Are umbrella companies the root of all evil?

Recent changes in Government legislation have meant that construction workers who operated for years, quite happily, as sole traders have been forced into working in a new and totally different way. As a result their tax home pay has decreased and, understandably, they are not happy about it. The changes have meant that, rather than paying income tax and class 2 and class 4 National Insurance contributions (£2.50 per week and 9% on profits between £7956 and £41865 respectively) construction workers are now being forced to pay class 1 contributions of 12%.

So why has this happened? Well, basically, unless an agency can show that a worker is not under the supervision, direction and control of the client, they will be liable for PAYE taxes which means that they will have to pay Employer’s NI contributions and deduct income tax and class 1 NI contributions from their workers.

To comply with these changes they can either take the workers on to their books along with all the legal and statutory payment obligations of an employer or they can refer the workers to an umbrella company. Umbrella companies are used very commonly in the IT industry; they provide an alternative to a Personal Service Company (one man Ltd company) for workers wanting to operate as contractors.

Agencies within the industry understand the way an umbrella company operates and will therefore offer a rate to the worker which is well in excess of the rate that they would offer should the worker be taken on their books as an employee. An umbrella company is a relatively new concept within the construction industry and, unfortunately, what is marketed as an umbrella company may be nothing more than a tax avoidance scheme which could leave workers subject to significant tax penalties at a later date.

A proper umbrella company will engage the worker under an over-arching contract of employment and will engage with the agency via a business to business contract. Invoices will be raised for the work done and when payment is received from the agency the umbrella company will meet its legal obligation to HMRC and make their Employer’s NI contributions. They will also deduct their margin which is around £25-£30 per week and make contributions to a pension scheme through the auto-enrolment scheme where applicable. The balance of funds is the worker’s salary which is then subject to PAYE taxes. All of this information should be given to the worker by the umbrella company before an employment contract is signed.

The umbrella company is then liable to pay maternity pay, paternity pay, adoption pay, sick pay etc etc and this should be made as a cost to the business, it should not be a deduction from the worker to only be paid back at a later date if circumstances arise. Umbrella companies are sometimes advertised to workers as financially beneficial because the worker can ‘claim expenses which increase take home pay’.

This is misleading.

The worker may be entitled to claim tax relief on costs for travel and subsistence, for instance, but only if they intend to work on more than one assignment whilst in the umbrella company’s employment and if they won’t be travelling to the same location for more than 2 years and if they haven’t spent more than 40% of their time at the same site over a 24 month period. Whether or not something can be legitimately classified as an expense depends on HMRC’s rules and not the umbrella company.

Some ‘umbrella companies’ also operate salary sacrifice schemes which means that they will assume that a percentage of the workers’ earnings will be classified as an expense and therefore subject to tax relief regardless of the costs that have been incurred by the worker. HMRC recently defeated such a scheme that was operated by Reed; the defeat cost Reed £158 million. Construction workers have basically been re-classified as employees by HMRC and they should not be financially penalised because of it. In any employment relationship there will be financial responsibilities for the employer but these should not be passed onto the employee. Any company referring workers to an umbrella company should realise that they will be making significant savings by handing over their employer responsibilities and the workers’ rates should be adjust accordingly.

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