What is a PAYE (Pay-as-you-earn) Umbrella Company?

By working through a PAYE umbrella company, a contractor/freelancer becomes a member of staff of the firm. Every month or week an umbrella company generates an invoice for the agency based on the contractor’s time sheet. Post the receipt of the invoice amount, an umbrella company pays the contractor a net salary after subtracting income tax and applicable national insurance contributions on the earnings for that period. After obtaining a contract, a contractor must send an agreement to the umbrella company for authorisation. There will be a separate contract signed between the contractor and the umbrella company. It is very simple to be a part of an umbrella scheme and a contractor must have his/her contract reviewed for IR35, prior to determining the payment structure to use.

What is a PAYE (Pay-as-you-earn) Umbrella Company?

The IR35 legislation is used to govern whether a contractor is treated as a ‘deemed employee’ for tax resolutions. A contractor’s IR35 status for every single contract will either be ‘outside IR35’ or ‘inside IR35’ depending on the contract and working provision with each client. If a contractor is ‘inside IR35’ (trapped by IR35) then he/she will be forced to take all earnings as salary only. Hence, using a PAYE umbrella company will be a practical option. However, if a contractor is ‘outside IR35’ (not caught by IR35) then he/she can take benefits of a salary along with dividends by setting up their own limited company – this considerably reduces the tax burden

Relationship between a client, a contractor, and an umbrella company

Relationship between a client, a contractor, and an umbrella company

A freelancer/contractor is hired by an umbrella company through a ‘Contracts of Employment’ agreement which states that an umbrella company is liable to issue an invoice for the work carried out by a contractor. Since, the tax amount and National insurance contribution will be subtracted by an umbrella company, a contractor will not be required to set up a company nor hire an accountant. An umbrella company is governed by HMRC and a contractor is paid are through a pay-as-you-earn (PAYE) system –expense claims may include facilities which are acceptable by the recommendations imposed by HMRC. By working under an umbrella company, a contractor can take home most of the pay, after deducting the fee payable to an umbrella company. Furthermore, a contractor must validate his/her payslip received from an umbrella companies. An umbrella company performs the role of an employer. Let’s understand the working of an umbrella company – the work arrangement will usually be as follows:

  • The umbrella company will sign a business-to-business agreement with an agency
  • Since, the individual is a freelancer/contractor, he/she will sign an agreement with the umbrella company
  • Freelancer/contractor will work with a client, who will verify the timesheet for the agency to authorise the number of hours/days worked
  • A freelancer/contractor will be accountable for sharing the timesheet with an agency as well as sharing a duplicate of the timesheet with an umbrella company which will comprise information on expenses as well
  • The umbrella company send an invoice to the agency for the number of hours a freelancer/contractor has worked along with any reimbursement applicable
  • Post the receipt of an invoice from the umbrella company, the agency with send an invoice to the end client for expenses and number of hours/days worked
  • After verifying the invoice, the agency will receive the payment from the client
  • According the payment agreement the agency will pay the umbrella company, post the receipt of payment from the client
  • The payment received by the umbrella company from the agency, include the reimbursement amount – a contractor is paid the amount through pay-as-you-earn (PAYE) system post deduction of tax and National Insurance (NI). A contractor will receive a payslip describing the deductions made before payment
  • As a final point, a contractor will receive compensation from the umbrella company, with all applicable deductions, including fee payable to the umbrella company

Advantage of working through an umbrella company

Working through an umbrella company is hassle-free, and it guarantees a contractor peace of mind, and security from compliance issues. Below mentioned are a few advantages of working through an umbrella company:

  • Additional benefits can be availed such as – childcare vouchers, contractor mortgages, contractor accommodation, employee rewards scheme, foreign currency exchange, group pension scheme, and much more
  • A contractor doesn’t have to bother about taxation and National Insurance contribution – these are computed by an umbrella company and deducted online before processing the payment
  • An umbrella company enables a contractor to work 24 hours by merely registering with the establishment. Usually, umbrella companies offer payments on the same day

Contractor loan scheme

Certain individuals who are supervised through umbrella companies and agencies are signing up to provisions which help them save tax. Majority of the employment organisations and umbrella firms function within the tax rules. However, certain umbrella firms and agencies encourage provisions that claim to be ‘tax efficient’ or ‘legitimate’ and offer contractors ways to keep most of their income, thereby, decreasing the tax liability. Such arrangements eventually result in paying extra tax, penalties and interest, and are never HMRC approved

Such provisions can work in numerous different ways, however, umbrella companies following such practices usually claim to help a contractor by letting them keep an increased portion of the income and reducing the paperwork. Such umbrella companies state that the payment is non-taxable as it isn’t considered as an income, rather a credit, loan, credit, or somewhat alike. But it must be noted that such payments are essentially no different to standard income, and it’s imperative to pay National insurance (NI) contribution and applicable tax. Below mentioned is an example that explains how such payments are made:

  • Suppose, a contractor/freelancer receives a payment post the deductions of National insurance and tax
  • After sometime, a contractor/freelancer receives another payment without any National insurance or tax deduction
  • It might be possible that the second payment was received from a different account number, possibly an overseas account, though not certainly
  • In such a scenario, the second payment will be reflected separately in the payslip and might be referred to as something apart from pay. Here, no National insurance contribution or pay would have been deducted

How to escape this

In order to avoid falling in such a trap, a contractor must check the below mentioned points:

  • If an umbrella company promises to give a contractor 80%-90% of the wages and be tax compliant that practically isn’t possible (this is questionable as the basic rate of income tax is 20% and NI contributions are also charged on earnings)
  • If only a portion of the income is compensated through payroll and subject to pay-as-you-earn (this indicated that a contractor is only paying tax of some part of the income received from a umbrella company)
  • If a contractor receives payment through credit, loan, or investment payment and the umbrella firm assertions that the pay is not subject to National Insurance contributions or income tax
  • The payment to be made by an umbrella company is directed through numerous corporations before it is credited into a contractor’s account

Usually, contractors are told that the arrangement is HMRC complaint, however, it turns out to be incorrect. The above mentioned arrangements can be extremely risky and HMRC always continues to defy tax avoidance arrangements. If a contractor is involved in such an arrangement, then, he/she is likely to be evading tax and possibly could result in giving extra tax, interest, and NI contributions, and additional penalties

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About the author
Blog Author

Sumit Agarwal
Sumit Agarwal (ACMA ACA India), the Managing partner of dns accountants is a highly respected accountant with expertise in helping owner-managed businesses.

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About the author
Blog Author

Sumit Agarwal
Sumit Agarwal (ACMA ACA India), the Managing partner of dns accountants is a highly respected accountant with expertise in helping owner-managed businesses.


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