Acknowledgement

IGP Corporate Ltd. includes this paper on contracting within its site since its original location on the Oxford University servers has been suspended. We make full acknowledgment to its author J F Johnstone.

An Introduction to Contracting

This document has been prepared for the purpose of introducing individuals to the contract staff market, working through employment businesses in the UK. It is based on the author's extensive experience of the contract market over a period in excess of ten years (as a contractor as well as an agent), various magazine articles, accountant and solicitor notes, and other varied publications which have attempted to bring this complex subject matter together over a period of years. The advice given is of a general nature. It is strongly recommended that professional accountancy and legal advice be sought by any individual considering becoming a contractor.

The author accepts no responsibility whatsoever, either expressly or implied, for any advice or comments given in the document.

The document is not for sale and may be copied freely to any interested party thinking of becoming a contractor.

J F Johnstone

Index

Advantages and Disadvantages of Contracting

What is a Freelance Contractor?

A freelance contractor is an individual who enters into a contract with a third party to assist in the completion of a task involving the individual's personal skills.

Advantages of Contracting

1. More money. Most employers are prepared to pay substantially higher rates to contractors than to employees. The employer benefits through savings in holiday pay, sick pay, redundancy, pensions, etc, and obtains the ability to review staffing levels and discard excess contract staff quickly, without additional cost.

2. Variety. The freedom to change jobs on a regular basis without associated blemishes in career history. Remember, you work for your own company, and having several contracts over a short period doesn't mean you have had several employers.

3. Independence. The satisfaction of a feeling of "self-employment".

4. Holidays. Not being fixed to set annual holidays. Having freedom to take extended holidays between contracts.

5. Travel. Experienced contractors are marketable in many locations, both at home and overseas.

6. Tax Savings. Possibility of organised tax planning through running your own business. Also, with tax not being deducted at source from your income, you can earn extra interest income.

Disadvantages of Contracting

1. Administration. Additional paperwork and day-to-day attention to your affairs is required as you are running your own business.

2. Accountants. It will, in most cases, be necessary to appoint an Accountant, who will inevitably wish to charge you for this service!

3. Self-Control. Ensuring you have enough money to pay the tax when it falls due.

4. Holiday Pay.You receive no remuneration for holiday periods.

5. Sick Pay. You receive no remuneration when absent from work through illness, although this can normally be offset by a good Permanent Health Insurance Policy, and the company can re-claim statutory sick pay.

6. Security. You are not protected by current legislation offering certain rights to employees (other than as an employee of your own company).

Setting up as a Contractor

There are basically FOUR ways in which you can become a contractor:

Agency Employee

Starting your own company is not a necessity for becoming a contractor, there are organisations who will take you onto their payroll and deduct your tax and NIC payments at source. Companies who undertake this method of employing people are called Employment Businesses (Agency), although they prefer to be called 'Systems Houses' or 'Consultancies'. Employment businesses are legally required to be licensed by the Department of Employment, and their activities are covered in the Employment Agencies Act 1973. To all intents and purposes, it is just like having another permanent job of a different nature.

The agencies who operate in this way, and who are licensed, do not have to act as your employer. They will normally give you a self employed contract which states they must deduct tax and NI at source, due to the Employment Agencies and Finance Acts. This in essence means they would not be liable for redundancy or other statutory payments when your contract comes to an end.

As an agency employee, you will not have deductible expenses for tax and may be the subject of a biased or incomplete service regarding tax planning and loan facilities. So, all in all, being an agency employee is almost the same as having a permanent job, but with more money and (possibly) less security. The other advantage is that you will have full Social Security benefits as with any other permanent job (including working for your own company). The disadvantage is that most agencies will only remunerate you for time spent working for the client, ie no holiday pay and only statutory sick pay.

Self Employed Status

At first sight, this may seem to be the most attractive option available to you. If you attempt to use this status via an agency, you are almost certainly going to have a confrontation with the Inland Revenue (under current legislation).

In any case, the agency will be breaking the law, unless they deduct PAYE and NI at source (as per Section 38 Finance No 2 Act 1985). Very few, if any, agencies will be interested in signing a contract with a Self Employed person under any circumstances.

Limited Company

The vast majority of people operating in the 'freelance' market-place now see this option as being far the most appropriate, and under current legislation, it is the most acceptable method of operating through agencies. Most contractors are registered with at least one agency, usually more (some register with every agency they can discover).

It is recognised that different industries each have their own conventions and types of people and skills, from 'Au Pairs' to Construction Engineers, and of course, computer professionals.In many cases, the advice given to set up a Limited Company isinappropriate. There now exists in the UK a veritable industry made up of Accountants who specialise in 'one man' Limited Company operations.

Forming a Limited Company may appear to be very daunting to some people, and it is true that a lot of legislation is in place relating to company formation and operation. This means that there is a fair amount of form filling and bureaucracy, particularly in the initial stages (formation, tax, VAT registration, etc). There are also some 'up front' costs. Ideally, you need a Solicitor (in addition to your 'good' Accountant) to look after your legal interests and to answer any legal questions you may have - also to look at contracts offered to your company from time to time.

The other disadvantages involve the mandatory keeping of proper records (eg, the setting up of the various company accounting procedures (your Accountant can help here), and since your company is a legal entity with you as its employee, it will have to pay employer's NIC costs and you have to pay your own (employee's NIC) out of gross earnings.

Most of the hard work of setting up and running a Limited Company is at the beginning of the process, although you will find that most professional agencies are geared up to making your debut as painless aspossible and, once you understand what is involved, it is really quite a refreshing way to earn a living.

Co-Operatives

Another possible alternative is to join a 'co-operative' when you obtain a contract (there is little point otherwise - 'co-operatives' are not agencies and do not operate as such). The 'co-operative' is a Limited Company in its own right, therefore it sees you as an 'apparent employee', even if you have already formed and are running your own Limited Company.

The 'co-operative' will handle all of your tax, NIC, VAT payments, invoicing, and the processing of fee receipts, and will keep all of your accounts records for you - all in return for a 'service charge' per week. In essence, they run their Limited Company for you. If you already have a Limited Company, they will still provide the services under this auspice if you wish, or you can opt to allow your Limited Company to lie dormant.

Generally speaking, 'co-operatives' do not have a licence to trade as an agency nor have any interest in doing so. However it is possible that, as your involvement with a 'co-operative' deepens, you may well get to know a few of the other people using their services and this could lead to increasing your range of contracts for new work when you need it.

The Limited Company

This is one instance where a person need GOOD Accountant because, in practice, many complex problems may arise and no decision should be taken without professional advice.

Any person starting their own business is inevitably taking a risk of financial loss and should take steps to ensure the following:

  1. That domestic and personal assets are safeguarded.
  2. That any tax liabilities arising from the business affairs are minimised.
  3. That the financial position of his/her family is protected in the event of illness or death.
  4. That he/she will be able to obtain access to adequate sources of finance additional to his/her personal investment in the business.

Most of the professional agencies are well used to assisting people in setting up a Limited Company, although beware that these services are not merely 'a device' for getting you out on contract quickly, with the agency then showing little or no interest in your affairs thereafter.

It is also worth mentioning at this stage that a contractor (and indeed all Limited Companies) should give some thought to insurance protection. Quite apart from the usual 'office contents' insurance (your computer, answering machine, etc) there should be some cover under 'general liability insurance', which will not cost too much per annum, but will provide protection against accidents that may occur during the course of work on the client site. Unfortunately, accidents can and do happen - even inadvertently or indirectly connected to you - and although the agency who has you under contract may have insurance cover over your activities, it may not be enough or of the correct nature to cover all eventualities. Under the Terms of the Employer's Liability Act, any Limited Company, firm, or person, employing anyone, must hold employer's liability insurance.

Some of the benefits, and otherwise, have already been outlined. Here, the distinct advantages and the few disadvantages are given in more detail, assuming that you have set up the Limited Company.

Advantages

1. Limited liability. Under the Companies Act, having paid for their shares, the members of the company have no further liability to contribute towards the debts incurred by the business. Beware, however, of the bank loans (or other creditors) requiring personal guarantees.

Also, Directors of a company must beware of knowingly incurring debts which they have reason to believe the company will not be able to pay. If they do so, they could be sued for fraudulent trading and be made personally liable without limit.

2. Legal entity. The company is a legal entity which is separate from that of its members, and thus has 'perpetual succession' until it is wound up. Changes in the identity of the shareholders do not affect the continuity of the company, hence you can buy off-the-shelf companies.

3. Continuity of management. It is possible to separate the management of a company from its ownership (some co-operatives operate this way). Employees can be promoted to very senior management positions without the necessity of owning shares.

4. Access to funds. As a result of the privilege of limited liability, companies are subject to various statutory controls, including the obligation to file their annual accounts with the Registrar of Companies. These accounts are then open to inspection from third parties (or you can voluntarily show your accounts to a third party, eg, bank or investment company).

5. Having a Limited Company affords its shareholding Directors more scope for tax and financial planning, and your Accountant should be able to assist in these areas - some of which are as follows:

6. Many other things can be regarded as genuine company expenses (the list is not exhaustive): salary paid to spouse and employer's NIC, telephone, answering machine, stationery, postage, office space used,heating, electricity, computer systems and consumables, accounting fees and most of your travelling expenses.

Again, where there is some 'overlap' between business and private usage (eg telephone), the Inland Revenue will adjust your PAYE allowances for business usage - your Accountant can negotiate upon your behalf in these instances.

In view of these safeguards, and because a company can be sued as a separate entity (and because of continuity of management), suppliers and providers of finance may be prepared to deal more readily with a company than with sole traders, individuals, or partnerships.

One particular borrowing advantage is that a company can give security for borrowing by means of a 'floating charge' over the whole of its assets (a device not available to the Sole Trader). There are a large number of financial institutions offering finance to companies of different sizes and at varying stages of development.

Disadvantages

1. The main disadvantage is the need for compliance with the Companies Act and its regulations, and the need to administrate the company. VAT, PAYE, invoicing, etc. Your Accountant can answer all regulatory questions (alternatively, books that specifically deal with these matters are available from libraries or good bookshops).

2. Assets. The fact that although shareholders as a body can exercise effective control over the company's affairs, they can not apply it's assets to their personal use, nor can they withdraw funds at will. Their drawings are restricted to such dividends as it is prudent to declare or by the way of remuneration. Except under certain circumstances, it is complex for a company to make loans to Directors - all benefits that are provided by the company to Directors (and their families) are taxable.

3. Property and Address. All residential property is regarded by Local Councils as domestic dwelling places and, whilst it is perfectly legal and allowable for a person to work at or from home, the Council's permission will need to be sought if you are running a Limited Company and employing other people, and/or making any structural alterations. As a rule, Councils do not like companies being run from private homes (because they fear complaints from neighbours, excessive noise, increased traffic, etc).

4. Finally, your company will have to pay Corporation Tax on any profit that it makes.

As mentioned earlier, the more professional agencies will be able to greatly assist the 'first timers' with all the necessary procedures and offer on-going advice and help throughout your relationship with them. In fact, even if you are merely registered with one of these agencies and not currently 'working for them', they will still be keen to help you where possible (otherwise they are not very professional and you would be better not bothering with them).

Initial Steps

Form the Company

There are several ways in which a company can be formed. The most common routes are through a company registration agent or through an Accountant or Lawyer. If you have time on your side you can normally choose your own name and specify the objects of the company. The company will then be created to your own requirement within about three weeks. If you don't have a lot of time to spare, most registration agents and some Accountants or Lawyers carry "shelf" companies which can be provided at a moment's notice. These companies can later be tailored, at extra cost, to your own specifications, including change of name. The cost of forming a company can vary from 75 pounds to around 400 pounds, depending on the approach adopted and the extent to which professional assistance is used.

Documentation Received

1. CERTIFICATE OF INCORPORATION: As indicated by its name, this is a certificate of the fact that the company was incorporated, where and when it was incorporated, and its registered number. The Certificate of Incorporation is required to be displayed in a public place at the registered office of the company.

2. MEMORANDUM AND ARTICLES OF ASSOCIATION: You will normally receive several copies of this, which is in fact the constitution of the company. This will set out the objects for which the company is formed, its powers on conducting its day to day business, and will indicate the capitalisation of the company and the original subscribers to the company. Copies of the Memorandum and Articles are normally given to the company's bankers, the Inland Revenue, the auditors, and may be requested by other individuals who intend to invest in or finance the company, or rent premises to the company. Spare copies should always be kept at the registered office.

3. STATUTORY BOOKS: These normally comprise various registers to be maintained recording the statutory affairs of the company, eg register of shareholders, directors, etc and minutes of all meetings of the shareholders of the company.

Statutory Forms

1. APPOINTMENT OF DIRECTOR AND SECRETARY (FORM 288): Each company is obliged by law to appoint two separate individuals to the statutory posts of director and secretary. In contracting companies, the Director will normally be the contractor himself. The Secretary will normally be the spouse or other close friend or relative of the contractor. The Secretary will be required to sign several statutory or tax returns of the company, including the financial report of the company, and therefore it is important that he/she should be someone close to the contractor.

2. NOTIFICATION OF REGISTERED OFFICE (FORM 287): The company is required to notify a Registered Office of the company. This will be the statutory address of the company, and may be different from the trading address of the company. All formal statutory correspondence and some tax correspondence will be addressed to the Registered Office of the company. The Registered Office will normally be the home address of the contractor (if he has a permanent address) or may be the office of the company's Accountants or Lawyers. It is worthwhile noting that the Registered Office of a company must be within the country of registration, and for this purpose Scotland, Ireland, England and Wales, are separate countries.

3. ISSUE OF SHARES (FORM 88-2): Each company by law must have a minimum of two shareholders. Normally the original two shares will be held by the registration agents, and transfer forms in respect of these will be received on acquisition of the company. These shares will then be transferred to the Director and one other person, normally the person who has agreed to be Company Secretary.

In some circumstances it is adequate to leave the company with two issued shares, but in other circumstances it will be advantageous to issue further shares in the company. Shares issue should be discussed with your Lawyer or Accountant.

Please check with the Companies Registrar that the shares have been allocated and recorded in the Register of Companies (otherwise you don't own the company).

4. NOTIFICATION OF ACCOUNTING REFERENCE DATE (FORM 224): The company must notify the registrar of the date to which it intends to draw up it's financial statements. In most circumstances this will be the month end closest to one year after commencement of the contract. However, in some circumstances the contractor may wish to nominate an accounting date for other personal reasons (eg spouse's business having a particular year end - sometimes useful for tax planning - see your Accountant!)

Once the Company is Formed

After completion of all statutory requirements, the company is officially owned by the shareholders. Thereafter, several other steps require to be taken:

Inland Revenue Registration

1. The company must be registered as a taxpayer for the purposes of Corporation Tax. The company will be issued with its own tax reference number. After a few weeks a Form CT41G will be issued to the company, which is a full questionnaire on the company's proposed activities and its ownership, etc.

2. The company must be registered as an employer. A separate reference number and an employer's pack will be issued from the Employer's Unit at Centre 1, East Kilbride.

3. The contractor must be registered as an employee of the company. This is done in the normal fashion, by submission of Form P45 to the relevant tax office.

VAT Registration

The majority of contractors are compelled to register for VAT, as their turnover (annual estimated income to the company) is normally expected to exceed the maximum level set for compulsory registration. Even where the minimum is not likely to be achieved, voluntary registration can often be advantageous. The pros and cons of VAT registration and procedures should be discussed with your Accountant.

Bank Accounts

It is recommended that the contractor should open two bank accounts in the name of the company:

1. A current or cheque account for the day to day transactions of the company.

2. A deposit or savings account which will be used to save funds for payment of VAT and tax bills.

To open bank accounts, it is essential that the bank manager must be shown the Certificate of Incorporation of the company (the original - a photocopy is not sufficient) and a copy of the Memorandum and Articles of Association of the company (which he will keep). Always ensure that the bank manager does not keep the Certificate of Incorporation of the company, as this must be returned to the Registered Office.

You most probably will NOT be allowed access to uncleared funds from your agent (ie your pay cheque) or any agreed borrowing facility, until the bank has confirmed that you are a registered Director and all statutory forms have been recorded at the Companies Registrar.

This can sometimes take a few weeks and your personal finances should be organised accordingly.

Credit Card Accounts

After approximately 3 months trading, approach your bank manager regarding a bank access/visa card. They are great for company petrol and travelling expenses, and much liked by the Inland Revenue (expenses are fully accounted for in the invoice documentation from the card company). It also helps us 'agents' with cash flow on business expenses, you (or your flexible friend) pay the expenses rather than the agent. There is an annual fee for the card, and your company normally has to settle the account in full on a monthly basis (this normally ties in with payments from your agent for the reimbursement of expenses).

Matters to be Attended to Throughout the Year

I list below an illustration of a number of matters which have to be attended to throughout the course of a normal year. You and your Accountant need to discuss who will be responsible for which areas in the list. Make sure you obtain a firm quote for the services he will perform.

What Expenses can I Claim?

Allowable

Not Allowable

Note 1. Motor Expenses

1. Company Cars
In the vast majority of cases it will be beneficial for the contractor to purchase a new car through his company, or to sell his existing car to the company. Most contractors seldom use their car on company business, therefore the cost of the Benefit in Kind and Fuel Scale Benefit charged by the Inland Revenue is more than offset by the benefit of charging all running costs and depreciation to the company.

2. Private Cars - Mileage Allowance
In some cases where extensive business mileage is envisaged, it may prove beneficial to own a private car and charge the company for the use of the car on business purposes. Current mileage rates vary from 25p to 36p per mile.

The best approach should be discussed with your Accountant.

Note 2. Capital Equipment

Capital allowance for capital expenditure is generally available, provided that the asset is used for business purposes, On motor vehicles this is restricted to a maximum of 2,000 pounds p.a.

How Much Tax Wlll I Pay?

As a contractor you will find that no tax is deducted from your salary at source, as it was when you were an employee. This does not, unfortunately, mean that you don't have any tax to pay! On the contrary it puts the onus on the contractor to calculate how much he ought to pay and when he is due to pay it. Fortunately there are Accountants who, for a modest fee, will make all calculations for you as part of their service!

What Taxes have to be Paid?

1. PAYE (Pay As You Earn)
PAYE, or Schedule E Income Tax, is due to be deducted by the company from the salary of the contractor. This tax theoretically must be remitted to the Inland Revenue monthly. However it is often possible to get Inland Revenue approval to remit this tax once, annually, each April.

2. NIC (National Insurance Contributions)
Class 1 NIC must be deducted from the contractor's salary each month. In addition, the contractor's company is liable also to pay an employer's NIC surcharge on each month's salary. The payment of these contributions to the Inland Revenue is made at the same time as the PAYE contributions mentioned above.

3. ACT (Advanced Corporation Tax)
ACT is due to be paid on dividends drawn from the company by the contractor. The ACT falls due on the 14th day after the end of the calendar quarter in which the dividend was declared.

4. MCT (Mainstream Corporation Tax)
MCT is payable on the profits of the company for an accounting period after deduction of the contractor's salary. MCT is reduced by ACT already paid, and is normally due nine months after the end of the accounting period of the company.

5. VAT (Value Added Tax)
VAT is charged by the contractor's company in addition to the contract price, however, it is also repaid to the Customs & Excise. It works on a type of rebate system where you offset your invoiced VAT against VAT on invoices to your company. The difference is paid to the Customs & Excise on a quarterly or annual basis.

How Do I Draw Money From The Company?

The big question to be considered is how the contractor should withdraw money from his company. Obviously the agent will pay the contract payments (on receipt of a formal invoice) to the company and not to the contractor, therefore the contractor has to consider the methods of obtaining that cash to support the lifestyle to which he wishes to become accustomed, ie:

Please DO NOT treat the company's money as your own, you own the company but the company owns and has to account for the money. Stick to the rules and I am sure your tax, accountant and bank costs will be reduced, and your administration a lot easier.

To Sum Up

Other than what I have already mentioned, I could write a book about what is allowed and what is not, what VAT and expenses to reclaim, etc. So once again, discussions with your Accountant are necessary. (I'm sure you get the message - find a good Accountant). He really will make life easier and handle most of the details contained in this document.

Finally, it really isn't as complex as it initially appears, if you are not sure on any point give me a ring.

Appendix A - To All Limited Company Sub-Contractors

Checklist

A limited company can have many advantages, but with the change of designation, come the responsibilities of a director and the loss of many benefits which would have been provided by an employer. Here is a CHECKLIST of the protection you should arrange and benefits you may require for your own limited company.

Liabilities

Most agencies are currently being evaluated for accreditation to the BS5750 standard. This standard I believe, will become a prerequisite for agencies over the next few years, in terms of approved supplier contracts. One area of concern that has been highlighted in my own company's quality analysis is public and employer's liability insurance, and limited company sub-contractors. Hence my reason for issuing this circular.

Insurance against YOUR legal liabilities for damages, claimants' costs and legal expenses, should be obtained, and as an employer even employing yourself, you legally require employer's insurance.

It is essential, in view of the importance to you of the investment being made, that sound independent financial advice is sought.

THE END for now.

From: jim.johnstone@almac.co.uk Tel:0224-620200 comments or information for inclusion in the document gratefully received.


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