As previously announced, because of the Covid-19 crisis, reforms to off-payroll working rules were delayed by 12 months, but have now come into effect on 6 April 2021.
If you work as a contractor, consultant, freelancer, or flexible worker you should already be aware of IR35.
‘IR35’ was the designation of an Inland Revenue (now HMRC) press release published in 1999 announcing changes to tax rules on “off-payroll working”. A basic example of off-payroll working would be:
- An individual worker provides services to an end-user client via an intermediary.
- The intermediary may be another individual, an employment agency, or a limited company owned by the worker.
- The end-user client pays the intermediary, which in turn pays the worker – or the worker receives dividends if the intermediary is a limited company.
- Because it is the intermediary which is paid by the end-user client, the transaction is not subject to Income Tax or National Insurance Contributions (NICs).
In the opinion of Her Majesty’s Revenue and Customs (HMRC), intermediary companies – formally called Personal Service Companies (PSCs) – were being used to shield individual workers who were effectively employees of the end-user client from Income Tax and National Insurance liabilities.
The changes, which touch on several pieces of legislation and involve various levels of legal complexity, are now generally referred to as IR35. However it is important to note that there are in fact two separate regimes in place, with different applications and effects. The original IR35 regime still exists, and applies to small companies, but the Off-Payroll Working Rules (OPWR) sit over and above the IR35 regime.
Some of the confusion around IR35 arises from not recognising the distinction. The original IR35 legislation has been in place for many years, if not always applied. It requires the intermediary to determine whether or not the worker would have been a deemed employee of the end-user client, but for the existence of the intermediary. If the worker would have been a deemed employee the intermediary must operate payroll, make deductions for Employee NICs, and pay Employer NICs on the fees for the service.
The new element is the Off-Payroll Working Rules (OPWR), which were introduced for public sector engagements in 2017. The effect is intended to be the same i.e. Income Tax and NICs are meant to be deducted at source before payment is made. The significant difference between the two lies in which company has the obligation to determine the employment status of the worker, and deduct IT and NICs. Under IR35 it was the company closest in the supply chain to the contractor. So, in many cases it would have been the lowest intermediary, often the company owned by the contractor, or possibly an agency.
Under OPWR the obligations, to determine the employment status and make any deductions required, fall on the end-user client, i.e. the highest company in the chain.
The use of contractors by the public sector became subject to OPWR in 2017. OPWR takes effect in the private sector from April 2021.
OPWR will apply to contractor engagements involving medium- and large-size companies as the end-user client. A medium- or large-size business is one which meets at least two of the following criteria:
- Turnover greater than £10.2 million
- Balance sheet with a value of at least £5.1 million
- 50 employees or more
Small companies will not be obliged to apply OPWR rules. However, they will still be subject to IR35 rules and the lowest intermediary will have to decide whether a contractor is effectively an employee. Moreover the reforms to IR35 are part of wider measures to reduce perceived tax avoidance. All companies that fail to take adequate steps to ensure their staffing arrangements do not permit the facilitation of tax avoidance by third parties in their supply chain are also at risk of being subjected to criminal penalties.
As noted above a critical aspect of OPWR in both the public and private sectors for medium-and large companies is that deciding if a contractor is effectively an employee will be the responsibility of the end-user client, not the contractor or other intermediary.
End-user clients will deduct Income Tax and Employee NICs as if under PAYE from payments made to contractors which the end-user client determines would be employees were it not for the presence of the intermediary. In addition the end-user client will also be responsible for paying Employer NICs. These tasks may be delegated further down the chain, but the end-user client remains responsible.
The factors that decide if a contractor is a 'disguised employee'
HMRC provides the following criteria for deciding if a contractor is effectively an employee of the business which engages them.
For a contractor to be an employee, they must be required to deliver their services in person, without the possibility of substituting themselves with another qualified person.
Mutuality of obligation
Both parties are aware and accept that the contractor is there to perform work, and the engaging business will pay for that work. However unlike an employee a contractor is not obliged to undertake work other than the contracted services.
Right of control
The engaging business has the right to direct and control the contractor – i.e. the engager decides what the contractor is to do, and also decides when and where the work happens. It is important to appreciate that it is the engaging business’s right to control the contractor which points to an employment relationship, even if that right is never exercised or only partially exercised.
Right of substitution, Engagement of helpers
If the contractor can send someone else in their stead, this supports the idea that the contractor is independent of the engaging business. If the contractor is expected to hire and pay any support workers, this also supports the contractor’s status as self-employed.
Provision of own equipment
A contractor should provide their own equipment and not rely on the engaging business to provide equipment and materials essential to the work performed. It should be noted that some organisations where security and data sensitivity are key factors, such as banks and some public sector organisations, do not allow contractors to use their own equipment such as computers, and insist on providing the necessary equipment. It is assumed that HMRC would take this into account in considering this factor.
How much risk is taken on by the contractor is a key factor in confirming them as detached from the engaging company. Some examples of financial risk include:
- The contractor investing their own time and money on training to improve the skills provided to an end-user client.
- The contractor quoting a fixed price, risking a loss if the job overruns.
- The contractor makes good any unsatisfactory work for no additional reward.
Opportunity for profit
The flip of risk – a contractor who can profit from reduced costs and well organised work is less likely to be regarded as an employee of the end-user client.
Length of engagement
The length of engagement is not expected to be a significant factor in determining if a contractor is employed or self-employed. However, an open-ended contract is usually associated with direct employment.
Part and parcel of the organisation
Something of a catch-all criterion for contractors who are regarded as an employee, and behave as such. This can take many forms, from the contractor becoming an essential part of the client company’s core activity (rather than an accessory), to habitual use by the contractor of the client company’s facilities. A self-employed contractor will always be clearly differentiated from the client company’s own employees. If a contractor is in an executive role, for example as project manager, making decisions or committing client funds, then the position needs to be very clear that those powers are strictly related to that project or role.
If the contractor is entitled to the benefits received by the client company’s own employees, this implies an employment relationship. Example benefits include paid leave, gym membership, or a car parking space.
Right to terminate contract
An employee’s right to terminate their employment is straightforward – they give notice to their employer. A self-employed contractor may be able to resign from an assignment, although this may be subject to certain conditions or risks (such as being sued by the client). HMRC says that the right to terminate is a minor factor in the overall determination.
A self-employed contractor would be expected to have multiple clients and not be reliant on just one. The contracts between the two parties would be subject to regular updates.
HMRC’s Check Employment Status for Tax (CEST) online tool
To help a company work out if a contractor would otherwise be an employee, HMRC offers an online diagnostic tool.
HMRC intends to respect the decisions produced by CEST but reserves the right to investigate any single contractor-client relationship to confirm compliance.
No registration or identification is required. The respondent works through a series of multiple-choice questions and at the end receives a determination whether the contractor in question is ‘inside IR35’ or ‘outside IR35’.
The HMRC CEST tool referred to above has been criticised as inadequate in that it is considered as missing out key determinants of employment status, and asking insufficient questions to obtain a full picture. Although CEST was revised in November 2019 it is still regarded by some observers as inadequate. End-user clients are advised to use it carefully, make a proper determination of an individual’s status, and to avoid making "blanket determinations".
What large- and medium-sized end-user clients must do
- Determine each consultant’s deemed employment status. It should be noted that end-user clients are expected not to make “blanket determinations”.
- Notify the consultant of the determination using a Status Determination Statement (SDS) and the reasons relied on in making the determination. It must provide a disputes resolution process if the consultant disagrees with the determination.
- Deduct Income Tax and Employee NICs, and account for them to HMRC. It must also make payment of Employer NICs.
What small companies should do
- Ensure they understand that they are operating under IR35 rules, even if they are not a large- or medium-sized company.
- Ensure they are aware of the need for a determination under those rules.
- Ensure they have “reasonable prevention procedures” in place to prevent the facilitation of tax evasion in their supply chains.
What contractors/consultants should do:
- Review carefully their own position and how the many factors which determine employment apply to them. The IoD Factsheet “Employed or Self-employed?” gives guidance on these factors. It should be noted that this factsheet is subject to revision in the light of developments in the interpretation and implementation of IR35.
- Ensure they understand whether the client will be using IR35 or OPWR for the engagement.
- Review carefully the contract governing the engagement, whether provided by the client or their own, to examine whether it contains clauses that would indicate employed status or not.
Ensure they obtain an SDS from any end-user client and review carefully the reasons given for the determination, and consider whether there are grounds for disputing it.
How the IoD can help
IoD members can ask the IoD Business Information Service to send them a copy of Lexis PSL's detailed Practice Note on IR35:
Request Lexis resources on IR35
The Practice Note provides a lot of detail on the facts about IR35, but also draws attention to IR35’s many grey areas.
IoD Directors Tax Helpline
The tax helpline exclusive to IoD members is ready to answer questions on IR35
IoD Directors Legal Helpline
Quick, concise guidance on commercial law and employment law (including IR35).
IoD Directors Advisory Service
One-to-one advisory sessions with employment lawyers and accountants. Ideal for more developed conversations. Sessions take place at 116 Pall Mall, or via phone.
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