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What is a PEO umbrella company?

The introduction of the Off-Payroll legislation to the private sector has created a compliance headache for thousands of hiring firms and recruitment agencies. As a result, many have sought to mitigate their administrative burden and tax risk by engaging contractors deemed ‘inside IR35’ via umbrella companies.

But while this approach relieves agencies, and in some cases hirers, of their tax-processing obligations under Off-Payroll, it does not effectively eliminate risk. This is because the payment processes adopted by traditional umbrella companies aren’t aligned with the Off-Payroll legislation, and could result in contractors litigating for unlawful deductions.

Fortunately, Professional Employment Organisation (PEO) umbrella companies provide an alternative solution that ensures fair tax treatment for contractors and minimal risk for agencies and hirers.

What is a PEO umbrella?

Under the PEO engagement model, the PEO umbrella company employs the contractor and pays them a gross rate. This model is particularly beneficial for agencies and hiring firms as it relieves them of much of the administrative burden and risk imposed by the Off-Payroll legislation.

Having employed the contractor, the PEO assumes liability for all employment risk, while they also assume responsibility for all Pay As You Earn (PAYE) reporting to HMRC. In addition to this, umbrella PEOs take care of timesheets, holiday, pension and statutory payments, as well as handling contractor queries and grievances. This arrangement enables agencies and hirers to continue to engage contractors without the associated administrative burden.

For contractors, PEO umbrellas provide much-needed transparency regarding income. By signing up to an umbrella PEO’s contract rate, as opposed to the controversial ‘assignment rates’ advertised by some agencies and traditional umbrella companies, contractors can be sure that their earnings won’t be subject to any potentially unlawful deductions.

Off-Payroll tax changes pose problems for many traditional umbrellas

Possibly the greatest advantage of partnering with a PEO umbrella is a result of the Off-Payroll legislation and the changes to the tax treatment of affected contractors that render tax deductions applied by many traditional umbrella companies non-compliant.

Traditionally, IR35 – Chapter 8, Part 2 of the Income Tax (Earnings and Pensions) Act (ITEPA) 2003 – has required that a calculation known as the ‘deemed payment’ be applied to the earnings of contractors considered ‘inside IR35’.

Here, rather than treating the contractor’s earnings as salary, the affected income would be considered the gross cost of hire to the ‘deemed employer’, and therefore inclusive of employer’s National Insurance Contributions (NICs).

Consequently, the ‘deemed payment’ calculation involves determining the portion of fees that need to be classed as employer’s NICs before deducting employment taxes from the remaining sum, subjecting contractors to considerably higher effective tax rates. This is the calculation typically applied by traditional umbrella companies.

However, tax treatment under the Off-Payroll legislation – Chapter 10, Part 2 of the ITEPA - centres on the ‘deemed direct payment’, the calculation of which is summarised in three stages:

  1. Identify the value of payment made by the fee-payer to the worker, excluding VAT
  2. Deduct costs incurred by the intermediary for materials used
  3. Deduct expenses incurred by the limited company that would be claimable if the worker was employed

Given the fact most contractors won’t have any applicable material costs or expenses, the deemed direct payment will typically be the agreed contract rate. The Off-Payroll legislation requires that this sum be treated as salary and subject to income tax and employee’s NICs via PAYE, correcting the unfair anomaly under the IR35 legislation.

Not only are employment taxes excluded from the deemed direct payment calculation, the deduction of employer’s NICs from employment income is also in breach of the Social Security Contributions and Benefits Act 1992, Schedule 1, Section 3(2)(a), which states:

‘No secondary contributor shall be entitled to make, from earnings paid by him, any deduction in respect of his own or any other person’s secondary Class 1 contributions.’

PEO umbrellas offer best solution to ‘assignment rates’ issue

Crucially, the PEO model negates the long-standing problem concerning ‘assignment rates’, which many agencies and umbrella companies have historically advertised, only to source employment costs from the sum via the ‘deemed payment’ calculation.

Government has attempted to combat such behaviour by requiring that agencies provide each worker with a Key Information Document (KID) at the beginning of their engagement. This document is intended to provide greater transparency by disclosing any fees or deductions that might affect the actual amount that the worker is being paid under PAYE.

The KID should ensure fewer contractors enter arrangements where they suffer unexpected deductions. However, this practice is still understood to be widely adopted, despite the introduction of the KID and the fact that ‘assignment rates’ aren’t accommodated within the Off-Payroll framework.

Conversely, PEO umbrellas facilitate the deemed direct payment prescribed by the Off-Payroll legislation and offer complete transparency over rates. They do this by strictly quoting contract rates that are solely subject to employee taxes while accommodating for the employer’s NICs liability separately within their margin.

The advantages of partnering with a PEO umbrella

Partnering with umbrella PEOs ensures agencies and hiring firms don’t run the risk of non-compliance, which ContractorCalculator CEO Dave Chaplin notes can result in further damaging repercussions:

“Given the fundamental differences between how tax is calculated under the original IR35 legislation and the Off-Payroll legislation, the approach taken by traditional umbrella companies is no longer suitable and results in contractors being subject to unlawful NICs deductions.

“The safest method for agencies engaging ‘inside IR35’ contractors is to ensure the rates quoted to contractors are treated as employment income as per section 7 of ITEPA 2003. Otherwise, they and any other intermediary involved could easily find themselves subject to litigation for unlawful deductions from affected contractors.”

As well as being a preferable solution for agencies and hirers from a compliance perspective, Chaplin believes the adoption of umbrella PEOs could provide many companies with a competitive edge:

“Contractors deemed ‘inside IR35’ will inevitably favour a compliant engagement model over one that threatens unfair tax treatment, and many would be advised to simply refuse engagements that expose them to unlawful deductions. This is just another reason why I believe traditional umbrella models will soon die out, to be replaced by PEO umbrellas.”

Published: 07 September 2020

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