What umbrella contractors need to know about taxes

What umbrella contractors need to know about taxes

Recently implemented laws have forced contractor umbrella companies to adapt by developing new operating models to remain in compliance.

For example, the 2015 Finance Act changed the rule book for contractors working via an employment intermediary by restricting who amongst them can offset travel and subsistence (T&S) expenses. The same legislation also restricted the kinds of expenses that salary sacrifice schemes can offset. Both changes came into effect in April 2016.

As with all other commercial enterprises, umbrellas must adapt to legislative change to remain both compliant with the law and competitive. For umbrellas, this has meant offering a broader menu of operating models to attract contractors. One observable consequence of this adaptation is that the umbrella sector has started to divide up into different segments, of which there are currently three main types.

Two of the three models are for contractors who are not subject to “supervision, direction or control” (SDC), meaning that they are autonomous service providers able to carry out their work as they choose. Typically, umbrellas adopting this model require contractors to undergo (and pass) an SDC test. These contractors can continue claiming expenses, which is important. This is due to the fact that they are often willing to travel significantly greater distances to their temporary workplaces than their permanent counterparts and they incur higher regular costs as a result.

The third model is a basic payroll service. Contractors working via this kind of umbrella will not be able to claim any expenses.

Let’s explore these three models in a little more detail. Contractors not subject to SDC and therefore eligible for claiming T&S expenses can choose between umbrellas offering either a “fixed expenses model” or a “mileage expenses model”.

Fixed expenses model

Contractors who know that they have a fixed level of expenses each month and are not subject to SDC can carry on as normal with a fixed expenses model. Because their monthly expenses are the same, their pay doesn’t need to be varied to take account of fluctuations in these costs. As a result, this model will not activate the new rules governing salary sacrifice.

The umbrella simply computes how much the contractor claims in expenses over a single year, divides the resulting total into 12 instalments and reimburses it to the contractor on a monthly basis. The chief advantage of this model is that contractors aren’t subject to administrative delays in receiving repayment for the expenses that they’ve incurred – the money comes in reliably in regular monthly amounts.

For contractors who know that their expenses vary significantly from one month to another, this model is not the best option on the table. Contractors who incur lower expenses one month and therefore do not claim the full monthly amount will effectively see their income dip in that period. On the other hand, when expenses are more than the pre-calculated monthly amount, contractors can claim tax relief on the excess – but not right away. They need to wait until HMRC processes their annual self-assessment tax return.

The mileage expenses model would be more suitable for these contractors.

Mileage expenses model

This model allows contractors who have passed the SDC test to recoup work-related mileage through their payslips. Effectively, they can claim the same amount of expenses that they would have done before the Finance Act came into effect in 2016, and they needn’t worry about their expenses varying from one month to the next.

However, those who opt for this model need to be prepared for one significant difference to the fixed expenses model: any costs unrelated to business travel specifically will not be automatically paid on a regular monthly basis and will instead be paid annually at the end of the year (i.e. after the completion of the self-assessment tax return or form P87 – an administrative task that some umbrellas will offer to do in the contractor’s stead). The advantage of this model is that it’s much more suitable for contractors who are unable to predict their monthly expenses because their costs vary too widely from one month to another.

HMRC’s authorised mileage rates allow contractors who use their own cars or vans for work-related travel to claim 45p per mile for the initial 10,000 miles of the year. Following this, the rate falls to 25p per mile. For contractors who use motorcycles to get to and from work, the mileage rate is 24p per mile throughout the year, irrespective of how much business travel they have clocked up on the odometer. Cyclists can claim 20p per mile.

Mileage is still the one expense that contractors can offset to lower their annual tax bill at source. However, the relief is unlikely to be available for contracts exceeding 24 months in duration. Once a contract crosses that threshold, the contractor’s workplace usually receives a permanent classification, and travel expense tax relief stops. However, if a contractor on one of these longer contracts must travel from a permanent workplace to a temporary site, then he or she can still claim the mileage for those journeys irrespective of the 24-month rule.

Payroll model

This is the best choice for contractors who incur little to no travel and subsistence costs. Because expenses are negligible, tax relief claims are unnecessary, and contractors choosing this model do not have to undergo SDC tests.

Umbrella companies offering the payroll model will process the contractor’s incoming fees on a PAYE basis. He or she will, of course, need to pay T&S expenses, which will not be claimable through the umbrella as tax relief. However, the advantage is that contractors using this model pay substantially reduced umbrella fees.

Each model is valid and has a legitimate place in the market. To sum up, the best model to opt for hinges on three issues:

  • The level of T&S expenses incurred
  • How variable these expenses are from one month to the next
  • Whether the contractor passes the SDC test

As many umbrellas offer multiple models, contractors will need to bear these issues in mind when selecting which one suits them best.

Further Considerations:

Avoid Emergency Tax Codes
Dividends: What are they and how are they taxed?

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