Contracting in the UK: a tax breakdown22/12/2016
Edit 26/03/17: The 2017/18 tax year is almost here! Read about the changes here.
When I started contracting about a year and a half ago, I absolutely didn't want to have to deal with anything accounting-related.
Which is fine really, as getting an accountant is highly recommended anyway - for various good reasons - and there is a plethora of companies on the market that do just that.
I picked one that had been recommended to me by a fellow contractor and they did everything for me, from opening my limited company and business bank account to dealing with VAT registration, among other boring things.
All I had to do was to sign papers and pretend to understand what they were telling me over the phone.
Earlier this year though, as I had been in the contracting business for a little more than a year, I started to feel like I should try and understand a bit more what was what.
Needless to say, it didn't turn out to be an easy task.
I started googling around and realised the first few result pages were hogged by accounting companies that were all more or less providing the same content - enough to get a global grasp, but nothing breaking down things in detail.
I kept digging nevertheless and, with my findings and some answers provided by my accounting team, I eventually got to a point which I think is a basic but decent understanding of what's going on, now all compiled below in a post I wrote while enjoying a well-deserved end-of-year holiday.
What could be better than an article about taxes to put you in the Christmas mood anyway?
- Tax Typology
- Yearly projection
What follows is closely related to my own contracting experience as an IT consultant, to the way I operate on a daily basis as the director of my limited company. While this post certainly isn't exhaustive, I think it covers most of the questions that will arise for the average contractor at some point, and should allow you to make a projection for your own company based on your personal situation.
The aim here is not for you to deal with your own company accounts, but more to understand the stuff your accountant is sending you, beginning with your personal illustration when you're just getting started.
I should also point out that what is described below only applies if you can prove that you operate outside of IR35, which is a whole other subject that I won't get into here. You can read more about it over there if you wish to.
Unless stated otherwise, all the info provided is valid for the 2016-17 financial year.
Taxes come in different flavours and the four main ones are: Corporation Tax, PAYE and National Insurance contributions, tax on dividends, and VAT.
In the United Kingdom, the department responsible for collecting taxes is HMRC (Her Majesty's Revenue & Customs).
1. Corporation Tax
Corporation Tax applies to the company's profits and is paid annually by the company, the deadline usually being nine months and a day after the end of your accounting period (which normally corresponds to the fiscal year - from the 6th of April to the 5th of April the following year).
The tax is 20%.
2. PAYE and National Insurance contributions
Income tax or PAYE (Pay As You Earn) is based on the employee's income (meaning the director) (meaning you) and is retained and paid for by the employer monthly or quarterly.
There is a yearly Personal Allowance of £11,000 on standard income, which essentially means that the first £11,000 of income are tax free.
Here are the tax bands for the 2016-17 fiscal year:
|Allowance (0%)||Up to £11,000|
|Basic rate (20%)||From £11,001 to £43,000|
|Higher rate (40%)||From £43,001 to £150,000|
|Additional rate (45%)||Over £150,000|
I should probably drop a quick note about expenses at this point.
These are the purchases you as the employee make that are related to your professional activity (transport, meals, hardware, etc). You declare these purchases as business expenses so your company can pay you back as part of your income, but that amount is tax free.
To put it differently, say you file £65 of expenses in a certain week, you will get this amount back as part of your income but it will not be deducted from your Personal Allowance.
National Insurance contributions
You pay National Insurance contributions so you can benefit from advantages like the State Pension or the Jobseeker's Allowance (the full list of benefits is available here).
There are different classes and category letters corresponding to different rates, but as a company director yours will most likely be class 1 and category letter A (unless specific circumstances as listed in the two previous links).
National Insurance contributions are paid by both the employee and the employer, based on rates and only above a certain yearly threshold, and the employer pays the total amount to HMRC along with the income tax.
|0%||From £112 (minimum wage) to £155 per week|
|12%||From £155.01 to £827 per week|
|2%||Over £827 per week|
The employee's threshold is £8,060, meaning the employee will start to see NI contributions deducted from their income once it meets £8,060 for the current fiscal year.
|0%||From £112 (minimum wage) to £156 per week|
|13.8%||From £156.01 to £827 per week|
|13.8%||Over £827 per week|
The employer's threshold is £8,112, meaning the employer will start to pay NI contributions once the employee's income meets £8,112 for the current fiscal year.
3. Tax on dividends
Being a company director allows you to pay yourself with dividends (since you own 100% of the company's shares) as well as the standard income.
Just like the latter, there is a Personal Allowance under which dividends are not taxed. Its amount is £5,000, which means that the first £5,000 of dividends are tax free.
|Allowance (0%)||Up to £5,000|
|Basic rate (7.5%)||From £5,001 to £32,000|
|Higher rate (32.5%)||From £32,001 to £150,000|
|Additional rate (38.1%)||Over £150,000|
Tax on dividends is paid annually while you complete your tax return.
We can already clearly see that standard income tax rates are significantly higher than the dividend ones - that's why contractors usually pay themselves the standard income's Personal Allowance only (so it remains tax free), and the rest with dividends.
The VAT (Value-Added Tax) is basically a tax that is paid every time goods or services are sold. As a business, you must register for VAT only if your annual VAT-taxable turnover is over a certain threshold (£83,000 for 2016-17, usually updated every year), but you can also voluntarily do so even if your turnover is less than that amount (here are some reasons why you would do such a thing).
When you pay for it depends on the chosen VAT scheme, which are quite numerous and vary according to your activity.
The standard way of dealing with VAT is to keep track of the VAT you invoice (and to pay the corresponding amount to HMRC whether your client paid the invoice or not) as well as the VAT of your business expenditure (which you can likewise claim even if you haven't paid the invoice yet), and to report these amounts to HMRC quarterly.
Depending on the side of your business and its turnover, however, different options are available to you.
Going into details for each of them is much like sticking your head down the rabbit hole, so I will only briefly describe some of them and linger for a bit longer on the Flat Rate Scheme, since that's the one I personally registered for (and seems to often be picked by contractors - or is advised by accountants anyway, since it also makes their life easier as we will see).
This scheme allows you to submit your VAT return once a year instead of quarterly, for a fixed amount based on the previous return (or an estimate for the first year you register for that scheme).
You then pay for or get back the difference at the end of the year.
The difference between this scheme and the standard one is that you pay and claim VAT for invoices that were actually paid rather than from the moment you send or receive them.
The VAT corresponds to 16.67% of the difference between the price you paid for an object (antiques, works of art...) and the price you sold it for.
At first glance the Flat Rate Scheme is quite appealing, since it greatly simplifies things and in most cases will actually save you some dough (via the VAT credit you get by charging more VAT than your company actually pays for - see the example below).
The way it works is that you charge 20% VAT to your clients as usual, but you only pay a fixed (lower) percentage of VAT to HMRC in return. That percentage depends on your activity (see the table on this page for comparison) and is reduced by 1% the first year - e.g. as an IT consultant my rate is 14.5% (and was 13.5% the first year).
That means that I charge a 20% VAT to my clients and pay 14.5% back to HMRC - the difference is the VAT credit, added to my company profit.
This is quite simple indeed since there is no need to keep track of the VAT for each business expenditure. The Flat Rate Scheme doesn't allow you to claim VAT on such expenses, apart for purchases above £2,000.
While it might seem like a no-brainer, there is slightly more to this: the scheme certainly simplifies the process around VAT, but this simplification also benefits to your accountant and HMRC. You will most certainly get VAT credit, which is a good thing, but whether it is more beneficial to you than say the Cash Accounting Scheme should be estimated first, based on your expected business expenses.
At the end of the day which option is best for you really depends on your personal situation, but in any case you should ask your accountant for comparative simulations between the different schemes to make sure you pick what works best for your business, not only what works best for them.
There is obviously much more to VAT than the above (specific rules for builders, charities, retailers... or even depending on whether you trade internationally), and there's quite some literature about it on HMRC's website if you need more information.
Alright, enough with the theory, it all truly starts to make sense once applied concretely.
Let's have a look at an example, in which we'll calculate the amount of take-home based on a weekly invoice of £1,500 plus VAT (+20%), so five days at £300 plus VAT per day.
In order to be tax-efficient, say we only want to pay ourselves the Personal Allowance of £11,000 mentioned earlier, which over a year (52 weeks) is £11,000 / 52 = £210 per week (approximately).
This will allow us not to pay any tax on income, meaning we will pay ourselves with dividends instead, which are taxed at a lower rate as we already saw.
Note: I am using a weekly average for the sake of simplicity, but then again this is just an example, YMMV.
Since our daily rate is £300 plus VAT and we charge 20% VAT to the client, we send a weekly invoice of:
£1,500 + VAT
= £1,500 + (£1,500 * 0.2)
= £1,500 + £300
Say we registered for the Flat Rate Scheme which, as an IT consultant, means we have to pay a 14.5% rate.
14.5% of £1,800 is £261, which is the amount we owe to the taxman.
Since the amount of VAT charged to the client is £300, in effect that's a VAT credit of £300 - £261 = £39.
Your company essentially keeps the difference between the VAT it charges and the VAT it pays (the VAT credit).
In our example, that means our company profit is now £1,500 + £39 = £1,539.
PAYE, NI contributions and expenses
We already saw that since we'll pay ourselves the Personal Allowance only, we won't pay any PAYE tax on our income. But as this allowance (£11,000) is more than the NI contributions thresholds (£8,060 and £8,112 for the employee and the employer respectively), we will have to pay some NI contributions eventually.
Assuming you would pay yourself the same weekly income throughout the year (52 weeks), the NI contributions could be calculated like so, as a weekly average:
The NI contributions rate is 0% up to £155, and 12% of the remaining £55, so £55 * 0.12 = £6.6 paid by the employee per week.
NI contributions are 0% up to £156, and 13.8% of the remaining £54, so £54 * 0.138 = £7.45 paid by the employer per week.
In practice however, NI deductions would only appear on your payslips once the employee's threshold is met, and the company's liability in this regard would only start to be accounted for once the employer's threshold is met.
For the sake of simplicity however, and to show you how they are accounted for, let's consider that we take these NI contributions into account on a weekly basis.
Our company pays us (as the employee) £210, plus £7.45 of NI contributions to HMRC, so £217.45 in total.
The company profit is now £1,539 - £217.45 = £1,321.55.
As we saw earlier, however, as a contractor chances are you will have expenses to file, such as transport costs, meals, books, etc. These expenses are paid to you by your company as tax-free income, so if you spend say £50 on that week, the company will pay you back £50.
Hence the company profit becomes £1,321.55 - £50 = 1,271.55.
You as the employee are paid £210 - £6.6 of NI contributions = £203.4. We don't count the £50 of expenses here, since you paid for it in the first place - your company is just paying you back.
It's cancelled out.
(Don't worry if you start to feel a bit schizophrenic at this point, that's perfectly normal.)
It is on this remaining company profit that the Corporation Tax is applied (20%):
£1,271.55 * 0.2 = £254.31
£254.28 is thus what you should keep in your company's bank account for the taxman.
That also means that the remaining £1,017.24 (£1,271.55 - £254.31) can be paid to you as dividends.
The total take-home is thus £1,017.24 + £203.4 = £1,220.64.
Wrapping it up
Let's go over our initial assumptions again and sum it all up:
- our daily rate is £300 + VAT
- we work five days a week
- we pay ourselves £210 per week throughout the year (that's 52 weeks)
- we registered for the Flat Rate Scheme
With that in mind, the weekly take-home would be £1,220.64 out of the £1,500 we invoice or, to put it differently, a whopping 81% of the initial amount.
But then again that's only an average amount, as in practice you wouldn't pay for the NI contributions until the threshold is reached and it is very unlikely you would work five days a week for 52 weeks (it's actually impossible, if only because of bank holidays).
You could probably still pay yourself £210 a week (even when you don't work), but not as much in dividends.
Let's consider it could be the case anyway, just for the sake of the example: does that mean you could earn 52 * £1,220.64 = £63,473.28 a year?
Well, not quite. We are not paying any tax on income, that's true, but let's not forget that dividends are subject to their own tax too.
That's why it now makes sense to think on a yearly scale, now that you understand how things work on a weekly one.
We know that the Personal Allowance for the current fiscal year (2016-17) is £11,000, which is tax free.
As for dividends, the allowance is £5,000, then the basic rate is 7.5% up to £32,000, and then 32.5% above that (and 38.1% for the higher tax band).
If we decide to stay beneath the first band for tax-efficiency purposes, that means that £32,000 - £5,000 = £27,000 is taxed at a 7.5% rate, so we would pay £27,000 * 0.075 = £2,025 of tax on dividends.
Meaning that over the year, we could get £32,000 - £2,025 = £29,975 as dividends after tax.
£11,000 is above the NI contributions thresholds of both the employee and the employer, but we're mainly interested in the take-home here so we can ignore the latter.
As we saw earlier the employee's threshold for NI contributions is £8,060 for the current financial year, and anything above that is taxed at a 12% rate up to £43,004 (£827 by 52 weeks). This means that £11,000 - £8,060 = £2,940 is taxed at a 12% rate, so we would pay £2,940 * 0.12 = £352.8 of NI contributions over the year.
Combining all of the above, we could get an income of £11,000 - £352.8 = £10,647.2, plus £29,975 of dividends, so a total of £40,622.2 after tax over the year.
With the same assumptions we used in the previous example, we would need to work £40,622.2 / £1,220.64 = 33.28, basically a bit more than 33 weeks over the year to reach that amount.
I hope this will shed some light on an obscure income statement or help your decision if you are considering taking the plunge and becoming a contractor.
I am not by any measure an accountant so there might be inaccuracies here and there, or I might have left out elements I'm not aware of (if that's the case please let me know about it in the comments).
Then again, the aim here is not for you to do your own accounting, but rather to give you the keys so you can make a projection for your own company based on your personal situation.
Finally, if you are contemplating becoming a contractor in the near future and are not sure which accountant to go for, I can hook you up with mine - just drop me a line.
Tax on dividends
- VAT registration
- The Advantages Of Voluntary VAT Registration For Small Business
- VAT Schemes for Small Businesses
- VAT Flat Rate Scheme
- IT contractor guide to Flat Rate VAT
Other related sources
- Preparing for the inevitable: What taxes will I have to pay?
- Rates and thresholds for employers 2016 to 2017