Contractors, know what umbrella companies charge you

There’s always been a steady stream of contractors who understandably want to know what umbrella companies deduct, charge and take for tax.

But that flow has turned into a geyser, because a whole new breed of contractors who have never used umbrellas before washed up on their shores, due to the effect of IR35 reform, writes Lucy Smith, managing director of Clarity Umbrella.

Before I put these contractors out of their misery by putting beyond doubt what an umbrella company charges, deducts and takes in tax, we need to back up and explore that reform.

Why question marks have abounded since April

In April this year, the contractor industry saw the introduction of the Off-payroll working in the public sector: reform of intermediaries legislation. Often referred to simply as ‘the off-payroll rules,’ this legislation reformed the way in which a contractor’s working in the public sector would be viewed for tax and employment purposes.

The reform has the effect of placing the responsibility of determining the IR35 status on the public sector body (rather than the PSC/limited company contractor), which would need to decide whether the relationship between the worker and the end-user (the public sector body) would be one of employment. If so, income tax and NICs will be payable i.e. the contractor would have to be paid via PAYE.

Where this is the case then there is “deemed employment” and the organisation that pays the fee to the PSC (whether that is the public body or an intermediary potentially the recruiter in many cases) is now required to make deductions for income tax and employee’s NIC -- and to pay these taxes, as well as employer’s NIC, to HMRC. 

The changes have meant that some agencies and end-clients are now refusing to make payments direct to PSCs. While that might seem unfair, it is thoroughly understandable in as far as the deductions are somewhat complicated to calculate for a contractor who operates on a daily contract rate.

So what are the alternatives? This is the question that many parties have asked since the April changes took effect, implying that the PSC model is not necessarily the ‘no-brainer’ it once was, in terms of take-home pay, compliance and administration or ease-of-use.

Where Agency PAYE and Brolly PAYE come in

Well, option one is often referred to as ‘Agency PAYE.’ Some recruitment agencies are able to operate standard PAYE, meaning you (the contractor) operate as an “agency worker”, and they (the agency) take care of the tax side of things for you. The rate you are given in this circumstance is your taxable salary.

Option two is work via an umbrella company. And this is where you become an employee under an overarching contract of employment and receive payment via PAYE. This is the process that is new to many contractors who, until April, were happy running their own PSC. Unlike Agency PAYE, there is more going on.

The first thing some of these newcomers to these options notice is that there is often a difference in rate between ‘Agency PAYE’ (option one, above) and Umbrella PAYE.

The uplifted rate you are given when working via an umbrella using PAYE is referred to as your ‘contract rate.’ It is not your taxable salary. The uplift in rate for the brolly option is deemed to cover the additional deductions that will be seen from the contract rate before your taxable salary is reached. So what about the calculations and deductions that then arise?

What brollies charge you

1) Employer’s National Insurance

Well, let’s start with the most popular. By ‘most popular’ I mean that we are regularly asked by contractors -- “why am I paying the Employer’s NI?”

In simple terms, all umbrella companies, as employers, have a legal obligation to pay Employer's National Insurance Contributions to HMRC. These contributions are made from the funds received from the recruitment agency/client with whom the umbrella company will have a business-to-business contract; and this is still deemed to be the umbrella companies’ funds until the taxable salary is reached.

2) The Umbrella Company’s Margin

This sum is also deducted from the contract value and is the money retained by the umbrella in order to operate their business. It has already been correctly pointed out on ContractorUK that, when comparing umbrella companies, the only difference in your take-home pay should be attributable to the differing margins that the umbrella companies will be applying.

3) The Apprenticeship Levy

The Apprenticeship Levy was introduced in April to all businesses with a payroll of over £3million. In reality, there are likely to be very few umbrella companies operating today that will not reach this threshold due to the number of workers they have on their payroll deemed as “employees”.

The Apprenticeship Levy must be paid on all earnings subject to Class 1 Secondary (Employer) National Insurance Contributions, and equates to 0.5% of the umbrella’s or public sector organisation’s payroll figure. The responsibility for the tax lies with the business closest to the PSC in the chain or the umbrella company, as the party deducting the employment taxes.

Let’s put this into perspective. A contractor earning £500.00 per day is going to attract an Apprenticeship Levy bill of around £50.00 per month. For umbrella companies, this means that the Apprenticeship Levy, similar to Employer’s National Insurance Contributions, has to be made from the contract rate.

Your taxable salary figure is only arrived at once the three areas listed above have been paid for from the contract rate. The taxable salary is, in essence, the figure you’re left with after the business costs have been accounted for.

4) Income tax and Employee NIC

Then, as the contractor will work with the umbrella company under an overarching contract of employment, their salary will become subject to income tax and Employee's National Insurance Contributions.

Still don’t get it?  In a nutshell, your salary is calculated as the contract value, less the umbrella company's margin, less the amount payable to HMRC for employer's NI and the Apprenticeship Levy.

Statutory Payments

It is important to note at this point that an umbrella company must not make deductions for statutory sick pay, maternity pay and paternity pay. As your employer, the umbrella company must cover these statutory requirements from their operating profit. If these are being deducted from the rate, then it may be classified as an unlawful deduction of earnings.

Holiday Pay

Umbrella companies should be working in line with the EU Working Time Directive, which in 2006 specifically stated that ‘rolled-up’ holiday pay is classified as unlawful. Rolled-up holiday pay is the name given to where an umbrella company deems to make a payment every pay-packet which is the amount of holiday accounted for within the original contract rate.

A compliant umbrella should actually retain holiday based on the contract of employment, and then make payment to the employee when they are actually taking holiday. Any unused holiday should be returned to the employee at the end of the assignment; this cannot be retained by the umbrella company.

Where we are now

Before April 2017, any contractor who was operating inside IR35 would have been paid via PAYE (even if they were operating via their own ‘Ltd’ company), would have seen the same deductions.   

So the ‘knowledge gap’ about what brollies charge, deduct and take in tax issue appears to lie in circumstances where a contractor may have been operating via their own Ltd company, perhaps when this may not have been the most appropriate route for their situation. Some contractors really scratch their heads today, when pre-April they were advised to operate outside IR35, but now find themselves in an ‘employee-style’ tax situation.

These contractors should note that HMRC indicated before April that it had been unable to police IR35 effectively. The changes in legislation to create the off-payroll rules therefore meant that the shift in liability for determining the status would bring those inside/outside decisions back into line.

Unfortunately for some contractors however, rates of pay set by the end-user organisations have not changed, and so the impact on the IR35 decision is now causing take-home figures for some contractors to drop significantly. The bottom line where brollies are not being opened up as an option, potentially because of the complexity hopefully cut through in this piece, is that it probably isn’t just clients who see the value in re-running ‘inside’ IR35 outcomes that the ESS churns out.