IR35: How losing the 5% expense allowance will hit PSC contractors
Amid the noise that is being made around April 2021’s private sector IR35 reform, a small but significant impact of the new rules appears to have been drowned out.
The five per cent expense allowance: what’s covered
Well, prior to April 6th 2017, any contractor operating inside IR35 and calculating a deemed salary through their limited company was entitled to an expense allowance equal to 5% of the income received from relevant inside IR35 engagements. The allowance was intended to cover administration costs such as
- Premises costs including home as office
- Accountancy and tax advice
- Costs of seeking new contracts
- Printing, postage and stationery
- Professional Indemnity insurance
- Training costs
- Computer equipment
- Bank charges
This 5% expense allowance was given at a flat rate, calculated on the gross fees receivable from an inside IR35 assignment and there was no requirement for the allowance to be supported by receipts or proof of expenditure.
Calculating the allowance (cont.)
The 5% was simply allowed by HMRC in the deemed calculation of IR35 salary as a fixed and limited claim against the above expenses. So, if a contractor had one assignment inside IR35 and one outside IR35, the 5% allowance will apply to the gross value of the invoice for the inside assignment. The full 5% was given on all relevant assignments -- even if there was no actual spend -- but conversely was limited to 5% of gross fees where actual spend was higher.
In addition to the 5% expense allowance, a contractor could also claim direct costs such as travel and subsistence.
All change under Hammond
But in 2017, following an announcement by then-chancellor Philip Hammond at November 2016 at Autumn Statement 2016, it was all change. Since the April 6th introduction of the off-payroll rules in the public sector, the applicability of the 5% allowance has been different, depending on whether the contractor is providing their services to public or private sector organisations.
In the public sector, HMRC removed the 5% expense allowance from the deemed salary calculations on the basis that it “reflects the transfer of responsibility for making a decision about where the rules (IR35) apply and deducting the associated tax and NICs payments”. Arguably, this reasoning by HMRC is tenuous and flawed since the 5% allowance was deemed to cover a multitude of administration costs, as set out by HMRC guidance and these went far and above the cost of an IR35 assessment.
Public sector contractors remain without the 5% allowance
Despite much dismay and protestation at the time from contractors and advisers alike, the removal of the rule remains, meaning any contractor using their limited company for an inside IR35 contract in the public sector can no longer claim the 5% expense allowance. These administration costs are now effectively funded from the contractor’s own taxed income.
From April 6th 2021, the same removal of the expense allowance will apply in the private sector, with one exception. Where the end-user engaging with the contractor is defined as a “small company”, the IR35 assessment remains with the contractor and accordingly so does the 5% allowance.
What difference, in financial terms, will that make to a contractor? Let’s consider an example.
Case study: Contractor Tom – the cost of no more 5% allowance
Tom is a contractor working through his own limited company in the private sector. His contract is for three months and is worth £50,000.
Prior to April 2021, Tom has assessed himself as inside IR35 and he knows that he needs to pay employment tax on his income of £50,000. Tom expects to receive an extension to his contract for three months to June 2021 and his end-client (a large company) has also assessed his assignment to be inside IR35.
The effect on Tom’s personal tax and company accounts is as follows.
Personal Tax: Impact on Tom of the 5% expense allowance removal
|Period end March 31st 2021||Period end June 30th 2021||Notes|
|Income||£50,000||£50,000||Amount paid to Tom’s company from the end client|
|Less 5% Allowance||(£2,500)||Nil||Allowance for administration costs allowed until April 5th 2021.|
|Gross Deemed Payment||£47,500||£50,000||Amount used to calculate Tom’s tax liabilities|
|Employer NICs||(£4,713)||Nil||Pre-April 6th 2021, this amount has to be paid by Tom’s company to HMRC. Post-April 6th 2021, Employer NICs are due from the fee-payer*|
|Net Deemed salary||£42,787||£50,000||Tom’s gross salary subject to PAYE and NICs, and to be included in Tom’s self-assessment|
* From April 6th 2021, the fee-payer is obliged to cover the cost of the Employer NICs and this is not to be deducted from the rate paid to the contractor. It is likely that the end-client will want to re-negotiate a new day rate, in this scenario, to reflect their additional costs. This example excludes the impact of any such re-negotiation and focuses purely on the impact of the changes around the 5% allowance.
Company Tax: Impact on Tom of the 5% expense allowance removal
|Period end March 31st 2021||Period end June 30th 2021||Notes|
|Turnover||£50,000||£50,000||Amount paid to Tom’s company from the end-client|
|Director Salary||£42,787||£50,000||Amount paid to Tom by his company|
|Employer NICs||£4,713||Nil||Amount to be paid to HMRC|
|Profit before tax||£2,500||Nil||Prior to April 6th 2021, with no other expenses profits amount to the 5% allowance and can be used to cover administration costs. Post-April 6th 2021 there are no profits and hence no funds to cover the running costs of the company.|
A significant sting, amid still significant benefits as a limited company
So from April 6th 2021, the loss of the 5% expense allowance will need to be factored-in to a contractor’s decision-making process, where they are undertaking an assignment inside IR35 for an end-client who is not deemed ‘small’ in size.
In Tom’s case, he will be paying income tax on 15% more of his invoice-value from April 6th 2021 despite him not being able to draw it all, as funds will need to be retained to cover his running costs.
The financial impact of the 5% expense allowance removal on contractors may therefore be significant, but there remain some very good reasons for continuing to operate through a limited company – where that PSC has an inside IR35 determination, and it’s unlikely contractors (or us advisers) will disregard them overnight.