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