Creating IR35 policies and procedures
Making IR35 determinations
Contracted out services
Despite changes to the off-payroll working rules (IR35) being in place since 6 April 2021, businesses continue to encounter significant compliance challenges when navigating the new regime. The changes imposed tax and compliance risks on businesses when engaging individuals to provide services through intermediaries, often known as personal service companies (PSCs). Initially, many businesses sought to mitigate increased risks by prohibiting the use of PSCs in their supply chains. However, widespread labour shortages coupled with the need for greater flexibility to manage supply chain fluctuations have driven many businesses to review human resources and procurement policies and reluctantly renew engagement of contractors through PSCs. Such businesses are now having to rethink their approach to managing IR35 risks.
This article considers some of the key challenges for businesses when applying IR35 and how they should approach compliance to effectively manage risks.
IR35 is an anti-avoidance rule targeting the use of corporate structures to avoid employment taxes. Broadly, where an individual (referred to in this article as the PSC contractor) is engaged "off-payroll" and through an intermediary such as a PSC, the individual can achieve employment tax savings, while the engaging business is not required to pay employer national insurance contributions (NICs) (currently at 15.05%). The basic premise of IR35 is that a PSC contractor should be taxed as an employee if they would have been an employee for tax purposes if they had engaged directly with the business. Previously, the PSC was responsible for applying IR35 and paying any employment taxes that were due.
Since 6 April 2021, a business that engages a PSC contractor, either directly or through a third party such as an employment agency, has been required to determine whether they are an employee for tax purposes (an "IR35 determination") and, therefore, whether IR35 applies to the arrangement. In effect, the responsibility for applying IR35 has shifted from the PSC contractor to the engaging client business.
The client business must take reasonable care when making an IR35 determination. The client must also issue a "status determination statement" (SDS) to the PSC contractor and any other intermediary it contracts with, confirming its determination and providing reasons.
If the client determines that an arrangement falls inside IR35, income tax, employee and employer NICs, and the apprenticeship levy (where applicable) will be payable. Where the client engages with the PSC contractor directly, the client as the "fee payer" will be responsible for deducting and accounting for the relevant taxes. If the client engages the PSC contractor indirectly through another intermediary (eg, an employment agency), the intermediary that is closest to the PSC contractor in the contractual chain is the "fee payer".
IR35 poses significant challenges for businesses, particularly those engaging large numbers of contractors in complex supply chains. Such businesses often need to overhaul their onboarding processes and undertake numerous IR35 determinations, involving an increasingly complex tax employment status test.
Creating IR35 policies and procedures
Given that businesses are now required to make IR35 determinations and issue SDSs when engaging PSC contractors (either directly or indirectly), they need to ensure that they have adequate onboarding controls and procedures to identify PSC contractors before they enter the supply chain. Failing to identify a PSC contractor, make an IR35 determination and issue an SDS may result in a business being held liable for income tax and employee NICs (in addition to employers' NICs and any late payment interest and penalties imposed by HMRC) due on the PSC contractor's fee. This may be difficult to recover from the PSC contractor.
Beyond identifying PSC Contractors, a comprehensive IR35 policy should also detail the engagement process for off-payroll workers and how IR35 requirements will be satisfied. The process for engaging with third-party intermediaries, such as employment agencies and umbrella companies, needs to be addressed. Agreements with third party intermediaries should be reviewed before signage to ensure contractual protections have been included to manage IR35 risks. New IR35 policies should be communicated across the business, with appropriate training provided to those involved in engaging and onboarding contractors.
When devising a robust IR35 policy, a business will also need to determine its strategic and holistic approach to managing IR35 risks, notably whether there will be restrictions on engaging PSC contractors across the supply chain – for example, only allowing direct engagement or limiting indirect engagement to a single employment agency. These issues will be particularly important for businesses with complex supply chains involving multiple third parties that may wish to engage the services of PSC contractors as part of delivering a package of services to the business.
The process for making IR35 determinations also needs to be detailed in the IR35 policy. The test for determining whether a PSC contractor is an employee for tax purposes is complicated and can be difficult to apply, creating an additional and unwelcome layer of complexity for businesses.
There is no single legislative test to determine employment status for tax purposes, rather the test has been developed through case law and involves considering several factors, such as:
- the level of control that the client exerts over the individual;
- whether mutuality of obligation exists between the parties; and
- whether the contractor is in business on their own account.
Case law has highlighted that the employment status test for IR35 purposes is often highly nuanced and the outcome dependent on the facts of each case.
Recent court decisions have confirmed the need to look beyond the relationship between the engaging client business and the PSC contractor and consider whether a PSC contractor is in business on their own account. These decisions have increased the complexity and uncertainty for businesses when making IR35 determinations, as it may be difficult for a business to collate sufficient information to accurately determine the nature of a PSC contractor's business dealings beyond their engagement with the client business.
To reduce the risk of Her Majesty's Revenue and Customs (HMRC) challenging an IR35 determination, the client should ensure that they focus on the practical reality of the engagement rather than the written contractual terms. IR35 determinations should be completed by people with a clear understanding of the true nature of the contractor's role, such as the hiring manager. This should be reflected in the business's IR35 policy.
When making IR35 determinations, it may be preferable for a business to use HMRC's "check employment status for tax" (CEST) tool. The tool is limited and has been criticised for failing to provide an outcome in approximately 15% of cases; however, HMRC has confirmed that it would stand by a CEST result if the information provided is true and accurate. Proper use of CEST may also satisfy the requirement to take reasonable care when making determinations. Consequently, using CEST may be the most effective way to manage the risks associated with IR35 determinations.
A business may seek to outsource IR35 determinations to a third party. Such an approach should be viewed with caution since the client business will remain legally responsible for making the determination and should therefore still review any outsourced determinations to ensure accuracy and that reasonable care has been taken. Given the need for a comprehensive review by the client business, the value of outsourcing IR35 determinations is questionable.
The IR35 policy should explain that evidence supporting determinations should be recorded and maintained. Such documentation may include, checklists covering the factors of the employment tax status test, copies of any CEST determinations, relevant correspondence with contractors, and copies of the contracts. The policy should also mandate that determinations are regularly reviewed and should be repeated every six months or earlier if there is a material change in the circumstances of the engagement.
A robust IR35 policy should effectively manage the risks that a business is exposed to when they are the "client" for IR35 purposes and bear the ultimate legal and tax risks of non-compliance. However, in complex supply chains, identifying the client may be challenging. Where a business engages a PSC contractor as part of a wider supply of services to another company, it may be unclear whether the client is:
- the company that is engaging the PSC contractor (the "service provider"); or
- the company that is the ultimate recipient of the services being supplied.
If the services are "fully contracted out" of IR35, the client will be the business engaging the PSC contractor. If the services are not "fully contracted out", the client will be the ultimate recipient of the services being supplied. Determining whether services are "fully contracted out" can be complex. HMRC distinguishes between circumstances where a business enters a contract for a supply of labour (and is clearly the client for IR35 purposes) and those where a business contracts with a service provider for the supply of a "fully contracted out service" (and is not the client, as it does not exercise sufficient control or have access to the information required to make status determinations).
Determining whether a supply is a "fully contracted out" service is a question of fact, based on real working practices and determined by reference to several factors. In complex supply chains, drawing the distinction can be difficult since multiple services may be provided under a single framework agreement. HMRC's published guidance is limited and often fails to resolve uncertainty.
Given that the client business is legally responsible for applying the rules and making IR35 determinations, if the client has been wrongly identified, the "true" client will have inadvertently failed to comply with IR35 and may face unexpected tax liabilities. To mitigate risks, a business's IR35 policy should detail the process for reviewing whether arrangements are "fully contracted out". At the outset, the relevant parties should agree who will be the client under IR35 and this should be reflected in the written agreement with appropriate contractual protections included. Supporting evidence should be retained. Complicated arrangements, where the position is uncertain may need careful reviewing and expert advice may be required.
IR35 continues to create compliance challenges for businesses. The difficulties in managing IR35 risks have been exacerbated by labour supply chain constraints and recent court decisions on employment tax status. Challenges may be more pronounced for larger organisations with complex supply chains, which may struggle to identify their entire population of PSC contractors and undertake large numbers of IR35 determinations. Devising a robust and comprehensive IR35 policy will be key to managing tax risks. Ultimately, however, compliance difficulties are likely to persist until improved HMRC guidance is published and the test for determining employment status for tax purposes is simplified.
For further information on this topic please contact Penny Simmons or Rachel McConnell at Pinsent Masons by telephone (+44 20 7418 8250) or email (p[email protected] or [email protected]). The Pinsent Masons website can be accessed at www.pinsentmasons.com.