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Tax and VAT for a PSC

This Content Was Last Updated on March 25, 2024 by Jessica Garbett

 

Summary

Taxation for a PSC can seem complex as a number of taxes come together – VAT, Corporation Tax, Dividend Tax, Income Tax, National Insurance.  On top of this there is the need to understand deductible expenses, and issues like salary and dividend mix.  With care this can be managed and understood, and the best tax result achieved.

This guide is part of a series. This is the index:

 

Contents

 


Definitions

Part of the complexity with tax is understanding the terms:

  • Turnover – sometimes called “takings” “sales” “business receipts” “gross income” or “business income” – this is the total amount of your business income.
  • Expenses – also called “costs” “outgoings” – this is the total of items you’ve spent running your business, ie the costs of earning your turnover.
  • Profit – also called “net income” – Turnover less expenses.
  • Accounts – a summary of your turnover, expenses and profit used to report your business performance for tax and management purposes (also called Financial Statements).  Typically comprises a Profit and Loss Account, and maybe a Balance Sheet.  These will be drawn up for your Financial Year which is normally the tax year, but you could choose a calendar year or the anniversary of your starting in business.
  • Bookkeeping – the keeping of records of turnover and expenses for accounting purposes.
  • Director – an individual running a company – normally in a PSC this will be the worker providing services through the PSC.
  • Shareholder – the owners of a company, who hold its shares.  In a PSC these will normally be the directors or their close family.
  • Salary – a payment for work done – within a PSC this will be paid to Directors.  Its deducted from the company profit before tax..
  • Dividend – a return on shares held in a company – within a PSC this will be paid to Shareholders.  This is paid from company profits after tax, and as tax has already been paid on these profits is subject to a lower rate of tax..
  • Salary / Dividend Mix – given that in a PSC Shareholders and Directors will normally be the same, and that these two streams have different taxation, the mix between them is important for tax.
  • Corporation Tax – a tax on a company’s profits.
  • Income Tax – a tax on an individual’s income.
  • Dividend Tax – a subset of Income Tax, charged on income from dividends.
  • National Insurance – a social security charge, separate to tax, charged on earned income – for a PSC this will be salaries rather than dividends.
  • VAT – Value Added Tax – a Turnover based tax on business activity.
  • IR35 – a set of tax anti avoidance provisions which impact some PSCs – read our separate briefing.
  • PAYE – a system for collecting tax at source on salaries.
  • CTSA – Corporation Tax Self Assessment – the system for reporting and paying Corporation Tax, via CT600 and iXbrl.
  • Self Assessment – the system for individuals to report and pay their taxes.

 


Basics of Tax for a PSC
(2024/25 tax rates)

To understand how some of these concepts come together, lets consider Pat, a contractor.

  • Pat provides services through PatCo Limited to MegaCo PLC.  The contract is for £10,000 a month, and is considered outside of IR35
  • Assuming Pat works 12 months of the year, PatCo’s turnover will be £120,000
  • Patco incurs operating expenses of £10,000 a year
  • Pat draws a salary of £12,000 and a dividend of £50,000
  • Pat also receives £4,000 of rent a year from a buy to let

On these figures (2024/25 tax rates):

  • PatCo Limited’s profits will be £97,600 (£120,000 less £10,000 expenses, £12,000 salary and £0 Employers NI on salary)
  • Corporation Tax will be due on £97,600 – this is reported to HMRC via CTSA
  • Pat’s £12,000 salary will be subject to Income Tax and NI via PAYE
  • There will be £25,486 of retained profit in the company  – Pat could draw this out but the tax on the dividend would go up.
  • On Pat’s Self Assessment the following will be shown:
    • Salary £12,000
    • Dividend £50,000
    • Rent £4,000
    • Total £66,000
  • Pat’s overall Income Tax liability, including Dividend Tax, will be calculated on £66,000 and any tax deducted at source via PAYE credited
  • Pat ends up with £57,050 net
  • VAT will be due on the £120,000 –
    • So PatCo will charge MegaCo PLC £12,000 a month, of which £10,000 is the fee for Pat’s services, and £2,000 is VAT
    • Every quarter the VAT is paid over to HMRC, less and VAT on expenses

Of course there are some permutations of this, mainly around Dividends – we’ll cover this below.

Case study 1 at the end of this page shows the position for Pat and Patco Limited.

 


Corporation Tax
(2024/25 tax rates)

Corporation Tax is paid on company profits – which is turnover less expenses.

Corporation Tax is reported to HMRC on a Ct600 CTSA (Corporation Tax Self Assessment return) along with a copy of the business accounts in a special format known as iXbrl.

The Corporation Tax is due 9 months and a day after the end of the financial year, and the CTSA return due in 12 months after the end of the financial year.  EG:

  • Financial year to 31 March 2024
  • Pay Corporation Tax 1 January 2025
  • File CTSA return no later than 31 March 2025

Corporation Tax rates from April 2023:

  • Small Profits Rate – profits of up to £50,000 – 19%
  • Main Rate – profits over £50,000 – 25%
  • Marginal Small Companies Relief applies  between £50k and £250k
  • Caution these thresholds are split equally between connected companies, so if you operate two or more companies, take advice, especially if profit is not equal in each.
  • See our briefing on Corporation Tax Rate Rise 2023 – Impact

The Marginal Small Companies Relief is complex, and for most companies – so long as they don’t received dividends from other companies – the rates can be simplified to:

Profit Band Marginal Rate
£0 to £50,000 19%
£50,000 to £249,000 26.5%
£250,000 plus 25%

 

 


Salaries and Dividends
(2024/25 tax rates)

Salaries and Dividends are often confusing.  Remember:

  • Salaries are a reward for work done
  • Dividends are a return on investment in shares

In a PSC Directors and Shareholders are normally the same, so there is merit in looking for the optimum salary / dividend split.    Depending on personal circumstances that tends to be a Salary of around £10,000 to £12,000 and the remainder as dividend.  There are a few factors which impact this, notably

  • Tax rates
  • NI rates
  • Cash requirements by the PSC worker

On the last point, cash requirements, company funds which aren’t needed immediately can be left as retained profit in the company, which defers tax, however the tax will catch up with you when you withdraw the funds, although if you anticipate having a time when you won’t be earning as much there can be merit in retaining profits until then and drawing them at a lower tax rate.

Case Studies 2 and 3 at the end of this page show some variations on the basic position for Pat and PatCo Limited which was set out above.

  • In Case Study 2, Pat has a lower dividend – there is less paid to HMRC but less take home for Pat and more retained profit locked up in the company
  • In Case Study 3, Pat takes all company profits out as a dividend.  This maximises take home, but at the expense of a higher tax bill

 


Payroll, Income Tax and NI

Directors are considered employees of the company, even if they control it.  Therefore the salary drawn from the company needs to be run under a payroll and deductions made via PAYE (Pay As You Earn).

There are three elements to the deductions here:

  • Income Tax on the salary – often this will be £nil as the typical small directors salary will be under tax allowances
  • Employers National Insurance – this is borne by the employer, PatCo Limited in this case.  So in terms of PatCo’s accounts there is an expense for Pat’s salary plus the Employers NI.
  • Employees NI.  This is a deduction from Pat’s salary as it is borne by the employee.
  • From 2023-24 there will be Health and Social Care Levy as well, subsumed into NI.

Payroll generally needs to be run monthly and reported electronically to HMRC via RTI contemporaneously.

 

National Insurance

This is only charged on earned income, eg the salary drawn from a PSC.  It is not charged on dividends or income like rent.

Employees NI (Primary Class 1 NI) is deducted from employees wages, at 8.0% on earnings over £242 a week and at 2.0% on earnings over £967 a week (2024/25 tax rates).

Employers NI (Secondary Class 1 NI) is paid by employers, and thus sometimes called a “tax on jobs” – the rate is 13.8% on weekly pay over £175 (2024/25 tax rates).

National Insurance is charged per source – so if you had two employments for example, or an employment and a self employment, they are assessed to NI separately.

 

Income Tax

Income Tax is charged on all income during a tax year, eg:

  • Salary
  • Dividends (special tax rates as they are from taxed profits)
  • Rents
  • Self Employments as a Sole Trader/ Partner
  • Interest

The tax rates (2024/25 tax rates) are:

  • £0 to £12,570 – 0%
  • £12,570 to £50,270 – 20% – Basic Rate Band
  • £50,270 to £125,140 – 40% – Higher Rate Band
  • over £125,140 – 45% – Additional Rate Band

The £12,570 0% Personal Allowance tapers out on Incomes over £100,000 at £1 tapered deduction for each £2 of income over £100,000 creating a 60% marginal rate.

Income Tax is aggregated – so all sources of income are added up and the bands above applied.  Normally the calculation is in slices as follows:

  • Savings income is the first slice
  • Salaries and rental income is the next slice
  • Dividends are the top slice

However this slicing order can be overridden if it saves you tax.

As mentioned, as dividends have come out of company profit on which tax has already been paid, they are subject to a special rate:

  • There is a £500 Dividend Allowance (2024/25 onward, redued from previous £1,000) – note the DA is part of the regular Basic Rate and Higher Rate bands, and not separate – it is a nil rate on that slice of dividend within the regular tax band
  • Dividends over £500 are taxed as follows:
    • 8.75% If they are in the Basic Rate Band
    • 33.75% if they are in the Higher Rate Band
    • 39.35% if they are in the Additional Rate Band

 


Marginal Tax Rate

In most cases, Director / Shareholders of small companies withdraw the bulk of their profits as dividend.  Lets look at Corporation Tax and Dividend Tax together.

Doing so is complicated by various factors, most notably:

  • The Corporation Tax rate tapering between £50k and £250k profit – so we will look at both 19% and 25%; and
  • Personal Tax rates varying according to the recipients overall income, excluding income from other sources.

Accordingly any generalised modelling is hypothetical except in the simplest of cases.

In the table below we’ve looked at the tax cost on £1,000 of income as Dividend at the Basic, Higher and Additional Rats of Dividend Tax and at both 19% and 25% Corporation Tax.

In reality the Corporation Tax rate may vary between these two extremes.  You’ll see that although the difference in Corporation Tax rates is 6%, the difference in effective tax rate is less, eg for a Higher Rate Tax Payer 46.34% at 19% Corporation Tax versus 50.31% at 25%.  High though these rates may be, bear in mind under PAYE there would likely be Income Tax at 40%, Employers NI at 13.8% and Employees NI at 12%, or for an equivalent Self Employment Income Tax at 40% and Class 4 NI at 9% (2023/24 rates).

Whitefield Tax
Effective Tax Rates on Dividend from a Small Company
 2024/25 Tax Rates
Extraction of £1,000 of Profit
Profit Corporation Tax Rate  Corporation Tax Profit = Gross Dividend Dividend Tax Rate Dividend Tax Total Tax Take Home Effective Tax Rate %
19% Small Profits Corporation Tax Rate
£1,000 19% £190 £810.00 Basic 8.75% £70.88 £260.88 £739.13 26.09%
£1,000 19% £190 £810.00 Higher 33.75% £273.38 £463.38 £536.63 46.34%
£1,000 19% £190 £810.00 Additional 39.35% £318.74 £508.74 £491.27 50.87%
25% Main Corporation Tax Rate
£1,000 25% £250 £750.00 Basic 8.75% £65.63 £315.63 £684.38 31.56%
£1,000 25% £250 £750.00 Higher 33.75% £253.13 £503.13 £496.88 50.31%
£1,000 25% £250 £750.00 Additional 39.35% £295.13 £545.13 £454.88 54.51%

 


Self Assessment

Self Assessment is the UK system of declaring tax information to HMRC.  In Pat’s case this would be salary, dividend and rent.

It applies to:

  • Sole Traders and partners
  • Company Directors who owe tax (including PSC users)
  • Landlords
  • Anyone else who owes Income Tax

You will need to send HMRC a Self Assessment return each year – in other words a tax return.  Self Assessment is just the name given to the process.

The deadline is:

  • 31 January after tax year for a online return (eg 31 January 2025 for the 2023-24 tax year)
  • 31 October after tax year for a paper return (eg 31 October 2024 for the 2023-24 tax year)

Your Self Assessment needs to include details of:

  • Salary
  • Dividends (special tax rates as they are from taxed profits)
  • Rents
  • Self Employments as a Sole Trader/ Partner
  • Interest
  • Pensions received
  • Pension Payments made
  • Capital Gains (From April 2020 Capital Gains on property sales, other than your own home if fully tax exempt, must be declared at the time of sale, not on the Self Assessment)

If you submit it online, or have an accountant assist you, the calculation of tax due (the “Self Assessment” aspect) will be done for you.

Tax assessed under Self Assessment for any given tax year is normally due on 31 January after the tax year

  • eg 31 January 2025 for 2023-24 tax year.

It can be paid via HMRC website or online banking, and HMRC will send you a statement by post (don’t forget to tell them if you move house).

 

Payments on Account

If your tax liability is more than £1,000 then you will normally have to make payments on account for the next year:

  • Payments on account are calculated automatically based on the preceding year at a rate of 50% of the liability for the year just passed
  • There is a 50% payment on account in January and another 50% in July – these are offset next January.
  • If the payments on account exceed the amount due you get a refund.

Payments on account are not due if more than 80% of your tax was paid at source.

 


Expenses for Tax

Expenses are important as they reduce your tax bill – its in your interest to maximise these within the law.

See our separate guide to expenses for PSC users

 


Contracts Inside IR35

Where a contract is inside IR35 then the split between salary and dividends is overridden by the IR35 rules – see our IR35 guide.

If the client is a Public Sector body, or a Large/Medium Private Sector organisation the client operated IR35 rules (sometimes called reverse IR35) apply

If the client is a Small Private Sector organisation then the original IR35 rules apply – operated by the PSC

Broadly speaking a Private Sector Client will be small if they have a turnover under £10.2m – although the full test is based on Companies Act thresholds.

There is a case study at the end of this document, showing how IR35 may impact taxes.

 

Income Shifting

Income shifting is the concept of using anothers tax allowances – commonly a spouse, but could be another family member, common law partner, civil partner, etc – to reduce your tax bill.

The so called “husband and wife company”, where one partner to the marriage produces all, or most of the income, but salaries and dividends are distributed 50:50 has historically been both common and treated benignly by the tax system.

In 2004 HMRC started to challenge such arrangements using what was called Section 660a (of ICTA1988), the so called “Settlements Legislation” – the details of this legislation are beyond the scope of this guide, but suffice to say it had been on the statute book since just after World War 1, and many people felt it was out of order for HMRC to suddenly start to change their interpretation of it.

A test case, Arctic systems, went through the courts and after early victories to HMRC, the final two appeals were won by the taxpayer.

As the law currently stands using spouse allowances is legal to reduce tax bills. This means if you have a non working spouse, or you are in the Higher Rate / Additional Rate Tax band  and your spouse isn’t, then it can be sensible to either or both:

  • Include your spouse as a shareholder in your PSC
  • Pay your spouse a salary for assistance

In the wake of the last court defeat the Government committed itself to legislation to prevent the above, so called “Income Shifting” legislation, more recently described by HMRC as “Family Business Income”.

This was to apply from 5 April 2008, but has been deferred indefinitely and hasn’t resurfaced at the time of writing (March 2024).

Generally, the protection from Arctic systems only applies to married couples or those in civil partnerships; the position for unmarried couples and other family relationships is less clear and income shifting strategies should be considered risky.   Generally they are ineffective if made in favour of minor children.

 


VAT (Value Added Tax)

VAT Basics

VAT is a turnover based tax – distinguished from being based on profits like Income Tax, Corporation Tax or NI.

The current VAT registration threshold is £90,000 (2024/25 tax rates) of rolling 12 month turnover:

  • If your business turnover is less than this then registration is optional, however if you are happy with the extra administration VAT brings and most of your customers are VAT registered businesses, then voluntary registration will save you some money in terms of recovering VAT input tax.
  • If your business turnover is over this, then registration is compulsory.
  • The threshold is based on rolling turnover, rather than tax year, calender year or financial year.   In your first 12 months this will be turnover to date.  After that you look back on a rolling 12 month basis at the end of each month to see if you are required to register.

If you run a business which mainly deals with consumers or non vat registered business, then it tends to be worth deferring VAT registration especially if you can’t pass the VAT on (which many consumer facing businesses can’t easily due to customer price resistance).  If you do need to register and can’t pass VAT on then beware of the “cliff edge” effect of VAT, in other words if your turnover is £89,999 no vat is due, if its £90,001 then you have to account for VAT on everything – you would need to get your turnover to £108,000 to break even with a VAT registration.

You can De-Register if turnover drops – read about VAT De-Registration

The current vat rate is 20%.

 

VAT Definitions

  • Input Tax – vat you incur on expenses – not all expenses have vat on them, and VAT applies only when you buy from a vat registered business.
  • Output Tax – vat you charge to your customers – this may be explicit eg £100+vat = £120 (Net £100, Vat £20, Gross £120) or implicit, eg Retail Price £120 = £100 net and £20 Vat.  Note its the net that becomes your turnover for self assessment / business accounts, in both cases £100.
  • VAT return – a quarterly return made to HMRC, with a payment.  At its simplest its Output Tax on sales less Input Tax on expenses and you pay the difference over to HMRC or claim an excess of Input Tax back (if you regularly have an excess of Input Tax you may be running at a loss).
  • Annual Accounting – an optional scheme to do one vat return a year instead of quarterly.
  • Standard Rated Items – these are sales or purchases with 20% vat on them.
  • Zero Rated Items – these are transactions within the scope of VAT but where the vat rate is 0%.
  • Reduced Rate Items – normally 5% on domestic electric and gas.
  • Exempt Items – outside the scope of vat.  How does that differ from Zero rate?  Well if your sales are zero rated, you still have to register and report for vat, but there is nothing to pay, and you can claim Input Tax back.  If your sales are exempt, you don’t have to register for vat and you cannot claim input tax back.
  • Invoice Basis – VAT is accounted for based on date of transaction rather than the date paid or received – eg an invoice dated 1 March paid on 1 May counts for vat as 1 March.
  • Cash Basis – VAT is accounted for based on when a payment is made or received –  eg an invoice dated 1 March paid on 1 May counts for vat as 1 May.  Cash basis tends to be simplest and easiest for most small business.

 

Quarterly Cycle – Normal VAT

The general cycle is that each quarter you:

  • Add up sales and Output Tax charged on them
  • Add up expenses and calculate Input Tax
  • Calculate the difference
  • Submit your vat return Digitally – see Making Tax Digital
  • Pay the difference if Output Tax exceeds Input Tax, or claim the difference back if vice verse

Example:

  • Supposing your weekly invoice is £1,000 to your agency. You are registered for VAT so you invoice them £1,000 net + £200 VAT = £1,200.
  • If your invoice is the same each week of the quarter then you will have collected VAT of £2,600 (i.e. £200 x 13) and this is due to be paid to HMRC no later than 30 days after the quarter end, via an online VAT return.
  • When paying HMRC you can deduct VAT incurred on expenses. EG if your expenses were £2,400 including VAT (equates to £2,000 plus £400 VAT) then you deduct the £400 and pay HMRC £2,200 (£2,600 less £400).
  • In terms of Corporation Tax, the company’s taxable income for the quarter is £13,000 and its expenses £2,000 – i.e. excluding the VAT element.

 

Flat Rate Scheme (“FRS”) – General

The FRS is a vat simplification.  Historically it was attractive as it offered savings to small businesses with a low cost base, but the “limited cost trader” rules have restricted its benefit now.

Under the FRS you charge VAT as normal to customers at 20%, but you pay over Output Tax at a lower rate, the “Flat Rate” and forgo claiming Input Tax (the lower Output Tax rate is meant to allow for Input Tax).

A point of confusion – Flat Rate is always expressed on gross income, whereas Standard Rate VAT is expressed on net, eg on £1,000 of VAT inclusive income:

  • under Normal VAT this is deemed to be £833 net income plus VAT at 20% of £167 = £1,000 gross income- the 20% applies to £833
  • Under Flat Rate the percentage applies to gross, so if 12% applies, then your VAT is £120 – i.e. 12% applies to £1,000

Entry eligibility for FRS is expected VAT exclusive turnover of under £150k, and businesses have to leave if VAT inclusive turnover exceeds £230k.

Typical Flat Rate Percentages:

  • Any other activity not listed elsewhere – 12.00%
  • Business services not listed elsewhere – 12.00%
  • Computer repair services – 10.50%
  • Financial services – 13.50%
  • Management consultancy – 14.00%
  • Computer and IT consultancy or data processing – 14.50%

However many businesses will be classed as Limited Cost Traders (see below) – this is almost always going to be the case for contractor companies (PSC’s).

Example:

  • Supposing your weekly invoice is £1,000 to your agency. You are registered for VAT so you invoice them £1,000 net + £200 VAT = £1,200.
  • If your invoice is the same each week of the quarter then you will have collected a total of £15,600 (13 x £1,200). Assuming a FRS rate of say 12%, you pay HMRC 12% of £15,600, so £1,872
  • There is no scope to deduct VAT on any expenses if using FRS
  • In terms of Corporation Tax, the company’s taxable income for the quarter is £13,728

 

Flat Rate Scheme (“FRS”) – Limited Cost Traders

From April 2017 the Limited Cost Trader rules restrict access to the FRS for some businesses with, as the name suggests, limited costs.  Limited cost means expenditure on business goods of less than 2% of turnover or £1,000/pa, which ever is higher.  To restate this in a more readable way, your expenditure on goods must be at least 2% of turnover subject to a minimum of £1,000pa/£250pq.  However the eligible expenditure here is limited:

Expenses that are excluded:

  • Vehicle costs including fuel, unless you’re operating in the transport sector
  • Food or drink for you or your staff
  • Capital expenditure
  • Goods for resale, leasing, letting or hiring out if your main business activity does not ordinarily consist of selling, leasing, letting or hiring
  • Goods that you intend to re-sell or hire out, unless selling or hiring is your main business activity
  • Goods for disposal such as promotional items, gifts or donations
  • Any services

Expenses that may be included – this is not an exhaustive list:

  • Stationery and other office supplies
  • Gas and electricity for a trading premises (ie not the costs associated with working from home)
  • Stock for a shop
  • Cleaning products
  • Software provided on a disk
  • Food to be used in meals for customers, eg a cafe
  • Goods provided by a subcontractor and itemised separately

 


Tax and VAT Case Studies

These cases show some of the detail set out above in computational form – they are simplifying some fairly complex interactions, so beware there are many variables to consider.

  • Case study 1 shows a mid range dividend value
  • Case study 2 shows a lower dividend value and higher retained profit locked up in the company
  • Case study 3 shows a maximum dividend and no retained profit

Case Study – Taxes – opens in a new tab

This case study shows how IR35 impact things from a similar baseline to case studies 1,2 and 3 above.

Case Study – IR35 – opens in a new tab

As always these case studies show a snapshot and there will be other variables to consider.