Contractors can quality for tax credits from HMRC, and would be prudent to make what’s known as a ‘protective claim’ each year. That means, in the event that their income unexpectedly falls, contractors will qualify for payments that could be worth over £10,000 per year (at the time of writing).
“HMRC’s tax credits are basically a means-tested benefit designed for workers on low incomes and individuals with children,” explains James Abbott, owner and head of tax at contractor accountant Abbott Moore LLP. “Contractors can qualify for both the working tax credit and child tax credit. It is always advisable to make an annual claim because you never know what the future holds, and a contractor’s circumstances can change.”
Abbott says that with a protective claim, contractors don’t actually receive any benefits if their income is above a certain level. But making the claim means they are in HMRC’s system and able to claim immediately if their income drops, say for an extended period between contracts or on the birth of a new child.
Eligibility criteria for contractors
“To quality for working tax credit, a contractor must be working for at least 16 hours per week and be on a very low, or no income, ie between contracts,” continues Abbott. “Although limited company contractors between contracts may be concerned that they are not working enough hours to be eligible, of course they are still working for their own company, rather than a client.
“Searching for the next contract opportunity, networking, checking job boards, applying for assignments and admin tasks like bookkeeping are all counted as ‘work’, and most contractors when they tot up this total find they reach 16 hours comfortably,” he adds.
Child tax credit is payable to individuals with children, such as parents and guardians, and it is the person responsible for the child who makes the claim. Households with an income below around £25,000 will qualify for benefit; households with higher incomes can also qualify if they have more than one child, a child with a disability and/or childcare costs.
Working tax credits are paid monthly by HMRC direct into the low earning worker’s bank account, while child tax credits are paid into the account of the primary carer of the child or children.
Calculating working and child tax credit
Abbott suggests contractors don’t try calculating their own tax credits, as the formula used by HMRC is very complicated: “Fortunately, HMRC will calculate a contractor’s tax credits for them if it is provided with all the information, such as household income, the number of children, any disabilities and other relevant information.”
If a contractor lives alone, the award is based on the contractor’s sole income. If the contractor is married, in a civil partnership or co-habiting, the award is based on the aggregated income of both individuals. Income is calculated on the same basis as self assessment, although the first £300 of unearned income, including dividends, is ignored. There are also some exceptions, such as the treatment of personal pension payments, which can work in the contractor’s favour.
The award is calculated based on the contractor’s personal circumstances. HMRC applies an ‘abatement’, or as Abbott better describes it, a reduction based on income. “The tax credit award reduces on a sliding scale according to household income; the more a contractor and their household earns, the less tax credit they receive.”
HMRC has published a guide that includes worked examples of how tax credit awards are calculated. It also has an online tax credits questionnaire, to help determine eligibility, and an online interactive tax credits calculator to provide an indication of potential entitlement.
Inform HMRC of changed circumstances immediately, or face possible ‘claw backs’
“Because there are so many variables based on a contractor’s personal circumstances that will affect HMRC’s calculations, it is essential that contractors inform HMRC immediately of any changes to their personal circumstances.”
Abbott says many families have received tax demands from HMRC asking for overpaid tax credits, because the individuals receiving the benefit did not inform HMRC of changing circumstances. These could be something as simple as a pay rise, or moving in with a partner whose income will suddenly become aggregated with the contractor’s. The claw back could cost families thousands of pounds.
HMRC will look at a contractor’s last year’s earnings and base the tax credit award for the current year on those past earnings. So, if circumstances and earnings change from year to year, it could have a big impact on the tax credits award.
“Fortunately,” Abbott says, “HMRC can be flexible about changing circumstances. If a contractor earns less than expected in the tax year, it will increase the tax credit award. If a contractor, and their household, earns more than expected, as long as the increase in earnings is below a certain level, HMRC will maintain the same level of tax credits.”
Claim in time or make a ‘protective claim’, or you could lose tax credits
Abbott warns that failing to claim on time, or to claim at all, means that a contractor may lose out on receiving extra cash: “Contractors should ensure they submit a claim as soon as possible, and immediately they think they may be eligible, perhaps because they’ve been between contracts for a while.”
Contractors should ensure they submit a claim as soon as possible, and immediately they think they may be eligible, perhaps because they've been between contracts for a while
James Abbott. Abbott Moore LLP
Contractors should then resubmit an application each year before the 31July deadline to ensure they stay in the system, because claims can only be backdated by three months. Abbott explains: “Even if a contractor does not expect to receive any tax credits because their earnings are too high, they can continue to renew. This protects the contractor’s claim if their income falls unexpectedly at a later date, and they won’t need to make a new claim.”
For example, if a contractor only submits their first tax credits claim on 6 January 2012, based on the figures for their self-assessment for the year ending 5 April 2011, and discovers that their income has fallen to the extent that they are eligible, they can only claim back as far as 4 November 2011. That would mean only 5/12 of that tax year’s award will be paid. If they had put in protective claim on 6 July 2010 or before , the claim would encompass the entire 2010/11 tax year, leaving the contractor much better off.
Deliberately paying a low income to qualify for tax credits is against the law
Limited company contractors have the flexibility to adjust their earnings each year. Many choose to leave money in their company if they don’t need to draw it down as salary and dividends. “So, says Abbott, “ contractor could be tempted to pay themselves very little simply to qualify for tax credits.
“But HMRC is wise to this potential scam, and there is legislation in place that prevents company directors from deliberately depriving themselves of income purely for the purposes of qualifying for benefits.” Contractors retaining profits in a business for sound commercial reasons won’t attract undue attention from HMRC, but massaging earnings around the tax credit threshold will.
Contractors should note that the child tax credit element has no working time requirement. However, Contractors should also be aware that HMRC are disqualifying directors of limited companies from claiming the working tax credit element who do not have an employment contract with their company and are not paying themselves for the qualifying 16 hours at National Minimum Wage (NMW). If this situation arises, Abbott urges contractors to consult their accountant and consider updating, or putting into place, the correct employment contract and company paperwork.
“Many contractors could spend their entire contracting career without ever qualifying for tax credits,” says Abbott. “But, for the sake of completing the paperwork once a year, working tax credit and child tax credit have provided many contractors with a vital safety net when their circumstances have taken a turn for the worse.”