Many IT consultants work under HMRC’s IR35 rules that are designed to prevent independent contractors (usually IT contractors), who would otherwise be liable for income tax and National Insurance Contributions (NICs), avoiding them in favour of the lower rates of tax available if they work through the intermediary of their own personal service company (PSC).  Normally, a PSC arrangement means that that the worker can pay him or herself dividends from shares owned in the PSC, which are not liable to NICs.  On that basis, the worker pays less in NICs than a regular employee.  Although corporation tax is payable on the profits of the PSC  (after expenses) such an arrangement will nevertheless normally mean a big income tax and NIC saving to the worker.

In E C R Consulting Limited v HMRC, decided in May, the First-Tier Tribunal sided with an IT contractor against the HMRC’s IR35 assessment that the worker was, for all intents and purposes, actually an employee, rather than an independent contractor, and so should have to pay income tax and NI at employee rates.  To do this, HMRC created a “notional contract” between the IT Contractor and the end-user that, it said, fulfilled the tests of an employment contract rather than a consultancy arrangement e.g. the end-user had control over what and how the work was performed and the right of the worker to provide a substitute to do their work was qualified and not unfettered.   The tribunal disagreed.  Interestingly, it said that the notional contract had a valid “substitution clause”, saying that even though it was a qualified substitution clause (the end-user had to approve the substitute – the worker could not unilaterally decide to send someone else over), the clause was enough to stop the individual being regarded as an employee.

The finding that a qualified substitution clause might not indicate employment is the real surprise in this decision.  As recently as 2008, the High Court, in Dragonfly Consultancy Limited v HMRC, had said that a contract must give the worker an unqualified right to provide a substitute to be a genuine consultancy arrangement rather than disguised employment. Dragonfly’s contractual substitution clause read –

“the company has the right to substitute a suitable qualified representative of the company [to] provide the services. The company further shall not disengage the services of the consultant or terminate or consent to the termination of the services of the consultant or provide a substitute consultant during the assignment except with the prior written consent of [the client]”.

The underlined words proved fatal to Dragonfly.  Under the contract’s terms the client could veto the consultant’s substitute so, the High Court said, this wasn’t a genuine substitution clause and the consultant was, in fact, an employee for tax purposes.

Surprisingly, though, the First-Tier Tribunal in the ERC Consulting case seemingly did not agree with the High Court’s analysis (despite the Dragonfly case being a High court decision and therefore binding on it) and that found a qualified substitution clause could be enough to show that (amongst other indicators) there was no employment relationship.  That makes the ECR Consulting decision extremely puzzling.

It is therefore hard to draw firm principles from ERC Consulting. The judgment is very fact specific.  Further, given the Tribunal’s somewhat radical departure from the High Court’s decision in Dragonfly on the point of “qualified substitution”, we can expect HMRC to appeal.  These cases, and others like it, reinforce how hard it can be for companies to precisely determine who is and who is not an employee.  This is particularly true in the world of IT Contractors where such contractors can, inadvertently, meld into the workforce.  It is relatively easy to state the indicators of an employment relationship, with the statutory protection and tax implications that entails, but hard to pin them down in practice.

Although it can mean them paying higher rates of tax, this uncertainty can also help IT workers, engaged on “consultancy” arrangements, to bring employment law based claims against the end-user of their services, or even their agencies.  Such workers could take their “new” status to Employment Tribunals in order to benefit from unfair dismissal rights that only benefit genuine employees.  Often, the view of the Employment Tribunal on the question of “who is an employee?” is, like HMRC’s, similar to the classic definition of en elephant – if it is grey, has four legs and a trunk, then it’s an elephant, whatever you choose to call it.  Similarly, if the relationship looks like employment (e.g. access to benefits, contractual terms, control by management, compliance with handbooks, right of substitution etc.), then it will be regarded as employment, even where contractually labelled as a consultancy arrangement.  On that basis, we recommend having your IR35 arrangements thoroughly health-checked before relying on them to protect you from either the taxman or the Employment Tribunal.