ESM3011 – Introduction: the position before 6 April 2000

Before 6 April 2000, an individual who would be regarded as an employee if engaged directly could avoid being taxed under Schedule E and paying Class 1 NICs by providing his or her services through an intermediary.

Typically the intermediary used in such circumstances is a company (commonly referred to as a service company), with only one employee (possibly two where a spouse is also employed by the company). That worker is the only shareholder, director and also earns all of the money for the company.

The company earns all, or almost all, of its income from supplying the worker’s services to third parties in circumstances that would be employment if the individual were engaged directly.

If the contract were with the worker directly, the worker would be an employee. However, the worker does not contract directly with the third party client. The service company enters into a contract, either directly with the client or via an agency, under which it agrees to supply the services of the worker. There is no contract between the worker and the client. The worker is therefore not an employee of the client.

There is an inter-company contract for the supply of the worker’s services. Therefore the Schedule E and NICs legislation does not apply to the amounts which are paid to the service company. The service company is paid gross and then has complete flexibility over how it disposes of what is essentially the worker’s wages. Often the service company pays the worker a small wage that just exceeds the NICs threshold, thereby ensuring that the year counts towards such rights as Statutory Sick Pay, Statutory Maternity Pay, and state pension. The balance of the income is paid out in expenses and dividends.

Companies with more than one worker, commonly known as composite service companies, have also been used in this way. Rather than there being one worker, the company has many workers, each owning a different class of share in the company. The composite company provides the workers’ services to different clients under separate contracts. Dividends are then paid to the workers on the different shares by reference to the amount earned from their contract. There is also the same scope for paying expenses and a small wage, as with a one-person service company.

A further variation involves the use of a partnership, which achieves a similar result. However, the worker takes the income as drawings rather than through dividends and does not receive a wage. The use of partnerships is a lot less common than the use of companies.

If the arrangements are set up correctly then, without specific legislation, it is difficult to counter this form of avoidance. See IM5322 for further guidance on such cases.