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The proposed IR35 reform represents the biggest change to employment tax for decades. Until now, businesses have been able to engage contractors using personal services companies (or other intermediaries) without having to give too much thought to the individual contractor's status for tax purposes. The proposed shift in responsibility for operating pay-as-you-earn (PAYE) and national insurance contributions (NICs) away from personal services companies towards the end user means that all businesses must review how they engage with contractors ahead of April 2020.
IR35 is a tax anti-avoidance rule designed to combat disguised employment in situations where an individual contractor is providing their personal services (ie, their labour) via their own intermediary (eg, a personal services company or partnership (collectively referred to as PSCs)) to an end user.
IR35 applies when the contractor would be an employee (or officeholder) for tax purposes, if they were hired directly by the end user. If IR35 applies, PAYE and NICs must be operated in respect of the fees paid to the PSC.
Under current (pre-April 2020) IR35 rules, contractors are responsible for assessing whether IR35 applies and, if so, operating PAYE and NICs on the fees that the PSC receives (excluding value added tax (VAT)) less certain statutory deductions.
Due to Her Majesty's Revenue and Customs' (HMRC's) concerns regarding non-compliance with IR35 by contractors there are plans to reform IR35 in the private sector from April 2020. IR35 was reformed in the public sector in April 2017.
Under the reforms, responsibility for assessing whether IR35 applies and operating PAYE and NICs (if a contractor is considered to be an employee for tax purposes) will move from the contractor to the end user. This will apply to any payments made on or after 6 April 2020, even if the services were provided before that date.
HMRC's expectation is that, as a result of these reforms, IR35 compliance will become easier to regulate. It is also predicted that end users will take a more compliant approach to IR35 assessments and will be more likely to conclude that contractors are in scope, resulting in increased tax and NICs.
End usera must assess whether a contractor is employed or self-employed for tax purposes. The end user must take reasonable care in making that assessment and confirm their assessment together with reasons in a status determination statement (SDS).
The end user must provide the SDS to the contractor and the PSC before making the first payment to the contractor. If there is an agency in the chain (see below), the SDS must also be provided to the agency. In practice, contractors accepting a new assignment are likely to want to know in advance of that assignment whether they will be assessed as within the scope of IR35.
The end user must have a dispute resolution procedure to enable the contractor to challenge the assessment. A contractor is unlikely to challenge an SDS which assesses them as falling outside the scope of IR35. However, HMRC may review the assessment. Thus, it is important that the SDS sets out in sufficient detail the basis on which the decision is made and shows that reasonable care has been taken.
If the assessment concludes that the contractor is outside the scope of IR35, the PSC can continue to be paid gross. However, if the contractor is assessed as within IR35, the entity that pays the PSC (the fee payer) is responsible for operating PAYE and deducting an employee's NICs on the fees that it pays to the PSC (excluding VAT). The fee payer must also pay employer's NICs and, where applicable, the apprenticeship levy.
If there is a UK agency in a chain, and the agency supplies the contractor via a PSC, the position is different. The agency is the fee payer because it is the party that is paying the PSC. As the fee payer, the agency must operate PAYE and NICs and pay employer's NICs and, where applicable, the apprenticeship levy.
However, the end user retains responsibility for issuing an SDS and providing a dispute resolution procedure. The SDS must be provided to the agency and the contractor and the agency must also be allowed to appeal the assessment.
HMRC can transfer PAYE and NICs liability from the agency to the end user if the end user fails to meet its responsibilities (eg, if it fails to provide an SDS before the first payment is made) or if there is no realistic prospect of recovery from the agency within a reasonable period.
There are more complex rules for offshore agencies.
IR35 is a tax rule. Crucially, it does not change a contractor's status for employment law purposes.
In addition, although IR35 is changing, it is still legitimate for contractors to use PSCs – it is not tax evasion to do so.
Subject to anti-avoidance provisions, small private sector end users will be exempt from the new rules and will not be required to determine whether IR35 applies. Instead, the current rules will continue to apply – the contractor will remain responsible for determining whether IR35 applies and the PSC can still be paid gross.
A corporate end user which is not part of a group will be treated as small in its first financial year and will remain small until it ceases to be so. Small companies will become medium or large if they meet at least two of the following conditions for two consecutive financial years:
- an annual turnover of more than £10.2 million;
- a balance sheet total of more than £5.1 million; or
- more than 50 employees.
If the conditions cease to be satisfied, the company must apply the IR35 rules from the start of the tax year following the accounting filing date for the second financial year. Where the small company is part of a larger group of companies, the group turnover and revenue must be considered and advice should be sought.
Non-corporate end users will be treated as small for a tax year if their annual turnover in the financial year ending at least nine months before the start of the relevant tax year was no more than £10.2 million.
The changes affect individual contractors using a PSC to provide their labour. Contractors will not be affected by IR35 if they supply their labour directly to the end user without using a PSC (eg, as a sole trader).
Contractors who are not tax resident in the United Kingdom and supply their services exclusively outside the United Kingdom are also unaffected. If they supply some services within the United Kingdom, the rules are more complex and advice should be sought.
IR35 is focused on the provisions of labour and not the provision of services. Therefore, fully outsourced services are out of scope. For example, if a company fully outsources its IT helpdesk or catering services to a third party, it need not determine whether IR35 applies to any contractors working for that third-party service provider.
The law requires end users to use reasonable care in making the status determination. The obligation is to assess what the contractor's status for tax purposes would have been if they had been engaged directly by the end user without a PSC.
This involves taking account of a number of factors, including:
- Control and working arrangements – how much control does the end user have over the contractor's hours and place of work? Can the end user direct how the work is done or is it highly skilled or specialised? Can the end user move the contractor to different projects?
- Substitution – can the contractor send a substitute? Have they ever done this? Can the end user reject the substitute?
- Mutuality of obligation – is there a binding commitment on the contractor or end user to provide or offer work?
- Integration into the business – how involved is the contractor in the business and its management? How would they introduce themselves to customers – as working for the end user or for themselves?
- Carrying on business on their own account – does the contractor take any significant financial risk? Do they need to make significant investments in equipment or tools?
- Other factors – for example, does the end user impose restrictions on what other work the contractor can do? Does the contract take up the majority of a contractor's time? Has the contractor previously worked for the company?
The SDS will be valid only if it includes the reasons for the determination. It must be provided to the contractor before they are paid.
The status determination assessment must be repeated if the contractor's assignment continues for any significant period (eg, at least every 12 months, although there is no guidance on this) or if the circumstances change.
The HMRC Check Employment Status for Tax (CEST) tool is an online tool for assessing whether a contractor would be an employee for tax purposes if they were hired directly. CEST was revised in November 2019 following criticism that it was not fit for purpose, but it still has flaws. In particular, it still fails to test whether there is sufficient mutuality of obligation in relationships between end users and contractors, which is one of the necessary conditions of employment (HMRC's view is that this condition is inevitably present). CEST also fails to produce any result in a significant minority of cases.
End users are not obliged to use CEST. However, it highlights the main issues that HMRC is concerned about when considering status for tax purposes. It also has the overriding advantage that as long as the information is entered correctly and kept up to date by the end user, HMRC is bound by the result. However, the end user must take responsibility for using the CEST tool. A CEST assessment which is carried out by a contractor personally is not binding on HMRC.
Given this, CEST is a sensible starting point in the majority of cases. However, end users still have the responsibility to make a status determination, even when CEST produces no answer. This means that businesses need an additional way to make status determinations in at least some cases.
When the IR35 changes were first discussed, there were calls for HMRC to provide a procedure for verifying IR35 decisions. However, the proposed legislation instead makes it the end user's responsibility to provide a process for resolving disputes.
If a contractor considers that the end user's IR35 decision is incorrect:
- they may make representations to the end user; and
- the end user has 45 days to review the representations and either:
- inform the individual that their initial status determination statement was correct; or
- issue a new status determination statement, withdrawing the previous one.
The end user must provide reasons for its decision.
If IR35 applies, PAYE and employee NICs must be deducted from the fees paid to the PSC (excluding VAT). Although the contractor would have needed to pay tax at some point, IR35 means that they lose the cash-flow advantage associated with using a PSC. In addition, the contractor is likely to be worse off in real terms, not least because the current generous expense rules under IR35 are being withdrawn as part of this reform.
On top of this, if IR35 applies, the fee payer must pay employer NICs and apprenticeship levy costs on the fees paid to the PSC. This means an additional cost of around 14%. These costs cannot be passed onto the PSC (although it may be possible, depending on the contractual terms, to renegotiate the fees paid to the PSC to ensure that the net costs do not increase).
If the end user engages the contractor via an agency, the agency will be responsible for operating PAYE/NICS and the apprenticeship levy, although is likely to negotiate reimbursement from the end user.
End users must have robust processes and controls for identifying and recording the use of contractors (including those supplied through an agency). End users must also have clear (and well-communicated) policies for contractor-hiring which ensure that appropriate authority is given before a contractor is appointed.
In addition, end users need a clear and consistent methodology for making status determinations, particularly in situations where CEST does not produce a result. End users will need to ensure that their status determination statements set out the reasons for the determination.
Contracts with PSCs need to reflect the IR35 reform. For example:
- the terms of the contract with the PSC should not contradict the basis of the status assessment made by the end user (eg, in relation to whether the contractor must do the work personally or can send a substitute);
- the end user should reserve the right to deduct PAYE and NICs (immediately if IR35 applies, in future in case the position changes, and pending any challenge to the status assessment); and
- the contract should include clear tax warranties and indemnities.
If the end user is also the fee payer (ie, there is no UK agency or intermediary in the labour chain), the end user must also adapt their payroll and accounts payable systems for IR35 compliance. For contractors in scope of IR35, the payroll system must operate PAYE/NICs on the fees excluding VAT, while the accounts payable system must pay VAT on the gross fees. The system must also align with the terms agreed with the PSC in relation to when invoices will be paid.
Contracts and working arrangements with agencies or other intermediaries should also reflect the revised IR35 position:
- Will the agency be precluded from supplying individuals via PSCs or will it just have to notify the end user in advance if it does so?
- Can the agency pass the full cost of operating PAYE/NICs and the apprenticeship levy back to the end user?
- Agencies will need to supply information to help the end user with the status determination statement.
- The end user must communicate the outcome of the status assessment to the agency and should always make sure that they do so in writing.
- Agencies must pass the statement to the entity with which they are contracting.
Although there is nothing unlawful about continuing to engage contractors through a PSC, the IR35 rules result in a significant administrative burden for the end user. Other resourcing options which do not involve PSCs (and so avoid the application of IR35) include:
- recruiting the contractor as an employee;
- contracting with the individual contractor directly either on a self-employed basis or as a worker; and
- requiring that contractors go through an agency or other intermediary where there is no PSC in the chain (ie, where the contractor is directly engaged by an agency or an accredited and tax-compliant umbrella).