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Accountancy

Guide to UK Taxation and National Insurance

Ways of Working

Once you start looking into becoming a contractor you’ll come across a number of different ways of working. The best option for you will depend on your circumstances and ambitions.

You might decide to operate as a sole trader and complete a self-assessment tax return as an individual. This is not usually an option if you’re finding your contracts through a recruitment agency, but if you’re happy to find your own contracts through other means, for example directly with the client, it could be a possibility.

Another option is to work through an umbrella company. In this case, the umbrella company would become your employer, so they would calculate your tax and NI on a PAYE basis. This option gives you flexibility and control over your career with the ease and security of full employment, and could be a good option for your first contract, particularly if you're not ready to commit to a long term career in contracting.

Running your own limited company is often the best option if you’re planning on contracting as a long term career and want to be more in control of your own destiny. It can also be the best option in terms of tax and wealth planning, though be aware that it might not be as attractive if your contract falls within IR35.

Corporation Tax

If you trade through your own limited company you will need to pay corporation tax, which is calculated on your profits. Taxable income for corporation tax purposes includes the profits you earn from running your business, income from investments and the sale of any assets where the selling price was more than the original cost.

Your expenses can include the sum that you pay yourself, so when you work out how much your business has earned, it’s important to remember to deduct your own salary.

Corporation tax is payable on profit at a rate of 20%.

For example, if you invoice clients for a total of £150,000 over the course of the year and have incurred expenses of £50,000 then your taxable profits will be £100,000 and corporation tax will be £20,000.
Corporation tax is payable nine months and one day after the end of the financial year.

Value Added Tax (VAT)

Many contractors are VAT registered, which means that they include VAT on their invoices to clients and then pass it on the government in the form of an quarterly VAT return. Because you would be collecting tax on behalf of the government there are financial incentives, such as the Flat Rate VAT Scheme. As the name suggests, this allows businesses to pass on VAT at a lower rate than the one they collect.

From the 6th of April 2017 the Flat Rate VAT Scheme changed. For anyone supplying services,irrespective of their industry sector, the flat rate % became 16.5%. This rate applies where a contractor is deemed to be a “Limited cost trader”, in other words has very few vatable expenses to claim. This means the scheme is much less beneficial to contractors than it was. 

Personal Tax

Contractors operating as limited companies may take an income in two ways: as a salaried director and through dividends as a shareholder of the business.

Income tax

Tax is calculated on your earnings over the course of the ‘fiscal tax year’ which runs from the 6th of April to the 5th of the following April.

You have a “personal allowance” of tax free pay, which is £12,570 for tax year 6th of April 2021 to 05th of April 2022. This means the first £12,570 that you earn does not attract any tax.

Any income beyond that initial £12,570 and up to £50,270 is taxed at a rate of 20 per cent.

Income between £50,271 and £150,000 is taxed at a rate of 40%.

Income above £150,001 is taxed at 45%.
If you earn more than £100,000 you should also be aware that your personal allowance will be reduced by £1 for every £2 more than £100,000 they earn. This means that anyone earning £122,000 will have no personal allowance.      

Dividends

The way that dividends are taxed changed recently, so you should check that anything you read about the subject reflects the most recent figures.

There is a £2,000 tax free dividend allowance and dividends in excess of that are taxed at varying rates.

The basic rate of 7.5% applies to dividends up to £37,700

The higher rate of 32.5% applies to dividends up to £150,000

The additional rate of 38.1 per cent is used for dividends above £150,000

National Insurance Contributions

Although National Insurance is treated similarly to tax when you are employed and is included in the same section on your payslip, there are some subtle but important differences.

  • Not everyone has to pay National Insurance, only those who are aged between 16 and the statutory retirement age (which will be 66 for both men and women from 2020).

  • National Insurance Contributions are linked to certain state benefits, so by paying National Insurance, you build up your entitlement to a state pension and job seekers allowance.

Contractors who trade through a limited company will be treated as an employee of the company as well as a director.

If you choose to take a salary as an employee, you will pay Class 1 (primary) National Insurance contributions at a rate of 12% on taxable income up to £50,000. The rate drops to 2% for income above £50,000.

As an employer, you will also need to pay Class 1 (secondary) employer’s National Insurance contributions at a rate of 13.8% on your employee’s taxable income.

Any dividends paid will not attract employer or employee National Insurance contributions, which is why many experts recommend limited companies as the most tax-efficient way of operating for contractors.

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