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P35 Employer Annual Return service company question and IR35 - contractor guide

Contractors who contract through their own limited company must complete a P35 Employer Annual Return and submit this to HMRC electronically by 19 May, or they will suffer an automatic penalty.

The P35 asks for detailed information about income tax and National Insurance Contributions (NICs) for directors and employees of the contractor’s limited company, and these will include contractors and their spouses. HMRC does provide detailed guidance on how to complete the P35, but contractors should take care when completing question six.

That question is specifically designed to target contractors to find out their IR35 status. There are two parts to question six: the first asks contractors to confirm if they are a service company; the second asks if they have operated the ‘Intermediaries Legislation’, ie, whether they have been working inside IR35.

HMRC guidance on service companies

In its detailed guidance on how to complete the P35, HMRC provides advice on completing question six by first offering its definition of a service company. The first question asks. ‘Are you a Service Company?’, and according to HMRC, the answer should be ‘yes’ if:

  • “An individual performed services (intellectual, manual or a mixture of the two) for a client or clients, and
  • The services were provided under a contract between the client and the company of which, at any time during the tax year, the individual performing the services was a shareholder or partner, and
  • The company’s income was, at any time during the tax year, derived wholly or mainly (that is, more than half of it) from the services performed by the shareholders or partners personally.”

Quite clearly, the overwhelming majority of contractors operate their limited companies in this fashion, where they, as a shareholder, performed most (‘wholly or mainly’) of the fee-earning work for their client and so must answer ‘yes’ to the first part of question six.

Contractors unsure of their status, perhaps because part of their business sells software or employs other workers, should seek professional advice from their accountant before completing their P35.

Have you operated the Intermediaries or MSC legislation?

The second part of question six asks if contractors have operated the Intermediaries legislation (commonly known as IR35) or the Managed Service Companies (MSC) legislation. On this question, HMRC’s advice is clear and says the second part of question six should only be answered ‘yes’ if:

  • “Income has been treated as deemed employment income and [Pay As You Earn income tax]/NICs deducted in accordance with the Managed Service Company or Intermediaries legislation (IR35), or
  • An engagement is within the IR35 rules but the deemed payment is nil because sufficient amounts of employment income has been paid.”

If a contractor is in effect a disguised employee, and would be employed were it not for their contractor limited company, then IR35 applies and the contractor must pay income tax and NICs as if they were employed.

Contractors answering ‘no’ to the first part of question six would automatically answer ‘no’ to the second part. Legitimate contractors genuinely in business who answer ‘yes’ to the first part of the question should in most cases answer ‘no’ to the second part.

Contractors in doubt of their IR35 status or whether they have triggered the MSC legislation should seek professional advice.

Contractors in doubt of their IR35 status or whether they have triggered the MSC legislation should seek professional advice.

Will answering ‘yes’ result in an investigation?

When question six was first introduced to the P35 in 2008, HMRC’s guidance was sufficiently vague that most contractors would tick the ‘no’ box to the service company question.

However, since the guidance was updated by HMRC in April 2009, most contractors would be required to tick the ‘yes’ box. This is because of the way that the majority of contractors work and run their limited companies – typically, they are the majority shareholders and deliver the company’s services personally.

Despite this potentially ‘target-rich’ environment for HMRC’s inspectors, there has been no published evidence that HMRC has used the data from contractors’ P35s to mount a wholesale campaign specifically targeting service companies, particularly as it does not automatically follow that a service company is inside IR35 or the MSC legislation.

Published: 17 May 2011

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