In the wake of the IR35 Off-Payroll Working Rules, UK hirers are turning away from independent contractors working through their own personal service companies in favor of umbrella company workers, perceiving them to be a safe option. However, in its recently updated guidance, HM Revenue and Customs (HMRC) spoke about the new and emergent risks for workers and hirers of using umbrella companies without doing due diligence.

In truth, no option is completely safe — every route used for hiring contingent workers carries an element of risk, which can only be reduced by carrying out effective due diligence and understanding what to look out for in compliance.

Definition of Umbrella Company

There is no legal definition of “umbrella company,” which is often used as a catch-all term applied to different models. Most commonly, it is used to describe a business that employs contingent workers as employees, whose services it provides to hirers via one or more temporary staffing firms. Such workers are given a contract of employment and paid via PAYE (Pay As You Earn), where income tax is deducted by the employer and paid to HMRC. As a result, they enjoy employment rights and during a temporary assignment will have rights given to agency workers, such as equal treatment with the hirer’s permanent workers. Importantly, for hirers, IR35 Off-Payroll Working Rules do not apply to such workers.

However, the same businesses that employ such workers in “umbrella companies” — described variously as accountancy firms, tax experts and payroll providers — usually offer other services to workers and skilled/qualified freelance contractors. These can include setting up personal service limited companies with differing levels of oversight and management of the company. Another option for those working in the construction industry is to be self-employed with the provider taking care of tax payments owed under the Construction Industry Scheme.

“Tax-Efficient” Schemes

Since the year 2000, providers of such umbrella company services have found many ways to make their services more attractive to hirers, staffing firms and workers or independent contractors. These “tax-efficient” schemes have involved the exploitation of tax loopholes to avoid paying the full amount of tax and National Insurance Contributions that would be due with an ordinary employee. These have included:

  • Deducting the cost of travel and subsistence expenses incurred when working on a temporary assignment.
  • Paying a fraction of salary through PAYE and the balance as a loan or shareholder dividends.
  • Paying the worker through one or more companies, trusts or partnerships, often based offshore.

HMRC will always challenge tax avoidance schemes, and the UK government has passed legislation to outlaw such activities. Most umbrella arrangements operate within the tax rules and correctly deduct tax and National Insurance Contributions from all earnings using PAYE. But the noncompliant providers of umbrella company services either have very poor memories, are newcomers to the market seeing an opportunity or are risk-takers. It is all too easy to be taken in by such schemes, which are often marketed as “HMRC-approved” when the tax authority will never endorse such products.

The latest guidance from HMRC warns against “mini umbrella company fraud,” which involves a promoter creating multiple limited companies that each employ only a small number of temporary workers. The fraud attempts to take advantage of two government incentives aimed at small businesses: the VAT Flat Rate Scheme and the Employment Allowance.

But companies focused on exploiting tax incentives do not make good employers and often structure the companies to reduce or avoid payment of PAYE, National Insurance and VAT. According to HMRC, employees, who are often not aware of these arrangements, lose out on some employment rights, do not know who their employer is and can be moved regularly between mini umbrella companies to help maximize profits from the fraud.

Legitimate Labor Supply

Failing to take reasonable action to make sure that your labor supply is legitimate can lead to significant legal, financial and reputational risks to your business.

One umbrella company model, which was outlawed in 2007 with the “Managed Services Company Legislation” — no relation to the “managed services provider,” which manages staffing suppliers on behalf of a hirer — appears to be making a resurgence. That legislation gives HMRC the power to transfer the tax debt owed by the company supplying the worker up the supply chain to the staffing firm and the end client.

Reasonable prevention procedures. In 2017, the UK Government made it an offense for businesses to fail to put in place reasonable procedures to prevent staff, suppliers and clients — or any other “external agent” within the supply chain, such as an umbrella company — from facilitating tax evasion. This offense can be deemed to have taken place even if the senior management team of the business in question was not involved in, or aware of, the act of tax evasion being carried out. The only way to avoid criminal liability is to show that the business has implemented “reasonable prevention procedures” – or to demonstrate that, based on the circumstances of the case, it would have been “unreasonable or unrealistic” to expect the business to have had those procedures in place.

Effective due diligence. Hirers may pass on due diligence to their agency suppliers, but it may be helpful as a defense against failing to prevent tax evasion to spell out in the service level agreement exactly what the procedures should look like. Effective due diligence should include the following:

  1. Know your suppliers. Do not assume tax compliance — be vigilant for previous business failures or possible criminal intent. Check the credibility of directors and verify that signatories of contract negotiations and documents are accountable office holders.
  2. Know how long your supply chain is. Margins become tighter with every layer of subcontracting, and opportunities increase for fraudulent infiltration of supply chains — check details of any onward subcontracting.
  3. Know your suppliers’ workforce. Understand what the relationship is between the workers and the provider of the labor. For example:
    1. Who provides the workers (i.e., which company)?
    2. Who manages that company, and do they have any accreditation (e.g., FCSA)?
    3. Who are the workers?
    4. What is their employment status?
    5. Who is responsible for making sure how they are paid and how much?
    6. Are they allowed to work in the UK?
  4. Assess source of rate reductions. If a supplier appears to be a better value for the money, check where that reduction comes from — is it low or no VAT? Can they account for the full payment of tax and NI contributions on the amount paid to the worker? Are travel and subsistence expenses being deducted from gross pay paid to a worker who is under your supervision, direction or control (which is unlawful)?

If a worker is under your supervision, direction or control, an individual supplied and paid by an umbrella company provider will offer the best solution for all concerned, but it is best to be vigilant to the potential risks.

For more information on compliance for those operating in the UK market, refer to SIA’s Contingent Workforce Regulatory Environment in the UK.