Managed Service Companies - Composite Company Model

On the 6th of December 2006, the Chancellor's pre-budget paper revealed a raft of proposed legislation called "Tackling Managed Service Companies", which if made law, will spell the end of Composite Companies.

With the Intermediaries Legislation (known as IR35) having proved ineffective in levelling the playing field, the industry is still witness to wide scale non-compliance costing the Exchequer an estimated £350 million in tax revenue. This latest proposal is a 'second effort' to remove what the Chancellor sees as an "unfair competitive advantage" that Managed Service Companies (MSC's) provide to their member contractors.

What is a Composite Company?
Like an Umbrella Company, a Composite Company is a managed service provider to contractors and freelancers who seek a hassle free alternative to running their own Personal Service Company (PSC). There the similarity ends, for more on PAYE Umbrella Companies,
click here.
  • So what is the problem with Composites?

    The problem in the Chancellor's view, is that their members are 'wrongly' being offered tax advantages that belong to those who are genuinely in business. The point that HMRC make, is that workers using MSC schemes are not in business of their own volition, but are actually in employment. And as employees they should be taxed at salaried levels. In spite of IR35, this is not happening.

    Please note, that a PAYE Umbrella Company does not offer such "tax advantages" and therefore is not the target of this proposed legislation.
  • Characteristics of a MSC

    Every Composite structure has a MSC scheme provider and a number of companies underneath it.

    The scheme provider mass markets its system to contractors and handles the administration and management of the companies underneath it on an ongoing basis.

    The scheme provider will at the outset, set up the Composite Company and determine the number of shareholders. It will set up and manage the bank account of the Company, and principally determine the greatest take home pay for the contractor. This further involves the retention of PAYE, NIC's and corporation tax, which are paid to HMRC as and when they become due.

    Within each Composite Company will be found several unrelated contractor/ freelancers, who are made shareholders. This is done to qualify for the tax advantages that business owners are entitled to.
  • How do Composites get these "tax advantages"?

    Below a schematic of what a typical Composite structure would look like:
    Composite Company structure
  • The Composite Company operates as follows:
    Each contractor gets paid a salary at the National Minimum Wage, labelled A1, B1 and C1 in the diagram. The workers pay income tax and employee's National Insurance Contributions (NIC's) on this salary and the Composite Company pays employer's NIC's.
    The remaining remuneration for each worker is subject to corporation tax as the profit of the Composite Company and then paid out in dividends.
    Each worker usually has his own share class paying out dividends, labelled A2, B2 and C2 in the diagram.
As long as they are basic rate tax-payers, there is no income tax due on these dividend payments, and there is no NIC's charge on dividend income.
Proposed MSC Legislation

IR35 was unsuccessful in addressing the problem that is Composite Companies, due to resource intensive nature that IR35 requires for enforcement.

This proposed legislation is aggressive in nature and at first reading, appears as though it will be very effective in dealing with MSC's.

For further reading on this legislation, read here.
What we said in the past

1. Very High Risk of HMRC Investigation

Events and circumstances over the last year point toward a massive crack down by the government, on such operations this year.

These are:
1.1 The 2006 Budget speech

The Chancellor specifically stated in the last budget, that Composite Companies would be investigated so as to establish their purpose: are they tax avoidance vehicles or genuine trading entities?

1.2 HMRC Office

A second specialist Revenue Office has recently been set up which has as its task, the investigation of all Composite Companies and their members.

1.3 The Finance Act of 2004

This Act stipulates that it is a legal requirement that all tax avoidance schemes be reported to HMRC. Since Composite schemes are by their nature, tax avoidance schemes, you can be certain that with this enactment, HMRC will have knowledge of their existence, how they operate and who its members are.

This legal requirement was a smart move by HMRC and was introduced to remove the problem it had been facing: tracking down tax avoidance schemes. Previously financial advisers in the business of creating Composite and other such avoidance schemes relied on this problem; namely that HMRC was struggling to keep track of these schemes in what was an ocean awash with them.

In the event of discovery, these advisers relied on their ability to quickly re-emerge under a different name and operate without detection for a lengthy period of time. No more.
Today, these advisers are now under a legal obligation to report their tax avoidance vehicles to HMRC or face massive penalties and fines.

Today it therefore seems ironic that these very schemes used to minimise tax liabilities for its members, now make the job for HMRC very easy by handing over all its members in one foul swoop. Remember this is no coincidence but rather a deliberate HMRC strategy to remove all tax loopholes previously prevalent in the contracting sector.

2. Risk to Contractor Wealth

With a Composite Scheme, the risk to a contractor's wealth comes in many forms:
2.1 Increased IR35 Risk

Operating through a Composite Company places the contractor under IR35 risk. See IR35.

IR35 hinges on one principle: were it not for the existence of the intermediary (i.e. the company through which the contractor operates), would the arrangement between the contractor and the client, be one of employment.

Where a contractor operates through an intermediary that exists and trades in its own right, the IR35 risk to the contractor is reduced on this point. With Composites however, this whole principle as to what they are comes into question. Are they genuine companies or are they schemes simply set up by contractors for the avoidance of tax.

We are certain, which way this will go - Composite Companies will be ruled as avoidance vehicles. This means that those contractors using these schemes increase their own likelihood of getting caught in the IR35 web, which in turn means further personal tax bills and penalties.

2.2 Shared liability

As a shareholder of a Composite Company, all shareholders fall liable for taxation underpayments and penalties incurred against any one contractor using the scheme. In other words, you will be jointly liable if another user of the scheme falls foul of IR35. So if they do not have the money or cannot be found, you could be forking out for someone else.

2.3 So called IR35 Insurance

Beware those schemes claiming that their contractors are automatically insured against an IR35 investigation.

To qualify for genuine IR35 insurance, a contractor would have:

to have their contract reviewed by a specialist employment law firm
the contract would have to reflect physical reality, and
to pay a premium to an FSA recognised Insurance Provider.

If these 3 criteria have not been met, a contractor is not covered against an IR35 investigation. End of story.

Since the Composite Company itself is not regulated by the FSA, we can see no way of them underwriting this so called insurance themselves.
It should now come across that the use of a Composite Company in today's contracting environment not only poses a threat to contractors' long-term financial wealth, but also puts them under the HMRC spotlight.