A mass migration of contractors from Managed Service Companies (MSCs) to umbrella companies is hitting the profits of the provider firms dramatically.

One provider said he would have to double his current number of contractors if he was to maintain the same net profit.

The vast majority of companies that were until recently providing MSCs have switched to umbrella-only.

The move comes after Chancellor Gordon Brown removed certain tax advantages from contractors working through MSCs. Giant, a major provider, said it had taken legal advice and that the umbrella model was the only option (Recruiter, 18 April).

The service offered by providers is now less valuable to contractors, and so generates less revenue.

Tony Harris, managing director of MyKeyPay, told Recruiter he was switching his 2,500 contractors from MSCs to umbrella schemes. However, he said that due to the decline in fees he was receiving, he would have to double the number of contractors working with Key to maintain the same profit.

Most providers now accept that transferring to a Personal Service Company (PSC), which some contractors had planned to do, is not going to get round the problem. They can't use the device, previously used by composite companies, of paying most income as dividends.

Contractors working through umbrella companies have to pay income tax through the normal Pay as You Earn (PAYE) and National Insurance Contributions (NICs).

The switch has resulted in some job losses for providers. Charterhouse, based in the Isle of Man, has made 80 people redundant.

Harris at MyKeyPay told Recruiter he had recently made a sales director redundant, but this was not really caused by the legislation and he did not anticipate further redundancies among his 70 staff.

Charterhouse said: "The delay in the publication of the Finance Bill, that laid out the precise definition of a MSC and the implications of the legislation, did mean that a number of companies, including [Charterhouse], pulled out of offering services to individuals with (PSCs) at a very late stage."

Mark Bale, group taxation manager at Charterhouse, told the 2007 Recruiter Forum that the new legislation, especially as it pertained to recruitment agencies being held liable for the unpaid tax debts of contractors, was "pernicious" and unlike anything "he had ever seen before".

Gabem says it will switch to umbrella-only in August. Matthew Brown, managing director at Giant, said fees per contractor had fallen as a result of the switch to umbrellas. Brown said he was confident of compensating for this by increasing volumes of business but admitted that this had not happened yet.

Some providers disagree with Giant's stance. Brookson has relabelled itself as an accounting services company and will continue to work with PSCs. The company employs about 170 people, of whom only a handful are accountants. Managing director Martin Hesketh said he had no plans for redundancies, and was looking to recruit more accountants. JSA says it will adopt a similar position to Brookson.