Gordon Brown announced controversial plans in his tenth pre-Budget Report (6 December 2006) to shake up the taxation of the contracting industry, which is being hailed as the most radical reform since the introduction of IR35.

Changes are to be made to the taxation of individuals who provide their services through a managed service company with effect from 6 April 2007.

It is widely thought that the new rules are designed to catch the ever growing cadre of freelance IT contractors who use managed service companies and who the Chancellor considers, are gaining an “unfair competitive [tax] advantage”.

The Government is keen to ensure that even if an individual is working through a company, income tax and National Insurance contributions are paid at employed levels. In the “vast majority of cases, managed service companies break IR35, designed to ensure the right tax treatment is applied, meaning workers get away with reducing their tax and national insurance payments”, the Government said in its paper “Tackling Managed Service Companies”. HM Revenue & Customs compliance officers also report that managed service companies have been paying travel and food expenses free of income tax and National Insurance contributions - even when no relief is due.

Managed service companies are invariably not in business on their own account (this contrasts with personal service companies) and the Government’s view is that the underlying nature of the contracts in which these companies are involved is one of employment.


The proposed new legislation will oblige the managed service company to operate PAYE on the income received by workers in relation to their services provided through the managed service company. As a result, workers who use managed service companies will, in the future, be exempt from the Intermediaries Legislation (IR35), but face more stringent rules that will be “less resource-intensive” for HM Revenue & Customs.

National Insurance obligations will arise by virtue of regulations to be laid immediately after the Finance Act 2007 receives Royal Assent.

Tax relief will be given for travel expenses to put managed service company workers in the same position as other employed workers by treating each of their engagements with an end client as if it were a separate employment with the end client, carried out in a permanent workplace.

A consultation document published alongside the pre-Budget Report says defining a managed service company under the incoming law is not “straightforward.” However, a company may be a managed service company when the worker does not exercise financial or management control over the managed service company, and where the company is mainly in the business of supplying workers to an end client.

The legislation will target any workers using managed service companies who are paid for their services directly or indirectly.

Third Parties and Agencies
“Third parties” to the managed service company, which may even include the employment agency, on the basis that it directly or indirectly “materially benefited” from the provision of services from the managed service company, will be liable for tax where the managed service company does not pay.

“The normal penalties for non-payment of tax and National Insurance contributions under PAYE will apply,” the Government said in its paper, “Tackling Managed Service Companies”.


Some commentators have said that the new rules will mean that individuals using a managed service company are likely to see a substantial decrease in their income as home to work travel and subsistence payments and/or dividends will no longer feature as part of their pay. It is likely that many will now consider setting up their own Personal Service Company.

It is clear from the Government’s paper that there will be difficulty in recognising a managed service company – indeed a large part of the paper is dedicated to determining what exactly a managed service company is. Even if this can be agreed, for the legislation to work it still has to be proved that workers are "disguised employees," which is exactly where IR35 fell apart.