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Contractor tax planning case studies

TAX PLANNING CASE STUDIES

In this blog I will look at how contractors can receive some spectacular returns by using tax planning rather than tax avoidance. Three fictitious case studies follow:
1. ERIC
Eric is 61 and widowed. He has just started receiving an occupational pension of £10,000 per annum. He has savings of £50,000, owns his house outright and has modest income requirements spending about £15,000 per annum to live the life he likes to live. He has just secured a contract which will generate £40,000 per annum. An independent contract review concluded that his contract was almost certainly caught by IR35. Eric would like to work until he is 65 when his state pension will commence. At that time he would like to increase his personal expenditure to about £25,000 per annum to travel and generally enjoy the first 15 years of his retirement.

Eric searches on the web and comes up with an Isle of Man organisation called Sanzibar. Sanzibar claim they have an innovative solution for contactors. Eric will be able to retain 82% of his fees. IR35 in particular is not an issue and Eric will have no administration to worry about because there is little or no tax involved, Eric won’t be able to claim tax relief on his contract expenses. Eric asks how the scheme works and he is told that he will receive a small salary from Sanzibar supplemented by loans. They explain that although the loans are technically repayable, Eric will never be asked to repay a single penny. They go on to say that the scheme is robust and comes with counsel’s opinion from none other than Cedric Smythe, head of chambers at Opinions4u. Eric is told that the opinion had cost £10,000. Finally, a schedule is provided showing his net income as follows:

Anticipated Turnover £40,000

82% return                      32,800
Less: Contract expenses 2,000

Net Return                    £30,800

Eric was impressed, but also arranges to see a local accountant Edward Peters. Edward tells him that Sanzibar are involved in tax avoidance and that HMRC would almost certainly challenge the tax free nature of the loan payments. Eric became worried. Edward then outlined his plan which was:

a) Eric should use a limited company which would register for VAT and join the flat rate VAT scheme;
b) Eric should pay the profits of the company into a pension scheme;
c) Eric should rely on his savings to supplement his pension income; and
d) on retirement Eric should start drawing his pension.

Edward went on to explain that the pension contributions would ensure compliance with IR35 without any resultant PAYE or NI Liability. He explained that when Eric started drawing on his pension 25% would be tax free and the balance would be taxed at 20%. Therefore the cash value of the contributions was 85% of the amount contributed.

The schedule Edward provided to Eric showed the following:

Fees                                                       40,000
Flat rate VAT Scheme advantage       1,040
41,040
Contract expenses       2,000
Company Expenses     2,000
Pension Contribution 37,040
41,040
Retained Profit                                    £ NIL

Value to Eric 37040 x 0.85               £31,484

Needless to say, Eric signed up with Edward Peters.

2. LAURA
Laura aged 45 and single was a reluctant contractor. Having been made redundant from her £100,000 per annum salaried position she was offered a contract providing management consultancy services to an expanding web based retail company hoping to float on the stock exchange in the next 2 years. Having failed to find a permanent job she accepted the contract to start on 1st April 2015. Laura was recommended by a colleague to speak to his accountant Edward Peters.

Laura met with Edward in late March 2015 and discussed her reservations with him. Edward established that the contract would bring in about £140,000 per annum. Laura had not been a big saver and had tended to spend all of her salary. She had however spent over 20 years in her previous employer’s final salary pension scheme and she was holding £70,000 cash net of the tax from her redundancy package. Edward discussed the nature of the work Laura would be doing and quickly decided it would be outside IR35. Edward laid out the following plan:

a) a limited company should be set up with Laura as the sole director and shareholder;
b) the company should register for VAT and join the flat rate VAT scheme at the 14% rate with a 1% discount for the first 12 months;
c) the company should pay contract expenses and company expenses estimated at £5,000 and £2,000 respectively;
d) Laura should live off her savings but draw a £28,000 dividend in December 2015 and a £10,600 salary in March 2016; and
e) a meeting should be arranged at the end of March 2016 to plan further steps.

As it transpired, in March 2016, Laura was offered permanent work to commence on 1st May 2016. Laura arranged to finish her contract on 1st April 2016.

On 10th April 2016 Laura delivered her records to Edward and a meeting was planned for 17th April by which time Edward expected the accounts to be prepared.

The accounts showed:

Turnover                                                 142,000
Flat Rate VAT Scheme advantage          6,200
148,200
Salary                           10,600
Contract Expenses       5,000
Company Expenses     2,000
17,600
130,600
Corporation tax @ 20%                           26,120
104,480
Less: Dividends                                         28,000
Retained Profit                                        £76,480

Edward said that the company should be liquidated by an Insolvency Practitioner and that the reserves would then be released to Laura as a gain subject to Capital Gains Tax at a rate of 10% after her annual exemption of £11,000.

An Insolvency Practitioner was duly appointed on 30th April 2016. His costs were £1,480 and £75,000 was released to Laura.

Edward then suggested that Laura should consider EIS investment. A specialist IFA was appointed and he recommended EIS investments in a scheme which funds TV programme production for the BBC. The IFA advised that EIS investment generated a 30% income tax credit and that gains could be re-invested. The IFA said that the TV production EIS was not risk free but that she was likely to get a return after just 3 years of between 95% and 106% of her investment.

Edward advised Laura that she should invest £11,000 straight away, £11,000 in April 2017, £11,000 in April 2018 and £11,000 in April 2019. As all of these investments were within 3 years of her capital gain, gains could be re-invested and as each investment matured Laura would have a new annual exemption so the liability would be washed away.

Laura’s immediate Cash proceeds were:

Salary                              10,600
Less Employees NI          (305)
10,295
Dividend                         28,000
£38,295

The gain suffered net tax as follows:
Capital Gain                       75,000
Less Annual Exemption   11,000
64,000
Less: Re-invested              44,000
Taxable Gain                    £20,000
Tax @ 10%                         £2,000

In the fullness of time, the EIS Schemes all matured yielding total proceeds of £44,000, the same as Laura invested, but she benefited from the 4 tax credits of £3,300 each. So her eventual total cash take was:

Immediate Net income from company   38,295
Contract Expenses                                        5,000
Capital Gain                                                 75,000
Less: Amount re-invested                       (44,000)
Capital Gains Tax                                       ( 2,000)
29,000
EIS Tax credits 4 x £11,000 x 30%           13,200
Maturing EIS proceeds                              44,000
£129,495

That’s a 91% return on her fees of £142,000.

3. JOHN
John aged 35 is married to Jill. John has just secured his fist contract as an IT Consultant starting on 1st April 2015. He expects to generate fees of £100,000 per annum. Jill is a qualified accountant and she used to work in Edward Peters office until she gave up working 2 years ago to start a family. Jill deals with the family finances and so she paid a visit to Edward at the end of March 2015. At the meeting Jill explained that they had been struggling to get by on John’s £60,000 per annum salary particularly recently as they had had to give up claiming child benefit. As a result they had built up an overdraft and credit card balances totalling £10,000 just to keep up with their mortgage. Jill explains that John had been talking to a friend who used some outfit in the Isle of Man called Gedaway who guaranteed a return of 85%. It seemed that John wanted to sign up with them. Jill was worried that HMRC would challenge the scheme and that they would end up with more debt. Edward echoed Jill’s concerns and said that tax planning rather than tax avoidance was the better approach.

Edward looked at Johns contract and believed it to be outside of IR35 (a view later supported by an independent contract review). Edward laid out the following plan:

a) a limited company would be set up with both Jill and John as directors and each holding 1 share;
b) the company should register for VAT and join the Flat Rate VAT scheme at the 14½% rate with a 1% discount for the first 12 months;
c) the company should pay contract expenses and company expenses estimated to be £2,000 each;
d) the company should pay dividends of £3,000 per month each to John and Jill for the first 6 months followed by £5,000 each in months 8 and 10;
e) salaries of £10,600 gross should be paid to each of them in month 12 (March 2016); and
f) a meeting should be arranged at the end of April 2016 to review progress.

At the April 2016 meeting Edward presented the accounts to Jill which read as follows:

Turnover                                               100,000
Flat rate VAT Scheme advantage         3,800
103,800
Less: Salaries                      21,200
Contract Expenses              2,000
Company Expenses            2,000
25,200
78,600
Corporation Tax @ 20%                       15,720
62,880
Dividends                                               56,000
Retained Profit                                    £ 6,880

Edward explained that there would probably be opportunities to draw the retained profits tax efficiently in the future. For example if John returned to permanent employment he could give his share to Jill and she could draw the retained profits as dividends fax free.

Edward set out the net cash position as follows:

Salaries                        21,200
Less: Employees NI       (610)
20,590
Dividends                    56,000
Retained Profits           6,880
Contract Expenses      2,000
£85,470

A return of just over 85% of Johns fees.

Edward went on to caution that in year 2, the 1% discount on the Flat Rate Scheme would be lost so the return would not be quite as good. For her part, Jill advised that their debts had been paid off and they now had some savings in ISA, and they were looking at starting a pension scheme for John. Jill was particularly pleased to let Edward know that she was once again in receipt of child benefit. Particularly useful with a second child on the way.

Disclaimer
This article is not intended to be and does not constitute financial advice or any other advice, is general in nature and not specific to you. Before using the above information to make an investment decision, you should seek the advice of a qualified and registered financial adviser and undertake your own due diligence.

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