The use of an Umbrella company by contractors increased rapidly following the Inland Revenue (now HMRC) issuing bulletin IR35. In simple terms, this bulletin introduced proposed changes to tax law that reduced tax avoidance by individuals who worked as contractors instead of being an employee of the company they worked for. The bulletin has become widely known as IR35.
The introduction of the rules detailed in IR35 reduced the scope for higher paid employees of companies to set up as contractors (still working for the same company) by setting up limited companies and drawing small salaries and taking most of the income as dividends, reducing their tax and National Insurance payments. Effectively, IR35 set up a series of tests to determine whether a person is a true contractor or a disguised employee of the company they are working for (client company).
When a contractor agrees a contract with a client company, whether it is directly or through a recruitment agency, there are risks that it could fall within the scope of IR35 and the contractor may be treated for tax purposes as an employee of the client company.
This is where the Umbrella company comes into play. The contractor is (or becomes) an employee of the them who will invoice the client company (or recruitment agency) for the hours worked and any legitimate expenses incurred. On payment being received by the company they will pay the contractor, deduct and account for tax and National Insurance. The expenses will be taken into account when calculating the pay, tax and National Insurance for the contractor.
Contractors who obtain work through recruitment agencies have slightly different arrangements. There are additional steps in the process that involves the agency is invoiced by the Umbrella company, the agency invoices and is paid by the client company and the agency then pays the Umbrella company.
Contractors working for an Umbrella company can show that they are not an employee of the client company and therefore do not fall foul of the IR35 rules. The Umbrella company charges the contractor a fee for the provision of its services and this is an allowable expense for tax purposes.
An example of how a contractor is paid is best shown:-
1: Time sheet completed and signed by client
2: Time sheet sent to Umbrella company with details of expenses
3: Company invoices client company
4: Client company pays invoice
5: Umbrella company pays contractor
Contractors who do not work through an umbrella company [http://www.umbrella-company.net] have to manage all the additional paperwork, manage the invoicing and account to HMRC for tax and NI. In addition they could face investigation for the breach of IR35 [http://www.umbrella-company.net/ir35/] rules. Suspected breaches of IR35 rules are complex and costly to defend. Even if you successfully show that you have not breached the IR35 rules, you can not reclaim the costs you have incurred.