Contractors are unlikely to be affected by the outcome of the PA Holdings case, despite fears that the underlying legislation, Section 447 of the Income Tax (Earnings and Pensions) Act 2003, which technically applies to all limited companies, will be applied to Limited company contractors.
“The legislation under which HMRC is pursuing PA Holdings in the Supreme Court is designed to address contrived company structures and dividends created for tax avoidance purposes,” explains James Abbott, tax partner at contractor accountant Abbott Moore.
“Even though Section 447 could be applied to all contractor limited companies that pay dividends, reclassifying their dividend payments as earnings and taxing them accordingly, the reason that the vast majority of contractors incorporate is so they can win work. HMRC’s own guidance makes it clear that owner managers of limited companies genuinely in business are not the intended target of the rules.”
Where has the PA Holdings case come from?
According to Abbott, the PA Holdings case has been rumbling on for well over a decade: “In the 1990s, management consulting firm PA Consulting decided that it would pay its employees bonuses using dividends, so they could deliberately avoid Pay As You Earn (PAYE) income tax and National Insurance Contributions (NICs).”
The legislation on the statue book is written in such a way that it could be applied to contractor limited companies, allowing HMRC to reclassify dividend payments as earnings and demand income tax and NICs on the payments
James Abbott, Abbott Moore
He continues: “The firm set up an elaborate tax structure, allowing it to route bonus payments through a separate offshore company with multiple share classes and pay dividends to the employees, instead of bonuses as part of their PAYE pay packet.”
Not surprisingly, HMRC discovered the scheme and took umbrage. It challenged the scheme via the tax commissioners, and then the courts, contending that the payments to PA Consulting’s employees were ‘earnings’ and should be taxed accordingly.
Legislation appeared in 2004, which is designed to prevent other large companies using contrived share structures to avoid paying tax on employee bonuses.
“Unfortunately, the legislation on the statue book is written in such a way that it could be applied to contractor limited companies, allowing HMRC to reclassify dividend payments as earnings and demand income tax and NICs on the payments,” adds Abbott.
Reclassifying share-owning employees’ dividends
“In November 2011, PA Consulting lost the latest round of the case in the Court of Appeal. The judges overturned the upper tax tribunal’s decision to classify the payments as both dividends and earnings, and concluded they should be treated as earnings,” continues Abbott.
This caused much consternation amongst the tax profession, because in previous cases, where payments were deemed to be both earnings and dividends, they were treated as dividends and taxed accordingly, without applying NICs.
“Following the Court of Appeal ruling, which PA Consulting is taking to the Supreme Court, the concern was that HMRC could decide that any dividend paid to shareholding employees, such as limited company contractors, was earned income attracting PAYE and employee’s and employer’s NICs,” says Abbott.
But in Abbott’s view, the level of threat for contractors is low. He explains: “HMRC’s own guidance currently focuses on large companies using complex and contrived share schemes for tax avoidance purposes, and specifically excludes genuine small businesses.
“Not only that, but genuine contractors can substantiate that their decision to incorporate was driven more by the need to obtain work from clients who won’t deal with sole traders or partnerships, rather than primarily as a tax avoidance strategy.”
Contractor paperwork is the main issue, not salary/dividend ratios
Although the government and HMRC could reverse their position on using Section 447 to reclassify dividends and go after all owner managed limited companies, Abbott feels this is currently unlikely. He also dismisses the fears some have expressed that HMRC’s Real Time Information (RTI) initiative poses a threat to contractors by providing HMRC with detailed insights into regular payments.
“Of greater importance than the ratio of salary versus dividend payments in small companies is the broader issue of correctly accounting for payments from the company to the individual,” he says. “Gone are the days of contractors making payments throughout the year and letting their accountant sort out the paperwork afterwards.
“Contractors must ensure that they put a badge on all the money that comes out of their limited companies, clearly distinguishing expenses and salary from dividends.”