What taxes should you pay as a contractor?

27th July 2016

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Ask any contractor what they find easiest about their job and few, if any, will say “it’s tax”. Accounting, record keeping, filing for and paying taxes can be both the most mind-boggling and boring aspect of the job. 

Getting the right advice is really important, because you want to be sure you are always staying on the right side of the law. Get it wrong, and you could end up paying a hefty price in fines, fees and interest. In some cases, you might even end up with a criminal conviction. 

Yes, accountancy and tax is serious and necessary, but it can also bring you great benefits. Organising your affairs in the most tax-efficient way can bring you significantly greater savings, and more money straight to your pocket. 

The first step to handling your financial obligations as a contractor is to understand which taxes you need to pay:

Income Tax/National Insurance

Contractors need to pay income tax on any money they earn. For those without an umbrella company in place, this will usually be through self-assessment. That means completing a tax return every year, documenting your earnings and allowable expenses. 

Your tax is calculated as a percentage of what’s left. This information must be submitted to HMRC (Her Majesty’s Revenue and Customs) in a timely, accurate way – unless you are paid via the PAYE (pay-as-you-earn) system, in which case your employer must submit the relevant information for you. 

Umbrella companies pay via PAYE, which means you are essentially treated like an employee. Unless you also take dividends from your company, you may not need to complete a self-assessment return.


Contractors who bill work in excess of a certain threshold are legally require to collect VAT (value-added tax) on behalf of the exchequer, adding a percentage on to the total cost of any work commissioned and remitting forward to HMRC on a monthly or quarterly basis. 

You are liable for adding VAT costs to your total invoice amount, and for making payments to HMRC accordingly.

VAT registered contractors and companies benefit from being able to reclaim VAT on purchases, which means spending on VAT applicable goods and services is cheaper for VAT registered contractors than non-registered contractors. 

Contractors can obtain further savings by registering for the VAT flat scheme, which allows small businesses to charge VAT based on a 20% rate, but to pay HMRC a reduced rate if they opt out of claiming VAT on purchases.

To be eligible for the VAT flat scheme, you must be VAT-registered and expect an annual turnover of £150,000 or less. 

The flat rate contractors pay depends on the type of business they run. The flat rate for management consultants is 14%. You can view a full list of VAT rates for different industries here

The pitfall of the VAT flat scheme is that you are no longer able to reclaim VAT on purchases except for certain capital assets over £2,000. However, for contractors who do not purchase equipment and services on a frequent basis, the flat scheme can still be the best option because of the substantial tax savings. 

One further benefit of registering for the VAT flat scheme is you are entitled to a further 1% discount in the first year of operation, reducing effective VAT rate you pay to 13%.

Corporation Tax

Corporation tax is the tax a company must pay on its profits. As a contractor who sets up a limited company, you will have to pay corporation tax. Corporate tax rate in the UK is currently at 20%.

The recent EU referendum result has sparked a discussion of a potential corporate tax cut. 

A Britain that left the EU would potentially be at the mercy of retaliatory tariffs imposed by the rump European bloc. Read more on the potential impact of Brexit on contractors here

Yet ironically Britain’s low corporation tax policy could become even more entrenched in the face of such tension. The appeal of a non-EU UK to global investors would likely be diminished, potentially forcing Westminster to compensate by slashing corporation tax even further.

If the potential tax reduction comes to reality, it could significantly benefit contractors who contract through limited company structure. 

Corporate tax is calculated based on your company profit. It is paid after expenditures are deducted from your revenue. For example, if your annual turnover (in other word, total revenue) is £100,000 and your expenditures amount to £30,000. The corporate tax is 20% x (£100,000 – £30,000) = £14,000.

Contractors can take either salary or dividends, or a combination of both out of the company as a source of income. While salary is treated as expenditures and therefore is tax deductive, dividends are not.

Dividends can only be taken out after corporate tax liabilities are met. 

Make sure you reserve the corporate tax amount in your business banking account at all times. The last thing you want is to take out excess amount of cash, and then are liable for a tax bill you can’t cover. 

Dividends and salary are also taxed at different levels, but with the latest tax legislation from HMRC came into effect in April 2016, the difference is narrowed. 

What is the most effective structure for a contractor? You can find out more in our Contracting – Financial Matters Guidebook.

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