The confusing situation surrounding umbrella companies should become clearer with the government’s audit standard due this month, says Sarah Coles

Last April, Her Majesty's Revenue & Customs L(HMRC) put recruitment agencies in a tight spot over contractors. It announced legislation to outlaw the providers used by many contractors, made agencies potentially liable for bad debts of those who fall foul of the rules and then didn't make it clear what they could do to stay on the right side of the law.

The industry was left to produce a variety of different vetting solutions, and a confusing array of audit products. Later this month, however, all should become clear, as the government is set to publish an audit standard.

The crux of the problem was what the government called managed service companies (MSCs). Jonathan Hughes, managing director of Atlantic Umbrella, explains: "There were a lot of companies offering to set up a company of which the contractor was a shareholder. The contractor then paid himself the minimum wage and took dividends. HMRC got fed up with that and introduced MSC legislation." So schemes were forced to operate through full PAYE and National Insurance.

This legislation was effective, because it set up a chain of responsibility for paying any back taxes, known as the debt transfer rules. Hughes says: "If they can't find the contractor it goes to the people who run the scheme — so the owners and directors are personally liable. If the provider disappears, the recruitment agency can be held liable for back tax."

This onus fell onto recruitment agencies on 6 January. They now have to check the legalities of any umbrella company or accountant they recommend to contractors, or they could be liable for bad debts.

To make matters worse, the rules forced many MSC providers to become umbrella companies, so there are now more than 120 operating, many with uncertain provenance. Hughes says: "The term 'umbrella companies' covers a multitude of sins. Some are employment-based companies, which are exempt, and others are effectively masquerading as umbrella companies; they don't give full employment rights and aren't really exempt."

Providers also maintain that some are sailing close to the wind when it comes to issues such as claiming expenses; so it's difficult to know who it is safe to recommend.

Of course recruitment agencies only get drawn into this if they offer recommendations. Some have therefore chosen to get out of this area. John Kell, policy officer for the Professional Contractors Group (left) says: "There are difficulties with a preferred supplier list. They are reluctant to recommend an umbrella company in case HMRC later decides it's a managed services company and they become liable for debt transfer."

But contractors will ask for help, and advice in setting up a company, and in order to offer the best service, agencies may need to put together a preferred supplier list, so it's worth looking at what can be done to stay on the right side of the law.

The first step is to simply avoid obvious bias in favour of a particular company. Martin Heskith, managing director of Brookson (right) says: "HMRC is only really after the rogues, doing things like only having one preferred supplier, or taking introductory fees."

Agencies can also take steps to vet the companies they are recommending. Hughes says this is popular: "Over the last six months I must have completed 500 audit compliance questionnaires from agencies trying to establish whether we are a PAYE umbrella company."

Tony Harris, managing director of My Key Pay, says: "Almost all the agencies have sent questionnaires now. They are wise to do that, because the risk is there."

Heskith believes this will offer a great degree of protection on its own: "If an agency makes a genuine attempt to get a questionnaire answered, the risk to them is pretty remote in terms of third party debt transfer."

Barry Roback, managing director of chartered accountants JSA (left) , agrees: "There were initially mixed opinions on whether getting involved in due diligence was a proactive activity, and whether HMRC would misinterpret it as pushing contractors into particular companies. However, the Revenue, so far, verbally and through guidelines, has shown it wants to see agencies exercise due diligence."

However, these questionnaires need to be carefully considered. Kell says: "A lot are going very far to show they have checked the contractor is not using an MSC. Perhaps they go too far in their requests. They send lengthy questionnaires, or ask the contractor to sign a declaration to confirm they are an employee. But the contractor isn't necessarily an employee, they may be a director of their own limited company, so they are made to make incorrect statements."

The umbrella companies themselves may also go through some sort of audit process. One has been launched by a new trade body, the Association of Employment Management Companies. This was formed out of a group of umbrella companies including Atlantic Umbrella, Orange Genie, Parasol and Plan IT.

Hughes explains: "To become a member, first you have a legal audit and you are vetted by your peers, then an audit certificate is signed off by the company's own auditors, then there's a secret shopper process. Then they become a member and can use the kite mark. We believe if you have a preferred supplier list of AEMC members there's no way you can be liable."

There are, however, those in the industry who have their doubts. Heskith, for example, says he would support a trade body with a broader perspective, while Roback says: "We are in discussions with leading members of the community about forming an alternative organisation, so watch this space."

An alternative to trade body membership is an audit provided by a commercial third party. There are a few on the market. Professional Passport, run by industry veteran Crawford Temple, is one of the most well-known, and although umbrella companies have mixed opinions, Roback, who used the service says: "We have adopted the passport standard. It was a rigorous audit process."

KPMG is also marketing an auditing product, and cites ContractorUmbrella as one high profile client.

Others used their own auditors. Heskith says: "We've done an internal audit with the help of Ernst & Young, and we have talked to HMRC directly. We're comfortable we are compliant."

The difficulty with all these products is that they cannot categorically guarantee that once audited, a company is safe to recommend. Fortunately, the uncertainty should be coming to an end, as the government is due to launch an audit standard of its own.

Some have high hopes for the standard. Heskith says: "As soon as the audit standard is published it will form the cornerstone for the compliance process."

However, there's a good chance it won't be an all-encompassing solution. Roback believes: "The standard will be overkill. I don't think the market can stand it. There aren't that many large companies who are willing to go through a £50,000-£75,000 audit exercise."

Even if a company goes through the process, it's still not guaranteed to be safe, as Roback explains: "HMRC can't give its seal of approval. It can't guarantee that if you follow the standard to the letter, you won't be pursued, because legally they don't have the power to be selective in who they pursue." And as Harris says: "£50,000 sounds like a lot of money for something with no legal authority."

Roback believes, however, it will serve its purpose and that: "It will be a measure which other organisations will be able to use as a basis for their compliance activities. The industry will settle on a common sense solution."

This still won't be foolproof, of course, so recruiters can't relax and leave compliance in the hands of the umbrella companies themselves. But they can take comfort from the fact that an audit, coupled with questionnaires, should be enough to convince HMRC their aims are above board, which the providers agree should be enough to ensure an agency is never held liable for debt transfers.