Employment status: Off payroll, on HMRC’s hit list
The government appears set to press ahead with more tax reforms in off-payroll worker arrangements through the intermediaries legislation (IR35).
The government appears set to press ahead with more tax reforms in off-payroll worker arrangements. Importantly, the expected reforms will affect every private sector organisation which engages and pays off-payroll workers through the intermediaries legislation (commonly known as IR35).
This article uses the generic term ‘contractors’ when referring to individuals undertaking work for organisations through off-payroll arrangements.
What is IR35?
The purpose of IR35 was well described in R (Professional Contractors Group) v IRC as being:
… to ensure that individuals who ought to pay tax and [national insurance contributions] as employees cannot, by the assumption of the corporate structure, reduce and defer the liabilities imposed on employees by the United Kingdom’s system of personal taxation.
The effect of IR35, when it applies, is to treat the fees paid to a service company or other intermediary not as revenue to that company but instead as deemed salary to the contractor, subject to income tax and national insurance.
The legislation for income tax purposes is at s49 of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA) and for national insurance purposes is in Regulation 6 of the Social Security Contributions (Intermediaries) Regulations 2000.
When does IR35 apply?
There are a number of working scenarios relevant to the application of IR35. Each requires that a working arrangement is provided via an intermediary of some sort, generally either the contractor’s own personal service company or an agency or both.
One scenario is that a contractor undertakes work for an organisation. The individual may enter into a contract directly with the organisation, in which case the organisation will have to consider whether that is an employment contract and so subject to PAYE. Or the contract may be between the organisation and the contractor’s personal service company, in which case IR35 requires consideration of whether, were it not for that company, an employment relationship would exist between organisation and contractor. This is generally referred to as the ‘employment status indicator’ or ESI test.
Another scenario is that a contractor undertakes work for an organisation via an agency and either they or their personal service company contracts with that agency. The agency in turn contracts with the end user organisation.
There has been little interest among employing organisations in the taxation obligations of IR35. The onus has been on the contractor’s intermediary to decide whether the arrangement falls in or out of IR35 and to fulfil obligations to declare and pay tax.
Changes to the public sector
There is undoubtedly a view in government that affected intermediaries are not properly implementing the IR35 legislation. Either they are not applying the ESI test at all or they are applying it incorrectly. In the latest government consultation exercise (see below), it was estimated that a third of people offering their services through a personal service company are working like employees but only 10% of this group apply IR35 correctly. As a result, the Treasury expects the loss of tax revenue to rise to £1.2 billion in 2022/23.
In April 2017, the government introduced changes to IR35 affecting the public sector. While it did not alter the ESI test significantly, it transferred the obligation to determine status and apply the appropriate tax from the contractor’s intermediary to the employing organisation itself. In short, if the public sector body gets it wrong, then it can face a significant tax liability. As a result, a number of public sector organisations have adopted a cautious approach to IR35, starting with the assumption that contractors will fall within IR35 and taxing them accordingly.
Proposed changes to the private sector
The expectation is that the change in tax payment obligations will now be rolled out across the private sector. This was signposted from the commencement of the April 2017 changes when it was noted that the public sector (including HMRC, a significant user of contractors) should get its own house in order first.
A consultation about a roll out to the private sector took place earlier this year and closed in August 2018. The consultation paper estimates that the amount of lost tax revenue due to non-compliance in the private sector was £700million in 2017/18. The government’s preference, as identified in the consultation paper, was to extend the public sector changes to the private sector (described in the consultation paper as the ‘lead option’).
Unsurprisingly therefore, the Chancellor’s Autumn Budget included an announcement that these changes will be rolled out to the private sector in April 2020, although only to ‘medium and large’ private sector organisations. We await definitions of which organisations will fall within these categories and which will fall outside.
Determining employment status
Key to IR35 is the proper application of the ESI test. A decision has to be made about a hypothetical contract between contractor and employing organisation and whether, if those two parties were contracting directly, there would be an employment relationship. However, the route to determining employment status is highly fact specific and often as clear as mud!
While the Treasury considers that there is widespread misapplication of IR35, recent cases on the issue of employment status underline how problematic this test can be.
MDCM Ltd v HMRC
In this case, the Tax Tribunal decided that HMRC had been wrong to determine that working arrangements through which a contractor, Mr Daniels, provided work to a construction company, via his personal service company, MDCM, fell within IR35. Both Mr Daniels and his wife were employees of MDCM. The working arrangement involved MDCM contracting with an independent introductory company called Solutions Ltd, then Solutions Ltd entering into a contract with the construction company, STL, which provided for Mr Daniels to work with STL.
Under these contractual arrangements, Mr Daniels provided ‘management services’, effectively operating as a night shift manager at one of STL’s sites. A flat day rate of £370 was agreed in the contract between STL and Solutions. That contract included an express substitution clause, although the tax tribunal found that Mr Daniels had never exercised the right of substitution and, in any event, STL was not required to accept a substitute. The tribunal decided that the hypothetical contract was a personal one and that there was mutuality of obligation between STL and Mr Daniels.
HMRC’s view was that, had there been a contract between STL and Mr Daniels directly, then he would have been regarded as an employee of STL. They argued that STL exercised sufficient control to be Mr Daniels’ employer. In particular, the company determined Mr Daniels’ hours and required him to report to a project manager, manage the site, ensure the correct workers were on site and ensure the work complied with health and safety rules.
The tax tribunal found that Mr Daniels represented STL as a contact point for a number of site contractors but while an STL manager visited the site weekly, there was no significant control. Other factors significant to the tax tribunal’s finding were that Mr Daniels:
- was not entitled to a notice period or any severance payment;
- received none of the usual employee benefits such as pension, sick pay and holiday pay;
- was paid a daily rate, which was a factor pointing towards a self-employed relationship; and
- had to pay his own travel and other expenses, although he took no other financial risk.
In deciding that the hypothetical contract would not have been an employment one, the tax tribunal concluded:
"We do not accept HMRC’s arguments about control but do agree that the requirement for personal services and lack of financial risk point to an employment relationship. However we find that the nature of the payment arrangements, a flat rate per day with no notice period and no entitlement to any employee benefits are inconsistent with employment. Further Mr Daniels was not treated as an employee."
Other recent cases
HMRC was unsuccessful in another recent tax tribunal case, Jensal Software Ltd v HMRC. Once again, a contractor engaged via intermediary arrangements was able to show that the hypothetical contract between individual contractor and organisation (in this case, the Department for Work and Pensions) would not have been an employment one.
Conversely, cases before Employment Tribunals are generally brought by individual claimants alleging employment relationships rather than denying them. Hafal Ltd v Lane-Angell is recent confirmation that the application of a test of employment remains far from straightforward. Here, the Employment Appeal Tribunal overturned a Tribunal decision that the claimant, who carried out work on a ‘bank basis’, was employed. The EAT held that there was insufficient mutuality of obligation for an employment relationship to exist.
While a tax tribunal and an Employment Tribunal apply an employment status test for different reasons, the test being applied is, for the most part, the same.
When the public sector reforms were implemented in April 2017, there was concern that much-needed contractors might move away from public sector organisations that deemed them as falling within IR35. Alternatively, the contractors might increase their fees to make up for the loss of net income that payment through PAYE would cause. While the latest consultation paper acknowledges that there is some evidence of these two consequences, the view is that such practices are not widespread and are manageable. Critics have pointed out that it is too soon to be able to gauge the position and draw any firm conclusions.
However, concerns are also now arising that contractors will challenge their entitlements under working arrangements which public sector organisations have decided fall within IR35 and so claim the statutory rights due to workers.
Many readers will recall that attempts were made in the early 2000s by agency workers to assert direct employment relationships between themselves and the organisations where they worked, effectively cutting out the contracts with the intermediary agency. These attempts were largely stopped by the EAT and Court of Appeal decision in James v Greenwich Borough Council, which stated that a direct employment relationship between agency worker and organisation should only be found where it was necessary to do so.
Since then, there has been a swing to a more purposive approach when determining employment status. Decisions such as Uber BV v Aslam show that Employment Tribunals appear willing to disregard the written contractual terms and look at the reality of the relationship.
Recently one contractor, Susan Winchester, who worked with HMRC through her personal service company and was considered as within IR35, decided to claim worker status direct with HMRC. This was presumably on the basis that the existence of the intermediary made no difference to the reality of the relationship between her and HMRC. The case settled shortly before the Employment Tribunal hearing was due to take place, which is unfortunate perhaps for those looking for greater certainty in this area. However, we will probably not have to wait for long for a similar case to be heard. Indeed, subsequent claimants may argue employee status in the alternative as well as worker status.
A significant factor in these settled proceedings is the absence of any direct contract between contractor and HMRC. It would have been particularly interesting to see if the purposive approach that appears to be now favoured would have stretched as far as enabling a contractor who falls within IR35 to have access to worker rights. Or would the EAT’s directions in James have stopped this?
Interestingly, in Sprint Electric Ltd v Buyer's Dream Ltd, the High Court was also willing recently to take a purposive approach to an off-payroll worker situation when considering the extent of a contractor’s intellectual property rights. The court decided that the true relationship was one of employer and employee, regardless of the contractual structures that the parties had chosen to put in place. While the circumstances in which the employment test was being applied in Sprint Electric were very different (consideration of intellectual property rights), the test itself was the same.
Lack of clarity
It is likely that the off-payroll reform will be rolled out to the private sector (and therefore it is a question of when rather than if). It is also likely that an increasing number of off-payroll contractors who consider that they have received a hard deal in tax terms will look to recover some or all of that lost income through increased fees or asserting statutory rights, or both. All of this indicates that the solution to HMRC’s concern about tax avoidance is far from satisfactory and does nothing to increase clarity about relationships, rights and tax liabilities. It is to be hoped that the government will not overlook this problematic area as it continues to consider its responses to Matthew Taylor’s review on modern workplace practices.
Weightmans are currently working with a number of organisations in reviewing their engagement practices and the status of those they engage, we would be happy to assist you with this complex area.
Read HM Treasury’s consultation on off-payroll working in the private sector.
A version of this article was first published in the November 2018 issue of Employment Law Journal.