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The main financial risks faced by umbrella companies
Posted Feb 18, 2010
This is part two of a two-part article, kindly provided by Professional Passport.
You can read part one here.
As we have already highlighted in part one; the risk of financial loss when using a compliant umbrella should be at a minimum as typically little, if any, money is retained by the umbrella provider.
The two main threats to an umbrella company's stability come from:
- A HMRC enquiry
- Financial management and reporting
It is also important to understand the corporate structure and make up of the umbrella; being clear on exactly which company the legal relationship exists with.
Many umbrella companies are part of a group of companies, often as a wholly owned subsidiary of a group.
The company that employs the contractors will typically only have contractor employees within that company with service contracts to other companies within the group for the provision of services required to run the umbrella; e.g. payroll and administration.
These companies rarely have any assets on their books and often the financials demonstrate that monies held are typically no more than future monies due to cover items such as PAYE, NI and VAT liabilities.
This has become the normal structure for many umbrella providers as it can provide protection to both the umbrella and the contractors.
Two relationships exist:
- An employer - employee relationship between the
contractor and the umbrella
- A legal contractual relationship between the umbrella and
Where a contractor uses an umbrella provider they do not have any legal relationship directly with the recruitment company. In the majority of cases this is not an issue but when things go wrong it can prove slightly more difficult. If a dispute arises between a contractor, who uses an umbrella, and the recruitment company the contractor has to rely on the umbrella to resolve this as it is the umbrella that holds the legal contract with the recruitment company.
This can, in extreme situations, present a conflict of interest as the umbrella will not want to disturb any commercial relationship it has with a recruitment company.
The legal relationship between the recruitment company and the umbrella is typically through this wholly owned subsidiary, as this is the company that holds the contracts.
Whilst it is entirely appropriate that the financial strength of the group be used as part of an overall financial assessment it must be remembered that the contract is not held with the group but the individual subsidiary. For this reason it is important that the assessment of umbrella companies is centred around the two main threats faced by umbrellas; a HMRC enquiry and financial management and reporting.
The first of the main threats faced by umbrella providers comes from a HMRC enquiry.
If during a HMRC enquiry HMRC felt that either the contracts or processes and procedures did not meet the requirements for demonstrating overarching employment then this could result in a significant tax assessment being raised; often at a level that could not be met by the company.
Overarching employment is achieved by an umbrella having an appropriate contract of employment in place with its contractors supported by the relevant processes and procedures.
This allows the umbrella to assess each of the contractors workplaces as temporary; subject to meeting the requirements of the other tests of workplace status. Where a workplace is assessed as temporary the umbrella is then able to allow the contractors to claim travel and
subsistence expenses. Many umbrella providers have agreed dispensations with HMRC for the levels of these expenses where the workplace qualifies as temporary.
It is important to remember that having a dispensation does not in itself demonstrate or confirm that HMRC accepts that the umbrella provider is compliant.
Where HMRC successfully challenges the overarching status of an umbrella providers relationship with its contractors, this results in each workplace being classed as a series of permanent workplaces. Where a workplace is assessed as permanent, no travel and subsistence expenses are allowed in relation to that workplace.
This reassessment of the workplace status will result in a significant tax liability for the umbrella. PAYE and NI would become payable on all the expenses disallowed, and in the case of an onshore provider, this liability rests with the provider.
This is the main reason why so many umbrella companies are structured as we described previously. Under current rules this would allow the umbrella to move their contractors to a new structure relatively easily, leaving a shell company behind holding the liabilities. In the fullness of time these shell companies are then often liquidated resulting in the loss only being experienced by HMRC on the additional assessed liabilities.
This structure offers both contractors and recruitment companies further protection against financial loss.
The early warning sign to a contractor that there could be an investigation which may result in HMRC raising such assessments is where a sudden change to the expenses policy of the umbrella provider is communicated to the contractors.
Where HMRC carry out an investigation and question the overarching relationship, the first action taken is the removal of the dispensation. This results in the umbrella having to amend their expenses procedures typically changing the amounts that can be claimed and requiring receipts to support all claims.
Financial Management and Reporting
This is another key area for umbrella companies.
Umbrella companies hold significant amounts of money that must be paid in relation to PAYE, NI and VAT liabilities.
If an umbrella uses any of this money to support the growth and development of the business this could result in the company failing as it is unable to meet these liabilities.
As we highlighted earlier; the typical current corporate structure of umbrella companies means that should this happen, the main risk of loss is to HMRC and not usually the contractor or recruitment company.
It must also be remembered that a compliant umbrella does not represent any risk to contractors or recruitment companies in relation to MSC legislation or debt transfer.
Where an umbrella provider has its overarching status challenged successfully by HMRC resulting in a significant tax assessment or where an umbrella provider fails to meet their PAYE, NI or VAT liabilities, these are unlikely to fall back on to the contractors or recruitment companies as MSC legislation and debt transfer does not apply. This is only true where the provider meets HMRC's definition of an umbrella and the situation could be very different
where the underlying offering fails to meet this definition or where the provider is based offshore.