This article was first published in International Tax Review and the original text can be found here.
IR35 legislation is an anti-avoidance initiative to prevent employees from working as contractors to save National Insurance. The anti-tax avoidance amendments, which enter into force on April 6 2020, could significantly affect the way companies work and the UK employment market.
However, the IR35 rules are yet to be approved in the next Finance Bill. Although implementation of the rules was delayed by one year from April 2019 to 2020, the Association of Taxation Technicians (ATT) has called for a further 12-month delay.
Given the December 2019 general election and delayed Finance Bill, the ATT has warned that businesses are left with “a greatly reduced and unrealistically short time frame in which to adapt to the changes” because companies are still waiting for the final legislation which will introduce these controversial changes to the off-payroll rules.
Nevertheless, it is unlikely that the government will delay implementation of the IR35 rules by another year and companies should therefore be prepared to comply from this year.
What is IR35?
The IR35 legislation, which has been in force since April 2000, targets single-owner managed companies (or personal service companies (PSCs)) where the owner works for the end client as a consultant but in reality is treated as if they were an employee.
The personal service company is used as a shield so that neither the end client nor the individual pay national insurance contributions (NICs). The effect of the IR35 legislation is to compel the contractor to assess whether the individual is in reality employed or self-employed and apply the appropriate tax treatment.
However, the IR35 legislation does not apply if the end client is an individual and the services are provided for purposes other than the client’s trade or business.
If, in reality, the individual who owns the PSC believes they are employed by the end client, the PSC would have to pay employer’s national insurance and the remaining available amounts would be treated as salary with an appropriate deduction for employee NICs. The total amounts are treated as paid at the end of the year.
If the individual has a number of engagements with one client, and is deemed to be an employee of that client, all monies received from that one client are treated as forming part of one employment. To compensate for expenses incurred in running the PSC, the legislation allows for a flat deduction of 5% of turnover as an expense.
2020 changes to IR35
There were some subsequent discussions and amendments to IR35 since it entered into force in 2000 but no significant changes were made until April 6 2016, when the responsibility to check whether a person was employed or self-employed was transferred to the end client if it was a public sector entity.
Further changes are being introduced, which are scheduled to apply from April 6 2020, when the responsibility to determine the employment status will shift to medium and large companies in the private sector.
Drawbacks of HMRC’s check employment status tool
To help businesses prepare for the changes, HMRC has provided the check employment status tool (CEST), which is available for free for anyone to check whether they are employed or self-employed. The tool has been widely criticised because it has one major drawback – it does not address mutuality of obligation.
HMRC said this is because: “every bilateral contract requires mutual obligations”, although the 2016 document on this goes further to explore HMRC’s argument. The CEST has since been updated to include a non-committal response as well as definitive “employed” or “self-employed” statuses, though mutuality of obligation still remains unaccounted for.
Regardless of the accuracy of the test, as long as the information provided to the online tool is correct, HMRC have said it will stand by the test.
One of the concerns many self-employed individuals have raised is the risk of their employment status changing as of April 2020 from self-employed to employed, which could lead to HMRC opening an enquiry into the earlier years on self-employment. HMRC has stated in a policy paper (published on October 22 2019) that it “will only use information resulting from [the new rules] to open a new enquiry into earlier years if there is reason to suspect fraud or criminal behaviour”. While this may be of some comfort to contractors, there is still a level of uncertainty because of the retroactive legislation regarding the loan charge and the issuing of an enquiry notice by computer. There is also some scepticism about how much reliance can be placed on HMRC’s guidance in an article published by the London Tax Society.
Practicalities for large businesses
From April 6 2020, medium or large private sector companies that utilise the services of contractors are expected to have put any workers who are actually employees on their payroll systems. This means that significant work has to be carried out beforehand to:
- Decide which department will take control of the process and responsibility for ensuring the new rules are implemented;
- Identify all contractors;
- Review their contracts and working relationships to decide whether they are employees or contractors;
- Issue the decision and allow time for discussion; and
- Amend payroll if required.
It is clear from discussions with various affected individuals that some companies fall at the first hurdle.
The human resources (HR) team sees IR35 as a tax issue (if indeed they are aware of it at all) and the tax department sees the legislation to be an HR issue because the tax team is there to implement the correct rules, not necessarily identify who they apply to.
In reality, this is likely to be a two-pronged approach, with HR being the intermediary between the tax department and company staff to ensure that all bases are covered. Regardless, both departments need to take a proactive approach if they wish to ensure that the legislation is correctly applied and in time for April 6 2020.
In the larger companies, where department managers are able to outsource the work unilaterally, the HR team may be unaware of which third parties the work has been outsourced to. It is essential that all personnel in the company who have any hiring power are made aware of the new rules and provide details of all work being outsourced and to whom. Future projections would also be useful.
Once all the contractors have been identified, their employment status needs to be determined. This can be done by the internal tax team, using the CEST tool and/or outsourcing the review to tax professionals.
For completeness, the person doing the review will need to look at the substance of the working relationship and not just the contract. This may include speaking with each contractor and manager to identify:
- Working practices;
- Who provides the tools/uniforms;
- Are there set hours?
- Is there a right of substitution? and
- How realistic are the terms of the contract?
This is likely to be more time consuming than many companies anticipate and each company should therefore ensure that sufficient time is made available for the analysis. Records should be kept for each stage of the evaluation process when determining the employment status for each individual.
Once the decision has been made by the company, it should be communicated to the individual and, to be on the safe side, any intermediary via a status determination statement (SDS). The legislation specifically defines a SDS as one where the client concludes that if the worker contracted directly with the client, they would be under a contract of employment or that the worker is a de facto office holder. In order to be a valid SDS, the client must have taken “reasonable care” in coming to the conclusions mentioned.
Companies should not take a ‘one size fits all’ approach to the rules and should instead approach each contract on a case-by-case basis. Otherwise, there is a danger that the SDS will be invalid. The legislation also provides for the worker or other intermediary to make representations to the client if they disagree with the conclusion reached in the SDS.
After April 6 2020, once the SDS has been issued, if it is determined that the worked is an employee, they should be placed on payroll immediately, even if the worker disagrees with the determination. If the determination is eventually overturned, steps will need to be taken to recover the NICs and income tax deducted. Clearly, getting the determination wrong or making sweeping determinations could end up with the company having to carry out more work in the long run.
If the worker (or deemed employee) disagrees with the conclusion and makes appropriate representations, the end client then has 45 days to review the decision and either change it or provide reasons for deciding that the original determination was incorrect. Although 45 days appears long enough to do this, the process must be completed and ready to implement by April 6 2020. If the client at the end of the chain does not respond within the 45 days, for tax purposes, they are required to make the relevant pay-as-you-earn (PAYE) deductions. They may also leave themselves open to a potential lawsuit if the worker considers that PAYE is being incorrectly deducted.
In the long-term it is, therefore, likely to be more efficient to review each case in detail and provide the worker with a careful analysis of the position and support for the conclusions reached in the first instance.
As a result of the SDS, there may well be discussions around remuneration and the work to be carried out. Individuals who consider themselves to be contractors are unlikely to want to take a reduction in salary, subject to market conditions or become employees, if they are used to a certain freedom in the way they work. Companies may, therefore, find themselves having to ‘let go’ of some individuals or have to pay more for others in terms of national insurance contributions. In addition, if a company determines that a contractor is in fact an employee, there may be legal repercussions regarding benefits, notice periods and other aspects of employment law. It would be useful for Companies to have and employment adviser on board throughout the process, just in case.
All parties should retain a clear audit trail of emails, notes of phone calls and meetings and any external advice to ensure that if HMRC asks any questions it can be shown that, at the very least, reasonable care had been taken to ensure that the correct status determinations were made.
Going forward, as well as considering the changes to the IR35 legislation, companies should ensure that there is a streamlined process for assessing all third parties who the company contracts with, individuals and PSCs. Suggestions include ensuring that all new contracts are reviewed and approved by a central team, which should ideally include personnel from HR, the department to whom the third party will report to and the internal tax department. This could be supplemented by an external professional who is aware of the IR35 rules and the company’s responsibilities in relation to them.
To summarise, the IR35 legislation has now been in force for nearly two decades. The changes from April 2020 are not complex from a tax perspective, but they could significantly change the way companies work and the UK employment market. To begin with, it may be resource intensive to make the company fully compliant with the new rules and preparation now is key to ensuring future compliance.