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Gross profit based payment pre-distribution

Can a UK company make payments to an individual contractor based on its gross profit?

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A company has an agreement in place to pay out every 6 months 70% of its gross profit pre tax to an individual contractor, who effectively runs the majority of its business. The individual is not a shareholder of the company. The remaining 30% of gorss profit is subject to corporation tax and paid out to the shareholder as dividends. Will HMRC have concerns about this arrangement? Does it make a difference if this individual is based in the UK or outside?

Thank you

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By paul.benny
30th Jul 2020 07:50

It might have been better to take advice from an accountant before setting up this arrangement.

There's simply not enough information here to give a definitive answer. For instance in many businesses paying out 70% of gross profit won't leave enough to cover overheads, let alone a dividend to the shareholders. The payment to the contractor may be in scope for PAYE/NI. And so on.

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Replying to paul.benny:
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By Nick10
30th Jul 2020 08:39

Thanks. The contractor is not in the UK, his hours vary and he is contributing to the business to approximately 70%, which is reflected in his compensation. What information would be relevant? Can he be subject to PAYE if he is an overseas contractor?

I did ask an accountant at the time and he said that it was fine, but I wanted to get a second opinion.

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Replying to Nick10:
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By paul.benny
30th Jul 2020 10:56

If the contractor is neither UK resident nor working in the UK, then PAYE won't be relevant.

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By Matrix
30th Jul 2020 07:55

If a contractor is running the business are you sure they are not an employee?

If they are running the business from outside the UK then you will end up with offshore tax issues for the UK company.

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Replying to Matrix:
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By Nick10
30th Jul 2020 08:47

Thanks. Apologies, I should clarify. He is not running the business in the sense of making strategic decisions, signing documents etc, but is doing approximately 70% of the actual work of the business for customers. The shareholder, based in the UK, who is also a director, is making the strategic decisions, signing documents and making all the filings. What is your view based on this? How would offshore tax issues be relevant - the contractor pays his own tax and the company pays it own tax?

The reason I raised this question in the format is because of the format of the compensation to the contractor which is based on gross profit rather than on a fixed fee or hours worked.

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Replying to Nick10:
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By Matrix
30th Jul 2020 08:54

I suggest that you get local advice on whether the payments should be subject to local payroll taxes and whether the sales role gives rise to local business taxes.

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Replying to Matrix:
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By Nick10
30th Jul 2020 09:41

Thanks Matrix. The contractor is paying all the taxes locally (Poland) as self employed so that's not an issue. My concern was from the point of view of the UK company. Do you think I should be concerned?

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By Paul Crowley
30th Jul 2020 08:52

How did contractor establish the relationship with shareholders?
It would look to be as if the contractor runs and owns the business having found a couple of residents prepared to act as stooges.

Who are you in this set up?

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Replying to Paul Crowley:
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By Nick10
30th Jul 2020 09:47

Thanks. The shareholder went to university with the contractor's wife so that's how they know each other. The contractor is an IT developer and CTO for the company. This is not a role that the shareholder/director can fulfill because she does not have the technical skills. However, the shareholder/director does sales, administration, accounting and legal for the company. The shareholder/director is my wife, so that's why I am making this enquiry.

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Replying to Nick10:
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By Tax Dragon
30th Jul 2020 09:54

My comment below was made before I saw this one.

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Replying to Paul Crowley:
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By Nick10
30th Jul 2020 12:36

Paul, any further comment from you will be much appreciated.

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Replying to Nick10:
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By Paul Crowley
30th Jul 2020 14:19

My concern was who really controlled the company, who operates the bank account, and risk to UK shareholder director for any wrongdoing.
If there is a problem with product sold by UK company will subcontractor be prepared to work for free to fix it. It appears that company cannot operate without subcontractor so all real power is with subcontractor, who is in a different legal jurisdiction.

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Replying to Paul Crowley:
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By Nick10
30th Jul 2020 16:04

Thanks Paul. The shareholder/director operates the bank account, issues all the invoices, signs all the agreements and the accounts. She therefore carries all the risk. The contractor will not require additional remuneration for rectifying any issues because he is compensated on a gross profit basis anyway, so if he does not fix something he is hurting his own remuneration. Can the contractor be replaced? Yes, he can be replaced by the shareholder/director by another CTO. He is great at what he does, but if he left, there are other CTOs out there who could take up his role.

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By Tax Dragon
30th Jul 2020 09:53

Don't JVs/partnerships work something along these lines?

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By johngroganjga
30th Jul 2020 10:17

What you should be asking about this arrangement is whether it is fair and reasonable to both parties, not whether HMRC will “have concerns” about it.

HMRC’s job is to collect tax. It is none of their business what commercial transactions taxpayers enter into. This is a free country.

If your wife and the other party have agreed that for the other party to have 70% of the gross profit and for your wife to have the remaining 30% less all the expenses is a fair division, so be it.

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Replying to johngroganjga:
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By Tax Dragon
30th Jul 2020 10:53

That's all true (and I was going to say something similar myself), but

johngroganjga wrote:

It is none of their business what commercial transactions taxpayers enter into.

of course they are interested in the business and commercial transactions to the extent that these effect the tax and related responsibilities of the parties.

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Replying to Tax Dragon:
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By Nick10
30th Jul 2020 11:53

Thank you. Very helpful. The reason that this got me thinking is that if the contractor was in the UK this would not be an issue for HMRC because all the tax would have been collected by them from the contractor as a self employed person through self assessment. However, because he is based in Poland HMRC effectively loses that money. The only way it could conceivably get its hand on the money is if the contractor became a shareholder and received the pay as dividends, in which case HMRC would get 20% on the 70% on gross profit as corporation tax. Can HMRC, in order to collect more revenue, deem someone, who is not, to be a shareholder for this purpose?

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Replying to Nick10:
By johngroganjga
30th Jul 2020 12:28

Nick10 wrote:

Can HMRC, in order to collect more revenue, deem someone, who is not, to be a shareholder for this purpose?

No of course they can’t.

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Replying to Nick10:
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By Tax Dragon
30th Jul 2020 12:37

Nick10 wrote:

The only way it could conceivably get its hand on the money is if the contractor became a shareholder and received the pay as dividends, in which case HMRC would get 20% on the 70% on gross profit as corporation tax.

I would disavow you of that notion. As a general principle, I mean - I have no idea of your specifics.

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Replying to Tax Dragon:
By johngroganjga
30th Jul 2020 12:32

Tax Dragon wrote:

That's all true (and I was going to say something similar myself), but

johngroganjga wrote:

It is none of their business what commercial transactions taxpayers enter into.

of course they are interested in the business and commercial transactions to the extent that these effect the tax and related responsibilities of the parties.

Yes of course they are interested in the transactions undertaken to ensure that they are correctly accounted for and taxed, but they can’t, as the OP seems to think, say to taxpayers “you have entered into the wrong kind of transactions entirely, and we are going to tax you as if you had entered into the right ones instead”.

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Replying to johngroganjga:
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By Tax Dragon
31st Jul 2020 07:31

I think you, me, paul.benny and probably others have misread the OP. Which probably doesn't help when trying to answer it. And is one of the huge risks you take in using any forum for getting advice, let alone one the is not intended for that purpose.

johngroganjga wrote:

If your wife and the other party have agreed that for the other party to have 70% of the gross profit and for your wife to have the remaining 30% less all the expenses is a fair division, so be it.

I now don't think it meant that. I think "gross profit" simply means "profit before tax". After expenses.

By some fluke, my first reply may well have been correct. It sounds incredibly like a 70/30 partnership. Between the overseas IT dude and the UK company. A partnership that may have reporting obligations as such in the UK. Or in Poland. Or both.

And a partnership that, having a corporate member, may have specific tax rules to be aware of.

If I'm right though, the 70% could not be liable to UK tax in the way that the querist worries about. So that's good.

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Replying to Tax Dragon:
By johngroganjga
31st Jul 2020 08:02

You may be right, but only if the OP doesn’t understand the term “gross profit” in the way that accountants do.

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Replying to Tax Dragon:
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By Nick10
01st Aug 2020 08:00

Thank you. You are right in that what I meant by gross profit is profit after expenses before tax. So the difference between gross profit and next profit is just tax. Are there any tax implications for the UK company if we accept that this is a partnership? Can funds in a partnership flow in the way described i.e. not through a commonly owned vehicle?

The company is about to become VAT registered, but was not until now. Is there any VAT that should be applied to payments to the contractor from the company under UK legislation?

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Replying to Nick10:
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By Tax Dragon
01st Aug 2020 09:18

See below.

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By paul.benny
30th Jul 2020 11:07

Let's describe the business differently:

We have a UK company (with a sole director/shareholder) that subcontracts all of its work to a party in Poland. The subcontractor is wholly or partly remunerated by a profit share.

If that's an accurate portrayal of the business, there are no obvious red flags as regards UK tax - although you might want to look at the VAT obligations of both parties.

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By Matrix
30th Jul 2020 13:36

Who bears the risk of getting it wrong? The company or the contractor?

I would check the contract and also get tax opinions from UK and Polish tax advisers based on the full facts. If the contractor only has one client then the Polish tax authorities could argue they are an employee and not self-employed.

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Replying to Matrix:
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By Nick10
30th Jul 2020 13:52

Thanks Matrix. Not worried about Polish tax authorities so much as they are a matter for the contractor. We can try to get a UK tax opinion, but I suspect that it will be expensive and it seems that there is no single view on this issue. Do you think there is a risk of the contractor being deemed a shareholder?

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Replying to Nick10:
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By Matrix
30th Jul 2020 13:56

I think there is a risk of the company having to pay Polish social security costs (+VAT and corporate tax?) which you are ignoring.

On the UK side, who completes the UK company’s accounts and tax returns?

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Replying to Matrix:
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By Nick10
30th Jul 2020 14:31

Thanks Matrix. The contractor is also working in another job, both jobs are remote and do not have fixed hours. On this basis, I doubt he could be classified as an employee, but let me know if you think otherwise?

I am less concerned about Polish tax authorities, but more about the UK where the company is based. UK accounts are completed by a UK accountant based on information (essentially a spreadsheet) provided by the director. He also files the tax returns. He thinks that the current arrangement is fine, but as explained I am just looking for a second opinion. Can the payments to the contractor be somehow reclassified as dividends?

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Replying to Nick10:
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By WhichTyler
30th Jul 2020 16:03

Nick10 wrote:

On this basis, I doubt he could be classified as an employee, but let me know if you think otherwise?

You also said that the contractor is the CTO which points towards employment. Have you run the HMRC status tool over this contract?

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Replying to WhichTyler:
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By Nick10
30th Jul 2020 16:47

The conclusion of the online tool is that his status could not be determined. Let's say he was considered an employee but one permanently based in Poland, what would be the UK tax implications for the company?

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Replying to Nick10:
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By WhichTyler
30th Jul 2020 21:37

They would need to read the DTT and see if they are creating a permanent establishment in Poland and see what the consequences of that are...

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Replying to Nick10:
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By Tax Dragon
30th Jul 2020 14:46

Nick10 wrote:

We can try to get a UK tax opinion, but I suspect that it will be expensive and it seems that there is no single view on this issue. Do you think there is a risk of the contractor being deemed a shareholder?

No single view in here, but we don't have much to go on (and we'd be wrong to try to form a 'view' anyway, without looking at documents, understanding mechanisms and money-flows etc).

Maybe I said it wrong before, but HMRC does not need to deem the non-resident to be a shareholder for additional tax to arise in the UK. But to use your logic, what happens if the Polish tax authority did something like that (and HMRC did not)? Some of the more experienced members in here told me that companies in the UK used to have to pay tax when they paid dividends. What rules are there in Poland? I agree with Matrix, don't take them for granted.

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Replying to Nick10:
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By WhichTyler
30th Jul 2020 21:41

Nick10 wrote:

We can try to get a UK tax opinion, but I suspect that it will be expensive and it seems that there is no single view on this issue. Do you think there is a risk of the contractor being deemed a shareholder?

Given that the status tool says the employment status cannot be dtermined by it (below), then there seems to be a reasonable risk that the contractor could be deemed an employee...

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By frankfx
30th Jul 2020 21:19

Have a word with contractor, express your concerns.

Then seek advice from a specialist tax adviser.
Your own accountant could farm it out .
And list the areas of doubt that you have .
Alternatively ask your own accountant to place his first and second opinion in writing.
Costs vary.
Contractor my be prepared to accept the cost of advice as a direct cost and not an overhead. Hurrah?
What price for a peaceful night's sleep.

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Red Leader
By Red Leader
31st Jul 2020 12:54

Do we have a view on the VAT position of the supply by the Polish contractor to the UK business? Presumably this is a reverse charge supply and therefore UK VATable?

Is the UK ltd co VAT registered?

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Replying to Red Leader:
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By Nick10
01st Aug 2020 08:04

Thank you. The company is about to become VAT registered, but was not until now. Is there any VAT that should be applied to payments to the contractor from the company under UK legislation? If we consider this to be a partnership, would this reverse charge apply? Seems less than intuitive why a Polish contractor who is self employed and not VAT registered himself would issue invoices with VAT to the UK company. Would this VAT be for HMRC or Polish tax authorities?

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By Tax Dragon
01st Aug 2020 09:19

Nick10 wrote:

Thank you. You are right in that what I meant by gross profit is profit after expenses before tax. So the difference between gross profit and next profit is just tax. Are there any tax implications for the UK company if we accept that this is a partnership? Can funds in a partnership flow in the way described i.e. not through a commonly owned vehicle?

The company is about to become VAT registered, but was not until now. Is there any VAT that should be applied to payments to the contractor from the company under UK legislation?

IMHO the format of this forum is very user-unfriendly, so I'm forcing it to put my response at the bottom.

Put simply, that response is that it is now time for you/your wife/the company/the partnership to take advice. There is a high risk of mistakes if you don't. And mistakes can cost a lot more than advice does.

For instance, if I'm right that there's a partnership (to me that doesn't sound unlikely, but it's not certain), then it's the partnership that needs to register for VAT. In many ways, that's a lot simpler (eg it avoids Red Leader's point - as well as the issue in your OP).

There may be some back penalties for getting it wrong so far, but they're likely a lot less than the costs of keeping on on the wrong track. If you are on the wrong track.

My advice: take (paid for) advice.

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Replying to Tax Dragon:
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By Nick10
02nd Aug 2020 09:20

Thank you. How do you suggest I go about getting paid for advice? How do I find the right person with the relevant expertise?

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