A Treasury crackdown on tax avoidance may spell the end for ‘managed service’ companies. Rebecca Power explains what this will mean for the firms that use them

HM Revenue & Customs is turning its attention to the employment status of workers – and it has its sights set on the construction industry.

In last December’s pre-Budget report, the government announced a clampdown on what it perceived to be widespread tax avoidance through the use of managed service companies.

The Treasury’s report, Tackling Managed Service Companies, estimated that the number of workers in them has grown from about 65,000 in 2002/03 to about 240,000 in 2005/06. The companies are particularly prevalent in the construction industry.

Managed service companies are usually set up by scheme providers to make the services of workers available to businesses. They are either single-person companies or composite companies, which supply the services of a number of unrelated workers. They seek to avoid PAYE and National Insurance contributions on payments to the workers by making them shareholders and paying them a mixture of dividends, expenses and salaries, not all of which are subject to PAYE and National Insurance.

The Revenue can go after third parties if a managed service company does not pay tax. This could extend to the user of the services – the construction firms

The new legislation applies from 6 April this year, except in relation to the “transfer of debt” provisions, which have been delayed until 6 August 2007. The legislation means that all payments made to the workers (whether as salary, dividends or otherwise) are subject to PAYE and National Insurance contributions.

In addition, the tax reliefs that were previously available for travel expenses are now limited, so any travel to and from the client is not deductible for tax purposes.

The legislation is given teeth by the third-party debt transfer provisions. These allow the Revenue to go after certain third parties if the managed service company does not account for the tax. Previously, even where the Revenue could establish a PAYE and National Insurance liability, these amounts often went unpaid as the managed service company would have no assets and would simply be wound up or cease to trade.

The third parties who could be liable to pay the tax include the directors of the company, the scheme provider and also “any person who directly or indirectly has encouraged, facilitated or otherwise been actively involved in the provision of the services of individuals through managed service companies”.

Workers will look to supply services through personal service companies or direct engagement, so construction companies will have more workers

There has been some concern that this could extend to the ultimate user of the services – that is, the construction companies – and this is something that the Revenue contemplates in its report Managed Service Companies: Transfer of PAYE and NIC Debts. The legislation is not intended to catch construction companies that do not know, or could not reasonably be expected to know, that they were dealing with a managed service company.

As this legislation is so comprehensive, construction firms are likely to simply stop using managed service companies – they won’t be tax or cost-efficient any more.

Those construction companies which have encouraged or facilitated or otherwise knowingly been involved with the provision of services through a managed service company would be advised to review those arrangements.

As a result of the changes, workers will look to supply their services through personal service companies (not established by scheme providers) or through direct engagement with construction companies. Practically, this means construction companies will have more workers whose employment status they will need to consider and get right.

The tax treatment of construction workers is now in the full glare of the Revenue’s gaze as it looks to significantly increase the amount of tax it recovers. This is not something that can be ignored, because the penalties for doing so will be costly.