Do composite companies help beat IR35?
Since IR35 was announced various inventive means and schemes have been put forward to circumvent the new legislation. But do they really work?
Putting aside offshore, foreign currency and Employment Benefit Trusts schemes, some of which are already under attack by government departments, the more common schemes are operated through composite companies (Composite) run by 'accountants'.
What is a Composite?
It is a specially created company which has individual contractors as its members, which enters into the contract with the client or agency and which pays the contractor a dividend as well as a (usually) very small salary from the income generated under the contract. It is similar to but differs from a properly run 'umbrella company' which also contracts with the client or agency but pays its contractors only in salary, net of PAYE and NI. Composites are subject to IR35 because of the dividend element, Umbrellas are not as there are no earnings that are not already chargeable to Schedule E income tax and national insurance unless the Umbrella makes payments out by way of dividend.
Why do Umbrellas or Composites exist?
The service traditionally provided by accountants for contractors is, needless to say, preparation of and advice upon accounts. Long before the emergence of IR35 some accountants realised that many contractors operating through limited companies could save costs by operating through a generic company - why have your own company if you can use one already set up and managed by accountants to maximize tax efficiency? This was an excellent way of attracting new contractor clients and offered contractors savings and a useful service. Hence the emergence of Composites and Umbrellas.
However, with the onset of IR35, the ball game changed and the opportunities for accountants to provide tax saving schemes was vastly reduced. The IR35 legislation, for example, generally limits the ability for IR35 ‘caught’ contractors to make deductions for expenses to 5%. In addition, a contractor's limited company caught by IR35 is required to pay tax on all the income the company receives and distributes, subject to the expenses allowance as if that money had entirely been paid to the contractor as an employee. Composites, as opposed to Umbrellas, therefore demand some scrutiny in ascertaining whether they help a contractor wanting to operate outside IR35.
The criteria for being caught by IR35 can be summarised as follows - if the individual is working under arrangements that would be considered an employment arrangement for tax purposes were it not for the existence of his or her personal service company, the tax will apply. It follows that the arrangements must reflect 'non-employment', namely genuine business to business arrangements.
Not surprisingly, therefore, when dealing with the Inland Revenue over IR35 the first point to establish is that the contractor is operating as a genuine business. This is what happened in the Lime IT case where the Commissioner decided that there was a genuine business set up because briefly the company had its own website and business paraphernalia, business insurance and offered its services as a business to clients. Consequently, IR35 did not apply. Interestingly, amongst other things, the Commissioners placed significant emphasis on the fact that the contractor had bought a laptop for use in delivery of the services. Lime IT remains the only case before the Special Commissioner, at the date of this article, where the contractor successfully established that the arrangements were outside IR35.
Contrast this case with the circumstances of a contractor operating through a Composite. A Composite is in business, but what does it do? It is not in the business of providing services to clients but instead is in the business of providing a tax efficient, payment efficient vehicle for its members. There is often no office paraphernalia and no website, and whilst there may be some evidence of business set up, such as business insurance, Composites generally (there are some exceptions) do not advertise for work from end users and have no management structure to supervise work done or act as an employer in any real sense of the word.
There are further questions relating to how Composites operate. For example, if a member buys a laptop to aid in the delivery of services to the client, who owns the laptop? Unless it is bought by the composite it will belong to the contractor - that defeats rather than assists the argument that the contractor is not providing personal services and that the company is supplying the service. How many laptops do composite companies own and who insures them? In the real world how many genuine businesses would choose to run their operation through a company over which they have no control simply because the personal payment arrangements are efficient? Do not forget that it is the Composite, not the contractor, that enters into the contract with the agency or client concerned.
So, if the contractor in the Lime IT case had operated through a composite rather than her own limited company, it is likely that the outcome would have been different. It would have been very difficult to argue that there was a genuine business set up for the purpose of providing services to its clients. That key element, the business on own account element, which helps to distinguish a "self-employment" arrangement rather than "deemed employment" under IR35, would have been missing.
Additionally, let's not kid ourselves, the Inland Revenue is guaranteed to be aware of such company schemes, if not now but at some point to come. By centralising "outside IR35" arrangements through a Composite, the Revenue has immediate access to a single source, the Composite, to collect tax from all its members. A contractor operating this way appears, therefore, to be massively exposed to IR35 risk.
Adrian Marlowe is Managing Director of Lawspeed. Adrian practised as a Solicitor for almost twenty years before forming Lawspeed, a niche legal consultancy specialising in IR35, contract and employment law for those operating in the IT and contracting industries. This article is for general guidance only and is not a substitute for professional advice where specific circumstances can be considered. Whereas the greatest of care is taken in providing this information, neither Adrian Marlowe nor Lawspeed cannot accept any liability for any action taken or not taken in reliance upon the information provided in this article.