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Umbrella companies – the three main tax models available for contractors

Contractor umbrella companies have been forced to evolve by adopting new operating models in response to recently implemented legislation.

New rules have been introduced to help determine which contractors trading via an intermediary qualify for travel and subsistence (T&S) expenses. The 2015 Finance Act also contains new rules that restrict the types of expenses that can be offset via salary sacrifice schemes. Both of these were enacted on 6 April 2016.

With umbrellas having to react to the legislative changes to remain competitive, firms are adopting a broader range of operating models to attract contractors. As a result, the industry has begun to segment, with three main models now being adopted.

The first two models enable contractors to continue claiming expenses and rely upon the contractor not being subject to ‘supervision, direction or control’ (SDC) as to the manner in which they carry out their work. They will need to be processed to ensure they pass an SDC test to use this type of model.

The last model is a basic payroll model, and does not enable contractors to claim any expenses. This type of model is being marketed cheaper than the other two, and is suitable for contractors with little or no expenses.

Fixed expenses model

The fixed expenses model is designed for contractors who have a known level of expenses each month, and enables those contractors to carry on as before, provided they are not subject to SDC.

Pay is not varied based on expenses because the level of monthly expenses is fixed. Consequently, the fixed price model doesn’t trigger the new rules regarding salary sacrifice.

In this model, the umbrella calculates the likely amount the contractor will claim in expenses over the course of a year. This figure is then divided up and reimbursed to the contractor on a monthly basis.

One advantage of the fixed price model is that the contractor receives their expenses at regular intervals throughout the year. However, this model isn’t suited to contractors who have unknown or variable monthly expenses.

If the full amount of expenses isn’t claimed each month, the contractors’ income effectively reduces. Where expenses exceed the fixed amount, tax relief can still be claimed, but only via a self-assessment tax return at the end of the year.

Mileage expenses model

The mileage expenses model provides relief whereby a contractor can recoup business mileage via their payslip. It enables contractors who pass SDC to claim the same level of expenses as they did prior to the legislative changes, without any concerns about having variable expenses.

The only caveat is that the full tax relief on non-travel expenses won’t be available until the end of the tax year where the contractor either completes a self-assessment tax return or form P87, which the umbrella may complete on behalf of the contractor. This model is suited to contractors who have a less certain idea about their level of expenses which are likely to vary each month.

By reference to HMRC’s authorised mileage rates, each year contractors who use their own vehicle for business journeys will be reimbursed 45p per mile for the first 10,000 miles if driving a car or van. After the first 10,000 miles this drops to 25p. Contractors riding motorcycles can claim 24p per mile throughout the year, regardless of how far they have travelled. For cyclists the figure is 20p per mile.

Mileage is the exception to the rule in that it is an expense that can be offset to reduce the contractor’s tax bill at source. Contractors are able to claim this relief for home to work travel providing their contract doesn’t exceed 24 months, by which point it would be classed as a permanent workplace and tax relief for travelling expenses would cease. Contractors can also claim mileage for travel from a permanent workplace to a temporary site, regardless of the 24 month rule.

Payroll model

The payroll model is suited for contractors who have little or no expenses. The monthly charges are significantly less, and no testing for SDC status is required because no tax relief on expenses is claimed.

The umbrella company processes the contractor exactly the same as before via PAYE, but any expenses they incur need to be paid by the contractor and are not claimed through the umbrella with tax relief available. In return, the contractor benefits from significantly smaller umbrella fees.

All three models are valid and have their place in the market, and the choice of model best suited to the contractor depends on three factors: the amount of expenses, the variability of expenses, and whether the worker passes the SDC test. Contractors can expect umbrella firms to offer multiple models at a time and need to consider which one is best suited to their needs.

SDC Testing

Testing a contractor for SDC is a complex task and requires extensive knowledge of employment case law. Umbrella companies who do not have in-house expertise and who need to test their workers for SDC compliance can use a cost effective solution built by Contractor Calculator and Qdos - This enables umbrella companies to quickly and efficiently process their workers for SDC compliance and also offers underwritten insurance for those contractors whose expenses are processed.

The test is fully automated online, takes only a few minutes to complete, and captures a comprehensive understanding of the workers situation. Answers are then analysed using a bespoke algorithm, based on expert knowledge of tax and employment legislation and case law, and an assessment is provided.

Contractors can now continue to use umbrella companies and claim expenses provided they pass an SDC test.

Published: 13 June 2016

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