That is a common misconception due to tax law changes in recent years. It used to be the case that a UK contractor paying themselves through this structure was significantly better off due to the large amount of dividend tax credits that were available.
So let me outline how this works these days as I run up against this argument a lot.
1) Any income that comes into the UK Ltd company is taxed at the corporate tax rate which as of this year is 19%.
1.1) This tax is paid on profit so if you pay yourself a normal salary out of this you will deduct this from the profits. Take note that dividends are NOT deductible from company profits before tax and as such is not a way for you to reduce your tax liability as a UK company. Dividends are only payable from after taxed money in your UK Ltd company.
1.2) Any expenses your company has in providing its services are deducted from profits. There is a misconception that you can write off A LOT of expenses but in actual fact that is not true. There are strict guide lines. Most of these expenses are also only valid if you are truly outside of IR35. Once you fall inside of it your allowed expenses decrease even more.
The above leaves you with your taxable company profit on which you pay your 19% corporation tax. (This is the tax that are being circumvented in the article by big companies.)
So now you as a UK Freelancer you now get the opportunity to pay yourself money from your UK Ltd company. You are then subjected to the following personal income tax:
1) Your tax free allowance as an individual is applied so you pay no tax on the first £11500 of income.
2) The first £5000 of dividends are also tax free. (remember this money has already been taxed at 19% in your corporation tax so is hardly free)
3) All other dividends that you then pay out to yourself are taxed as per the different tax brackets set out for personal income tax on dividends. (Again remember that 19% tax has already been paid on the this money before you can distribute it to yourself.)
So lets look at an example:
- Lets say that as a contractor you work for 10 months (42 weeks) out of the year at £500 per day. We also assume you have no problem in getting your clients to pay (a real risk in certain industries). That leaves you with 210 days that you bill at £500 per day. 210 * 500 = £105000 which is your income coming into the company before deducting allowed expenses.
- Lets now say you are not inside IR35 and you can claim travel and subsistence against this amount. That normally works out at around £500 per month of expenses you can deduct. (We assume you have already bought your equipment that you use on site etc.)
- You also need to pay your accountant, which does not work for free, the going rate in London is around £130 per month
- You now pay yourself a small salary up to the allowed personal allowance for the year of £11500
Your total corporate taxable income is now as follows:
105,000
-1,560 (Accountancy fees £130 x 12 months)
-5,000 (£500 expenses for the 10 months of billable work)
-11,500 (salary of around £958 per month for the 12 months of the financial year) =86,940 (This is the amount you pay corporation tax on) -16,518.60 (The amount of corporation tax you pay at 19% on the above £86940)
=70,421.40 (This is the amount you can now distribute to yourself in dividends)
So now your personal income tax looks as follows:
11,500 (Salary received up to tax free allowance and tax of 0%)
5,000 (Dividends with 0% tax allowance)
65,421.40 (Remaining dividends that you are taxed)
-14,136 (Tax levied on the 65,421.40 dividends that are taxable, combination of the different tax bracket rates on HMRC website.) =67,785.40 (Income you receive after tax)
So on £105,000.00 of earned income as a freelancer you end up paying £30,654.60 of income taxation (Corporation and Personal tax).
If you were a normal salaried employee you would pay £31,696.40 on £105,000 salary. (www.listentotaxman.com)
So I would argue it is hardly tax avoidance and if I take into account the risk I take as a freelancer then I am hardly working through a UK Ltd company to avoid tax. Most people still believe that the same rules of the 90's apply to UK ltd companies and freelancing but it is simply not the case.
Please do check the above with your accountant to confirm as this is not financial advise and I am not an accountant. However there are really not many options for avoiding paying tax as a UK freelancer. Keep in mind that the £5k dividend tax free allowance is also being reduced to only £2k from 2018 onward.
- A £500 daily rate is very attainable when you work as a contractor in London. a £105k salary for the same type of work - not so much... I would argue that most people don't really have a choice and they HAVE to become contractors to get that kind of money.
- Nobody is forcing you to take ALL the money on your company account and pay it to yourself as a dividend. You can leave most of it there, or even invest it on the company's behalf. You have the power to decide when you want to pay the taxes on this money, and this can be very valuable. And there are other (perfectly legal) practices that can keep you in the lower tax bracket. If your accountant did not explain these to you then it's probably time to look for a better one :)
The example was simplistic by taking all of the dividends out to make it a straightforward comparison with a salaried employee who also has to take all of their and thus do not get to defer their tax.
Being able to choose when you pay tax is one of the biggest advantages of working through a UK Ltd company. But by choosing when you pay you hardly avoid paying tax. The bill will be due sooner or later.
As for legal ways to reduce the corporation tax you pay, I would love to hear more as the options I know of would be to setup pension contributions or doing a voluntary liquidation. (which is only an option for the day you decide to stop contracting as you are not allowed to be a director of a UK limited company for 2 years after completing the liquidation)
Every contractor accountant I have spoken with has given the same advice. So if what you are doing is legal I would be interested to hear who your accountant is.
Always remember that your accountant won't be the one that HMRC comes after if you followed dodgy advice.
Thanks for your very thorough reply! I will definitely run the numbers when I get back home.
One thing I noticed from a first reading: You didn't include the expenses payments as income (intentionally or not), which is an extra £5000 a year that goes in to your personal bank account.
You are most welcome. You are correct, I did not include them in the personal income you receive as I have created the example in the way you would do your tax return calculation. So the expenses are deducted from your company profit before tax as it is your company that is incurring the expenses.
You do get reimbursed for those expenses if you make them via your own credit or debit card, otherwise if you use a company card for them you will never have that money touch your own bank account. I do agree that you benefit from being able to use "before tax" money to pay for some of your expenses.
The tricky thing about expenses is that not everything is allowed to be deducted as an expense. If for example you take your client out for a meal and a few drinks and you account for that as Business Entertaining, that amount is not eligible for tax relief and thus you cannot deduct that from your profits to reduce your company's taxable income. It will then get taxed at the company level.
What I am trying to show is that the argument that Freelancers in the UK "avoid" paying tax compared to permanent employees is not true anymore. Yes we do have the ability to plan our tax better. However there seems to be this idea from permanent employees that freelancers are paying only 10% income tax when that really is not the case. There is a slight benefit, and from the above example a little more than £1000. Obviously there are other options and scenarios with spouses being made directors of the company etc. But it is hardly reducing your tax to the 7% achieved by Apple.
One also takes a lot bigger risk since personal injury, illness and non-paying clients do have the ability to derail your earnings in a really big way. If you get the flu and are out for a week that hurts. Or heaven forbid you have an accident and are unable to work for a few months while recovering.
Most of the freelancers I know do it because of the freedom and flexibility they get out of it, not because there are substantial tax advantages.
I would be very interested to hear your thoughts after you have run the numbers yourself.
So let me outline how this works these days as I run up against this argument a lot.
1) Any income that comes into the UK Ltd company is taxed at the corporate tax rate which as of this year is 19%. 1.1) This tax is paid on profit so if you pay yourself a normal salary out of this you will deduct this from the profits. Take note that dividends are NOT deductible from company profits before tax and as such is not a way for you to reduce your tax liability as a UK company. Dividends are only payable from after taxed money in your UK Ltd company. 1.2) Any expenses your company has in providing its services are deducted from profits. There is a misconception that you can write off A LOT of expenses but in actual fact that is not true. There are strict guide lines. Most of these expenses are also only valid if you are truly outside of IR35. Once you fall inside of it your allowed expenses decrease even more.
The above leaves you with your taxable company profit on which you pay your 19% corporation tax. (This is the tax that are being circumvented in the article by big companies.)
So now you as a UK Freelancer you now get the opportunity to pay yourself money from your UK Ltd company. You are then subjected to the following personal income tax: 1) Your tax free allowance as an individual is applied so you pay no tax on the first £11500 of income. 2) The first £5000 of dividends are also tax free. (remember this money has already been taxed at 19% in your corporation tax so is hardly free) 3) All other dividends that you then pay out to yourself are taxed as per the different tax brackets set out for personal income tax on dividends. (Again remember that 19% tax has already been paid on the this money before you can distribute it to yourself.)
So lets look at an example: - Lets say that as a contractor you work for 10 months (42 weeks) out of the year at £500 per day. We also assume you have no problem in getting your clients to pay (a real risk in certain industries). That leaves you with 210 days that you bill at £500 per day. 210 * 500 = £105000 which is your income coming into the company before deducting allowed expenses. - Lets now say you are not inside IR35 and you can claim travel and subsistence against this amount. That normally works out at around £500 per month of expenses you can deduct. (We assume you have already bought your equipment that you use on site etc.) - You also need to pay your accountant, which does not work for free, the going rate in London is around £130 per month - You now pay yourself a small salary up to the allowed personal allowance for the year of £11500
Your total corporate taxable income is now as follows: 105,000 -1,560 (Accountancy fees £130 x 12 months) -5,000 (£500 expenses for the 10 months of billable work) -11,500 (salary of around £958 per month for the 12 months of the financial year) =86,940 (This is the amount you pay corporation tax on) -16,518.60 (The amount of corporation tax you pay at 19% on the above £86940) =70,421.40 (This is the amount you can now distribute to yourself in dividends)
So now your personal income tax looks as follows: 11,500 (Salary received up to tax free allowance and tax of 0%) 5,000 (Dividends with 0% tax allowance) 65,421.40 (Remaining dividends that you are taxed) -14,136 (Tax levied on the 65,421.40 dividends that are taxable, combination of the different tax bracket rates on HMRC website.) =67,785.40 (Income you receive after tax)
So on £105,000.00 of earned income as a freelancer you end up paying £30,654.60 of income taxation (Corporation and Personal tax).
If you were a normal salaried employee you would pay £31,696.40 on £105,000 salary. (www.listentotaxman.com)
So I would argue it is hardly tax avoidance and if I take into account the risk I take as a freelancer then I am hardly working through a UK Ltd company to avoid tax. Most people still believe that the same rules of the 90's apply to UK ltd companies and freelancing but it is simply not the case.
Please do check the above with your accountant to confirm as this is not financial advise and I am not an accountant. However there are really not many options for avoiding paying tax as a UK freelancer. Keep in mind that the £5k dividend tax free allowance is also being reduced to only £2k from 2018 onward.