The Art of Substitution

The original article was published in Taxation Magazine on 30 July 2019 and can be viewed here.

On 2 May 2019, Keith Gordon provided the delegates of the London Tax Society with an overview of recent tax cases. The talk covered a range of cases and tax concepts, but the topics that generated the most discussion related to the art of substitution.

The case of RS Dhillon and GP Dhillon Partnership TC05583 (Dhillon) centres on a haulage company run by Mr Dhillon (D) and his wife. D entered into contracts with a number of individuals to fulfil agreements with Dhillon’s clients for delivery of construction materials.

HMRC asserted that the lorry drivers were employees and issued determinations under Regulation 80 of the Income tax (Pay As You Earn) regulations 2003 and decision notices under s8 Social Security Contributions (Transfer of Functions etc) Act 1999 for the PAYE and NICs they considered were due. Dhillon appealed on the basis that the drivers were considered to be contractors.

In arriving at his decision, Judge Citron referred extensively to previously established case law, in particular, “the threefold test set out by Mackenna J in Ready Mixed Concrete (South East) Limited v Minster of Pensions and National Insurance (1968).” This threefold test is as follows:

“A contract of service exists if the following three conditions are fulfilled:

(i) in consideration of a wage or other remuneration the worked will provide his own work and skill in the performance of some service.

(ii) in the performance of that service, the worked will be subject to the other’s control to a sufficient degree.

(iii) the other provisions of the contract are consistent with there being a contract of service. Matters reviewed in relation to the “big picture” include (but are not limited to) whether the individual is going into business on their own account, whether they provide their own equipment and uniforms, how integral they are to the business etc

Keith highlighted that these tests are must be applied in the order stated. i.e. even if the other provisions of the contract indicate a contract of service, if the individual is not personally required to carry out the service or if there is insufficient control, then they cannot be deemed to be employed.

In the Express and Echo Publications Ltd v Tanton. [1999] IRLR 367 case (Tanton), the contract included a substitution clause which had been exercised. The clause was that “In the event that the Contractor is unable or unwilling to perform the Services personally he shall arrange at his own expense entirely for another suitable person to perform the Services.” The judges concluded that where there is no requirement for personal service, it cannot be a contract of employment.

HMRC state in their guidance that the officer “cannot assert that a right of substitution does not exist just because a substitute has never been provided” (ESM0538). Thus it follows that having a substitution clause in the contract should be enough (depending on the strength of the wording) to demonstrate that a person is self-employed. Conversely however, it appears that if there is a requirement for personal service, although this is a strong indicator of employment, the other tests (above) would need to be satisfied before a decision is reached.

This then resulted in a discussion over how a court would decide whether a substitution clause was genuine. If a bona fide contractor has a substitution clause but never uses it, is it still valid? HMRC’s view is that the third party’s point of view should be obtained (ESM8560) and for this reason, it is essential that any contractor not only includes a substitution clause in the contract for services, but also draws their customer’s attention to the clause and obtains their agreement for this to apply.

Based on the decision in Dhillon, it appears that for any substitution clause to be beyond question, it must be unrestricted. In Dhillon, the substitution clause was generally used only if the first driver were legally not allowed to take it (due to, for example, having driven the previous evening and being over the permitted number of driving hours).

However, Keith said that the contract itself was not restricted in this way and this should have led to the Tribunal finding for self-employment.  In Ready Mixed Concrete, the substitution could undoubtedly take place if the contracted driver were unwilling to take the job. In addition, it was made clear that the driver would be responsible for paying the replacement. In Dhillon, the payment of the substitute appeared to be less clear cut.  The concept of substitution and the discussion that followed merited further research.

For a number of years, HMRC have remained consistent in their view that the drivers cannot be self-employed unless they are carrying on their own haulage business (Heavy Load,  Alistair Kendrick, 14 June 2016). However, in Brian Turnbull [2011] FTT 388 (TC), the FTT found that Mr Turnbull did not employ his driver because there was no obligation to provide work and because control over the driver was exercised by Mr Turnbull’s customer rather than Mr Turnbull himself.

In Usetech Limited, Mr Hood was the sole employee of a Company, which engaged in contracts with Clients to provide (computing) services. Although there was a substitution clause in the contract between the Company and the Client, and it appeared unfettered, the judge found that in reality, the Client “would not have accepted a substitute” provided by the company, without question. The judge went on to clarify that while he would “not go so far as to say the right to substitute was a sham” he did consider that “the right of substitution was illusory”. The case clearly shows the depths to which the contractual terms and substance of the relationship between the person carrying out the services and the end client are analysed at Tribunal. Going back to Dhillon, Citron J confirmed that the “power of delegation that is “limited” and “occasional”” indicates a contract for services but is insufficient to put the matter beyond doubt.

The nature of a working relationship can affect not only employee/contractor taxes, but may also impact individuals in relation to IR35. Advisers need to do more than just review contractual terms before advising their clients and should consider the true substance of the relationship, asking in depth questions about the day to day operations and the reality of the situation. This is particularly relevant where the right of substitution is available, unfettered and bona fide, but has never been invoked.

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