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Contractor tax avoidance schemes – an overview

Contractor tax avoidance schemes are typically nothing like the risky and aggressive schemes used by very wealthy individuals, or the complex strategies adopted by large corporations. So says David Colom, principal of contractor accountants DJ Colom & Co.

“Most of the schemes we hear about in the media are a million miles away from what contractors do, and are only used by the seriously wealthy few,” he explains. “Models such as those based on currency arbitrage, offshore share dealing and creative industry partnerships can be highly risky and aggressive, hence HMRC’s winning streak when attacking them.”

Colom notes that the best schemes targeting contractors tend to be underpinned by watertight application of tax legislation, boosted by faultless implementation, and promoted by reputable and reliable promoters.

The tax avoidance scheme spectrum

“There is a spectrum of schemes available to contractors,” continues Colom. “At one extreme are the highly risky schemes that I would never touch and won’t be marketed by reputable accountants because they would understand the risks involved.”

Most of the schemes we hear about in the media are a million miles away from what contractors do, and are only used by the seriously wealthy few

David Colom, DJ Colom & Co

According to Colom, these schemes are largely sales-led by salespeople who know little or nothing about tax, how the schemes work and the risks: “Salespeople rarely talk about risks because they don’t understand them!”

Then there is a middle ground of less risky schemes, but which still ‘push the envelope’, and may often be based on an obscure point of tax law. These schemes probably work but are riskier than the ‘quality end’.

Colom explains: “Schemes marketed at what I call the ‘quality end’ of the spectrum do work. Commentators may not like them, and are often sceptical about whether they work. Such schemes can also be branded as immoral and against the ‘spirit’ of the law. But they are fully compliant with the law and do work.”

Tax avoidance schemes for contractors to avoid – currency arbitrage

Colom’s concern is that contractors with an elevated appetite for risk and who wish to actively choose a tax avoidance scheme then go on to choose unsuitable options.

“An example is the so-called Boyle Case, where IT contractor Philip Boyle lost his case against HMRC,” says Colom. “This scheme involved contractors signing up to an Isle of Man company. They received exotic foreign currencies in exchange for loans that were supposed to have been traded.

“The idea was to turn earnings into non-taxable foreign exchange gains. On paper, in theory, it should have worked if implemented properly. But what became apparent during the tribunal was that none of the paperwork was put into place by the scheme promoter to make the transactions a reality.

“So, when the tribunal judge looked at the evidence to support the scheme, they found that it did not exist. The exchange gains were completely artificial and in reality there was no borrowing by the contractor to fund the trades. The promoter had the plan, but was not actually following it through.”

Creative industry schemes, such as Icebreaker

Another type of scheme that Colom would urge contractors to avoid are those based on creative industry partnerships. These came to media prominence in 2014 as a result of the participation of well known celebrities in the Icebreaker scheme.

“This was a big case and very complex,” says Colom. “The scheme was underpinned by forming multiple limited liability partnerships, each of which was supposed to be trading on a commercial basis and each supposed to be making a profit.

“The scheme was partly funded by the individuals participating, and partly from loans. The businesses were structured in such a way that a trading loss would arise and the partners would be able to transfer this loss over to offset income from other sources.”

Colom confirms that the scheme did not work largely due to implementation. If a business borrows money and uses it for trading expenses, it can offset the loss against profits from another trade. But the money borrowed by Icebreaker was not actually used to fund expenses.

“In this case the money was used for capital purchases and not as revenue expenses,” continues Colom, “If the scheme had been implemented in the way that it was intended, then it could have worked. A reasonably good quality scheme from good quality promoters failed because of a technicality.”

The ‘Working Wheels’ scheme

Another scheme model that Colom warns contractors against are those based on complex arrangements with offshore charities and UK-based trading entities, such as the ‘Working Wheels’ scheme.

“The entry level for these types of schemes are frankly much higher than the average contractor can afford, but that is not the only reason contractors should avoid them,” says Colom.

“Participants set up as a secondhand car dealer. Money is channelled tax free into a charity with a Channel Islands trust, but the charity actually only receives a token donation. The participants claim tax relief on their supposed charitable donations.

“These schemes are expensive to run and usually require hundreds of thousands of pounds as minimum investment. Even contractors earning very high day rates would not normally get near being able to take part in such schemes.”

Contractor schemes that do work

From December 2010, the government introduced targeted anti-avoidance legislation that meant that using a loan from an employee benefit trust (EBT) was no longer allowed. What used to happen, according to Colom, was that the umbrella company – if it was an employed scheme (see next section) – would invoice the agency that would then pay the umbrella.

“The contractor was an employee of the umbrella company and would receive a salary at minimum wage. The rest of the contractor’s fees were paid into an EBT, on which the employer would get tax relief and the EBT would make a loan to the contractor.

“The third party EBT model has been disbanded and now the loans are made directly by the employer. The scheme is managed in such a way that the employer is able to get tax relief on the money loaned to the employee/contractor, and the employee/contractor is satisfied that the employer can’t recall the loan.”

Colom notes that before the 2014 Budget, most schemes were offshore, but measures introduced by the Chancellor then mean that most have some onshore funds as there is now no benefit to remaining offshore.

Employed and self-employed schemes

There are two variations of the schemes on offer to contractors: the employed and self-employed schemes. Colom highlights that it is important for contractors to understand the difference between the two, because they have significantly different risk profiles.

“The self-employed scheme is based on HMRC’s rules that say a contractor who is a director of their own limited company can split their duties so that some are classed as employed and some as self-employed,” explains Colom.

“This is more risky than an employed scheme, because if it goes wrong then it is the contractor – not the scheme promoter – who foots the bill for unpaid income tax and National Insurance Contributions (NICs).

“With an employed scheme, the contractor employee receives a loan from their employer. Income is taxable whereas loans – if they are proper ones – are not. Not surprisingly, HMRC hates the concept of loans because it sees them as a substitute for income.”

Colom emphasises that HMRC has so far lost some challenges of loan-based employed schemes in the tax tribunals: “Judges have said that if it is a loan that is properly documented in terms of repayment and interest, and that can be evidenced, and can also be called in, then all the boxes are ticked and it is a real loan. Loans cannot be taxable.”

The ‘spirit of the law’

The media and politicians make much of the ‘spirit of the law’ when framing anti-tax-avoidance arguments. But Colom asserts that in his and most tax advisers’ opinions, there is no such thing and contractors should not be ‘conned’ by it.

“There is poorly drafted legislation and properly drafted legislation. If properly drafted, then you don’t need to rely on a ‘spirit’ of any kind,” he says. “Any professional will follow exactly what the legislation says and does not need to second guess what the government actually meant when it drafted the legislation.

“Tax accountants and lawyers are not the government and don’t draft the law. If the government intends something, it should be put into the right words before it is approved.”

But Colom does warn contractors against using schemes that rely on ‘loopholes’: “Sometimes there are mistakes in the legislation. There are tax avoidance structures built on these mistakes. But this kind of strategy is highly aggressive and therefore highly risky; I would not recommend it to contractors.”

Colom concludes: “Tax avoidance is perfectly legal, despite its demonisation by politicians and the media. However, contractors should think carefully before entering into schemes, and take advice from reputable and professional advisers.”

Published: Thursday, 10 July 2014

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