HMRC has won key Managed Service Company case at the Court of Appeal
The Court of Appeal has dismissed a key appeal involving the provision of contractors via Managed Service Companies (MSCs), ruling in favour of HMRC.
The case, Christianuyi Ltd and others v HMRC, relates to five limited companies that all provided the services of individuals as contractors. The companies had been set up for the contractors by Costelloe Business Services Ltd, a London-based company that was dissolved in 2016.
HMRC argue that the limited companies involved are MSCs and sought to charge the additional tax due to payments made to the contractors between 2007 and 2010 – some £159,000 between the five companies.
The contractors appealed to the First-Tier Tribunal (FTT) in 2016, who upheld HMRCs decision. The case was then escalated to the Upper Tribunal (UT) who again ruled in favour of HMRC in 2018.
The contractors were then allowed to appeal the UT ruling at the Court of Appeal, who dismissed their appeal last Tuesday, finding that Costelloe was indeed an MSC Provider “involved” with their clients’ companies.
These are the key findings of the case:
- A company is an MSC Provider if it (a) advertises PSC services and (b) receives a regular fee from the PSC
- HMRC do not have to prove that the MSC Provider is promoting the services of the PSC itself
- MSC “transfer of debt” provisions will be used to transfer the unpaid tax and NI debt to the MSC Provider and directors
- The case is unlikely to be appealable to the Supreme Court
- If this case sets a precedent, HMRC are likely to prioritise MSC cases over IR35 cases because MSC is easier to prove
Background
The Managed Service Company legislation was brought in at Finance Act 2007 to combat tax avoidance schemes that successfully side-stepped IR35, called “composite companies”.
IR35 was introduced in 2000 to prevent perceived tax avoidance using one-man limited companies. At that time, dividend tax was effectively zero below the higher-rate income tax threshold, so a contractor earning less than £28,000 could draw a minimum wage from their company, subject to PAYE, but draw the rest of his or her contract receipts as dividends, net of corporation tax, but free of income tax. Contractors on higher rates would only be subject to dividend tax above the higher-rate threshold.
Because IR35 targets small Personal Service Companies (PSCs) providing the services of individuals, there is an exemption for larger companies: if the individual’s shareholding is less than 5%, IR35 ceases to apply.
Composite schemes thus took advantage of this exemption by grouping 21 or more contractors into a “composite company” as shareholders. The company would be controlled by an umbrella company which would control the bank accounts, facilitate contracts, professional insurances, invoicing and payments and therefore safeguard these complete strangers from acting improperly against each other.
Such schemes flourished in the years after IR35 was introduced, hugely reducing the effectiveness of the IR35 legislation. Simultaneously, umbrella companies were also offering “limited company as a product” type-services to individual contractors, where the umbrella would facilitate company formation, contracts, invoicing, payments to the contractor, payments to HMRC and the filing of company accounts and returns – these “Managed Service Companies” (MSCs), as they came to be known, were still subject to IR35 but reduced the administrative overheads of working via a PSC to virtually zero, and were a popular alternative to composite schemes for contractors who didn’t feel comfortable with the composite model.
Both composites and MSCs were a problem for the Exchequer, so legislation was introduced at Finance Act 2007 to combat them. The Managed Service Company legislation essentially regards any PSC that was “involved” with an MSC Provider (i.e. umbrella companies or accountants offering standardised company products) to be a Managed Service Company, which means all company receipts have to be distributed as salary subject to full PAYE income tax and National Insurance, with no dividends allowed.
The MSC legislation was cleverly drafted to provide for unpaid tax debts of MSCs to potentially be chargeable to various involved parties, including agencies or end-clients – this put the onus of due diligence onto agencies, so that any umbrella companies that tried to flout the legislation found most agencies were unwilling to contract with them. Composite companies and “managed” limited company products thus disappeared from the marketplace.
The MSC Legislation
The MSC rules are contained at Income Tax (Earnings and Pensions) Act 2003 Part 2, Chapter 9 which was inserted by Paragraph 4 of Schedule 3 to the Finance Act 2007. The rules took effect from 6th April 2007 for income tax and from 6th August 2007 for National Insurance.
The rules contain criteria for defining what is an MSC (the company providing the contractor’s services) and what is an MSC Provider (the scheme promoter). For MSC to apply, the MSC provider needs to be “involved” with the MSC.
An MSC Provider is any company “who carries on a business of promoting or facilitating the use of companies to provide the services of individuals” – this is easy to demonstrate but isn’t enough in of itself for MSC to apply.
The key part of the legislation is whether the MSC Provider is “involved” with the PSC, therefore making the PSC an MSC, and meaning that all payments to the contractor must be considered employment income.
For an MSC Provider to be involved with a PSC, one of the following criteria must apply to the MSC Provider:
- It benefits financially on an ongoing basis from the provision of the services of the individual (i.e. the contractor),
- It influences or controls the provision of those services,
- It influences or controls the way in which payments to the individual (or associates of the individual) are made,
- It influences or controls the company’s finances or any of its activities, or
- It gives or promotes an undertaking to make good any tax loss (tax liability insurance for example).
Details of the case
The Christanuyi case relates to contractors who were using a composite scheme who were then migrated into their own separate PSCs when the MSC legislation took effect.
The previous appeals had related to the involvement of Costelloe with the related PSC companies. The Upper Tribunal found that Costelloe was involved with the companies, because:
- It benefitted financially on an ongoing basis from the provision of the services of the individuals (a management fee was deducted from contract receipts)
- It influenced or controlled the way in which payments to the individuals were made (Costelloe deducted tax liabilities to a retention account at source and paid them to HMRC)
- It influenced or controlled the contractors’ finances or any of their activities
This aspect of the UT ruling was not appealed. Instead, the appellants chose to argue that Costelloe was not an MSC Provider under the statutory definition because it did not promote the services of the MSCs to the contractors’ agencies or end-clients.
This is a poor argument however. The legislation does not require the MSC Promoter to promote the services of the MSCs themselves to agencies and/or end-clients: to fall under the statutory definition, the MSC merely has to promote the use of companies to provide the services of individuals – i.e. an umbrella company that promotes the use of limited companies to contractors as a contracting “solution” falls squarely into the definition of an MSC Provider. There is no requirement for the MSC Provider to then promote the use of its clients’ PSCs to agencies or end-clients.
The judge, Lady Justice Rose, considered at length not only the legislation itself but also the relevant government consultations and HMRC guidance documents before ruling that “Costelloe is, in my judgment, undoubtedly an MSC provider and the Appellants are undoubtedly MSCs”.
It looks unlikely that there is any scope for a further appeal to the Supreme Court, and should this case become case law it may have wide ranging implications for HMRC’s limited company/PSC strategy.
The MSC legislation is much easier to prove than the highly complicated employment status criteria used to determine IR35 status, so HMRC are expected to focus more heavily on MSC cases moving forwards. The transfer of debt provisions also allows for HMRC to transfer MSC tax debts that are otherwise uncollectable to the MSC’s directors (usually this would be the contractor), the MSC Provider, agencies and end-clients, meaning they are almost certain to be able to collect the unpaid tax from one party or another.
Contractors should expect to see HMRC targeting more and more MSC schemes in the near future.
26th March 2019.
Sources:
http://www.legislation.gov.uk/uksi/2007/2070/pdfs/uksiem_20072070_en.pdf
https://www.contracteye.co.uk/what_is_a_msc.shtml
https://www.legislation.gov.uk/ukpga/2007/11/schedule/3
https://beta.companieshouse.gov.uk/company/05925837
http://financeandtax.decisions.tribunals.gov.uk//Aspx/view.aspx?id=9026
