through a single limited company: “…as long as the profit or loss on each trade is disclosed separately to HMRC each year as part of submitting the company’s corporation tax return.
“Even though the profits would be separately declared to HMRC, only a single set of accounts would be filed with Companies House.”
Charging and claiming VAT on different, and partially exempt, income streams
Although a hairdresser and IT contractor can co-exist within the same limited company, there comes a point where having two limited companies may be the simpler option, particularly where the other trade is potentially making sales which are exempt for VAT purposes, such as in the case of a property letting business.
Having two separate companies avoids complex VAT partial exemption calculations which can limit the VAT contractors might be able to claim for some of their expenses.
When it’s OK not to charge VAT, and when it’s not OK
Abbott has already highlighted that businesses seeking to evade VAT by trading as two separate entities just to save VAT may fall under HMRC’s disaggregation rules.
HMRC has been known to use disaggregation rules to prevent splitting a business in two purely to evade VAT when in reality it is a single business
James Abbott, Abbott Moore LLP
But it is acceptable to run one company which is registered for VAT and one company which is not registered for VAT, as long as it has sales below the registration threshold as Abbott explains: “A contractor who might have, say, three contracts in a financial year – two with software houses and one with a bank – can invoice the software houses from from the VAT registered company and the bank from the non-VAT registered company.
“That way,” he continues, “the software houses will be able to reclaim the VAT as normal. The bank makes, in effect, a 20% saving because it is not being charged VAT by the contractor. Banks, like many financial organisations, cannot claim VAT. However, to avoid HMRC using its disaggregation rules, the overriding factor must be that there are commercial reasons for having separate companies.”
Associated companies lose corporation tax allowances
HMRC’s rules say that several limited companies owned by the same person are associated and sometimes companies owned by other family memberscan be treated as associated with a contractor’s company as well. And there are corporation tax and transaction rules that can impact negatively on companies of this type.
“If a contractor is the controlling shareholder of two limited companies, these companies will be classed as associated,” says Abbott. “That means small company corporation tax limits must be distributed equally between all these companies.”
Small companies will pay 20% ‘small profits rate’ of corporation tax (correct at the time of writing) on profits up to £300,000. Two associated companies must share the £300,000 allowance between them, ie £150,000 each above which their average corporation tax rate moves towards the higher (main) rate of corporation tax, which is 26%.
“A contractor might make profits of £220,000 in company A, and a profit of only £20,000 in company B” continues Abbott. “Company A pays 20% corporation tax on £150,000 and 27.5% on the remaining £70,000. Company B’s corporation tax ‘allowance’ is wasted.”
No arm’s length transactions’ between associated companies
When two associated companies do business together, because of their shared ownership, the transactions are not considered to be at ‘arms length. HMRC will look closely at transactions between associated companies to ensure that all transactions are ‘reasonable’.
According to Abbott, contractors must ensure that when their two associated companies do business between them, the costs are reasonable: “If company A decides to recharge company B for stationery costs, it must do so at reasonable rates. It can’t charge a huge margin simply to massage company B’s profits.”
Offsetting losses and ceasing to trade under Section 1030A
When a contractor is trading through a single limited company, they can offset the profits on one trade against the losses on another, which can reduce profits declared for corporation tax. “Offsetting losses is not possible between two limited companies unless the contractor has formed a ‘group’, and the companies are part of the group,” adds Abbott.
But it might be advantageous to run two different types of business through two companies if there is a chance one might cease trading. Normally, if a contractor decides to stop contracting and close the company, they can benefit from HMRC’s Section 1030A rule, which allows them to extract the remaining cash in the business as capital and thus pay the lower capital gains tax rates, rather than corporation tax.
Abbott gives an example: “Let’s say the contractor has been running their contracting business in the same limited company as a property letting business. If the contractor decides to stop contracting and take full time employment, normally they could extract any cash in the business and close the company using Section 1030A.
“However, if the property business continues to trade in this company, or is transferred to another business connected to the contractor, then the contractor can’t use Section 1030A and will have to pay corporation tax, and potentially higher rate income tax on any money they take out.”
“There are both commercial and taxation advantages and disadvantages to running two companies in parallel,” concludes Abbott. “Calculating the benefits can be quite complex, and this is one area where contractors would benefit from expert accountancy advice to help them choose the solution that best suits their personal and business circumstances.”
Good luck with your contracting!