Advise your clients carefully on IR35
Navigating the new off-payroll working regulations that apply to private sector clients from 6 April 2020 can be tricky, especially if the ultimate engager is a medium or large company. Peter Rayney provides us with a definitive guide.
Note - The IR 35 and offpayroll working terms are often used inter-changeably. However, it is perhaps more correct to refer to IR 35 when talking about the original PSC legislation which was introduced in April 2000 and offpayroll working when referring to the more recent legislation requiring the engager to deduct tax at source.
Practitioners will be aware of the ‘original’ IR 35 rules that have been in place for nearly twenty years. These rules – found in Part 2, Chapter 8, Income Tax (Earnings and Pensions) Act 2003 (‘ITEPA 2003’) - were intended to tackle ‘disguised employment’ arrangements where workers/contractors personally provided their services through a personal service company (or PSC).
Broadly speaking, the owner-worker of a PSC is responsible for determining whether its fee income should be treated as generated from an employment or ‘self-employment’ relationship with the client/engager/end-user. This is determined by ignoring the PSC and imputing a hypothetical contract directly between the worker and the client/end-user.
A typical PSC operating structure is illustrated below:
The law stipulates that owner-worker must hold at least 5% of the ordinary share capital of the PSC. Certain partnership intermediaries are also caught by the legislation.
Where the PSC owner determines that the engagement is a deemed employment, the PSC must treat the income arising from that engagement (after making certain limited deductions) as deemed earnings. This means that the PSC is responsible for applying PAYE and NICs (including employers’ NIC at 13.8%) on the deemed earnings.
Unfortunately, according to HMRC’s research, some 90% of PSC’s have - in HMRC’s opinion! - failed to properly comply with these rules. It also appears that, due to lack of resources, HMRC has not been able to police IR 35 compliance effectively. According to Treasury estimates, this lack of compliance is likely to result in an annual loss of tax revenue of some £1.3 billion by 2023-24.
2 What is different about the offpayroll working rules compared to the original IR 35 provisions?
As a result of the large non-compliance problem referred to in Q1 above, the Government decided to change tack.
This led to the introduction of the offpayroll working rules – found in Part 2, Chapter 10 ITEPA 2003 - which shifts the main tax compliance burden and collection responsibility to the engager/fee payer (instead of the PSC).
The engager/fee-payer must therefore determine whether an ‘employment’ engagement exists with each PSC that provides services to it. Where this is the case, the engager/end-use must account for PAYE/NIC in the same way as it does for any ‘individual’ employee (albeit outsidethe normal payroll). Non-resident engagers may also be caught.
The offpayroll working regime brings a significant change in the tax risk for the engager. Under the original IR 35 regime (referred to above), provided that the contractual arrangements between the PSC and the engager were structured correctly, the engager was not liable for any unpaid PAYE tax and NIC if the engagement was deemed to be an ‘employment’ – the tax liabilities lay with the PSC.
3 What about the position where individuals provide services directly as a sole trader?
The IR 35/offpayroll working rules only apply where individuals provide their services through a PSC. Where services are provided as a ‘sole trader’, it remains the case that the engager must always consider whether the services are provided via a genuine self-employment. If the engager considers that the services are of an ‘employment’ nature, they must withhold and account for PAYE/NIC in the normal way.
4 What is the starting date for the offpayroll working rules?
They are already in operation for public sector engagers (and have been since April 2017). However, the offpayroll working regime is being extended to all large and medium sized companies/organisations operating in the private sector – with a start date of 6 April 2020. Small private sector businesses are therefore exempt from these rules.
Under the original proposals, the ‘private sector’ rules were to apply to payments made for services provided after 5 April 2020. However, as part of the Government’s widespread response to assist businesses during the COVID-19 disruption, the extension of the Off-Payroll Working (OPW or IR35) rules to the private sector has been delayed until 6 April 2021. Therefore, it is likely that the ‘private sector’ regime will apply to payments received for services provided after 5 April 2021.
The ‘small business’ exemption rules are broadly based along the lines of the Companies Act 2016 definitions.
In a supply-chain, the ‘small business’ exemption is only tested against the end-engager/client – the size of the other firms involved in the chain is irrelevant ; the fee-payer or the contractor’s PSC, is irrelevant.
Under current proposals, end-engagers/clients that have has been asked by the PSC/‘worker’ to confirm whether they are ‘small’, must provide this confirmation within 45 days. This requirement is required to certainty to the workers and others involved about the relevant tax rules that will apply (see draft HMRC ESM10011A).
In the case of a ‘singleton’ company (i.e not a subsidiary of a parent company), it will qualify as ‘small’ provided it meets two of the three following conditions:
- Annual turnover no more than £10.2 million
- Gross balance sheet total no more than £5.1 million; or
- Average number of employees no more than 50
The company can be small in its first accounting period and generally in its second accounting period. On an on-going basis, a singleton company is treated as ‘small’ for a tax year starting after the Companies Act 2006 accounts filing deadline for an accounting period in which it qualified as small.
Companies that are part of a corporate group (involved in a joint venture or under ‘common ownership) will not qualify for the small company exemption if the ‘consolidated’ group etc. does not qualify as small. This will be the case where the group meets two of the three following conditions:
- Total group annual turnover exceeds £10.2 million (net) or £12.2 (gross)
- Total gross balance sheet total no more than £5.1 million (net) or £6.1 (gross); or
- Average number of employees in the group exceeds 50
Note - The ‘net’ figure under turnover and gross ‘balance sheet’ assets excludes amounts relating to group companies. It is possible to use either the net or gross figures for the purposes of the test.
Certain listed companies and financial service sector companies can never qualify as small.
A different rule applies to other engagers, such as sole traders, partnerships, and overseas companies. They will always be ‘treated’ as small during their first tax year. In its following years, the business will be treated as ‘small’ if it satisfies the above Companies Act 2016 ‘turnover’ test only. For this purpose. the relevant accounts are those that end at least nine months before the start of the tax year being tested.
Where the status of the fee payer/engager changes to ‘small’, it should notify the actual worker/contractor and the PSC before the tax year about the change and that the deemed employee status assessment is withdrawn (see Q7).
6 How does the fee-payer/engager determine whether an ‘employment’ relationship exists?
Under the offpayroll working rules, the relevant end-engagers need to make an accurate and robust determination of the worker/contractors ‘status’ and notify the reasoning for the decision. This will provide an audit trail for HMRC in the event of an enquiry. The law requires the engager to take reasonable care when carrying out the relevant assessment.
HMRC expects engagers etc. to use its Check Employment Status Tool (‘CEST’) – which is located online at www.gov.uk/guidance/check-employment-status-for-tax.
Guidance on the use of CEST can be found at www.gov.uk/hmrc-internal-manuals/employment-status-manual/esm11000.
As expected, CEST contains questions dealing with the relevant factors that would normally be considered when determining whether an employment relationship exists; including worker’s duties, rights of substitution, degree of control, length of contract, working arrangements, financial risk and so on.
Thankfully, the latest version of CEST is a considerable improvement on the ‘heavily criticised’ earlier version. HMRC has indicated that the CEST has been “rigorously tested against case law and settled cases by officials and external experts”. It is understood that some 30 questions have been updated or included and more than 300 stakeholders took part in its testing and feedback comments.
Importantly, HMRC confirms that it will stand by the results obtained from CEST provided the relevant information is accurate and has been input correctly and it is used in accordance with its guidance.
From a practical viewpoint, given the time that it likely to be spent on making a ‘status determination’, many engagers may be tempted to make a ‘blanket’ determinations across the same category of PSC workers. However, they must be able to show that ‘reasonable care’ has been applied. Furthermore, these determinations should be reviewed at least annually and where the underlying arrangements are amended.
If the engager/fee-payer has concluded that the relevant engagement is one of ‘employment’ (and this will not always be the case), it must provide the PSC worker with a Status Determination Statement (‘SDS’). Where there is a multiple supply-chain, the end-engager must hand down the SDS to the next party in the chain – this will often be an employment agency.
Businesses should therefore allocate responsibility for making ‘status decisions’ to the appropriate department or manager, whether this be human resources, finance team, operations and so on.
The SDS will confirm that the engagement is one of employment, and therefore the engager will deduct and account for PAYE and NIC when paying the PSC. If the engager determines that there is a genuine ‘self-employment’ relationship, it does not have to provide an SDS and it will pay the PSC on a ‘gross’ basis.
It has been widely reported that many businesses in the financial services sector have taken pre-emptive action to avoid dealing with status determinations. A number are apparently planning to avoid dealing with all PSCs with the PSC workers being offered full employment contracts or working under a PAYE basis.
Offshore engagers that have no UK presence are outside the ‘off-payroll’ working regime. They do not have to provide an SDS – in such cases, worker/contractor is responsible for applying the normal IR35 rules (see Q15).
8 What about director’s services being provided through a PSC?
Individuals sometimes provide services as a ‘director’ through their PSCs. The IR 35/offpayroll working rules treat ‘office holders’ (such as directors, non-executive directors, company secretaries) in exactly the same way – i.e they are treated as deemed employees and a SDS is still required. Therefore, for example, where an individual acts as a director for a client through their PSC, this will be subject to the same tax treatment as a deemed employment (see Q12).
9 Does an ‘employment’ status determination make the worker an employee?
Not necessarily – while the employment status rules are similar to those in tax law, they are not the same.
Consequently, an SDS indicating ‘employment’ does not automatically make the worker an employee under employment law. It may be that their legal status is one of ‘worker’, which would entitle them to holiday pay, automatic enrolment to a pension scheme and the national minimum wage. If the relationship is considered one of ‘employment’, more extensive rights would be available, such as protection from unfair dismissal.
10 Will an ‘employment’ SDS open the PSC up to an IR 35 enquiry in relation to earlier years?
Many workers, contractors have understandably been worried that if they are treated as ‘employed’ under the extension of the offpayroll working rules in April 2020, this may trigger an HMRC ‘IR 35’ enquiry into their PSCs for earlier periods.
A degree of comfort can be obtained from HMRC confirmation that it does not intend to use gleaned from ‘real time information’ (‘RTI’) PAYE submissions to initiate IR 35 enquiries into earlier periods. That said, HMRC always has the right to ensure that there has been proper compliance with the IR 35 regime in earlier years and will seek to do see if there is evidence of fraud or criminal behaviour.
It would appear possible for the PSC’s tax treatment to be challenged under the normal self-assessment procedure, but the likelihood of a successful challenge depends on whether the engager’s analysis was flawed.
11 Does the worker/PSC have any right of appeal against a status determination?
Unfortunately, there is no legal appeal process for disagreeing with an SDS.
However, a worker or their PSC is entitled to disagree with the SDS by following the engager’s status disagreement procedure. Currently, there is no legal deadline for starting the ‘disagreement’ process – but see HMRC ESM10015 which states the practical deadline being the date of the last payment under the engagement.
The engager must reply to the ‘disagreement’ letter/notice within 45 days. The response must provide its reasoning and confirm that the original SDS was correct or issue a new SDS (of self-employment!). Workers must require with the minimum requirements of any status disagreement process otherwise they will be liable for the relevant tax and NICs etc.
Where the engager has issued an ‘employment’ SDS, it must account for PAYE, Class 1 National Insurance Contributions (‘NICs’) – both employees and employers (currently at 13.8%) – and any Apprenticeship Levy (‘AL’). The PSC worker/contractor should provide sufficient information to the engager to enable the correct tax deductions etc. The ‘cost’ of the employees’ NIC would often be picked up by the PSC but it depends on the terms of the contract. However, employers’ NIC and AL would normally be a cost for the engager and can only be passed on to the PSC if the contract permits this.
Where the PSC charges VAT for the services provided this is levied on the gross amount charged and is separate from the PAYE/NICs deduction. Any expenses incurred by the PSC that would be deductible if the worker/contractor was working directly as an employee of the engager, are allowed when calculating the PAYE deduction.
The engager will remit the relevant PAYE/NIC for the offpayroll PSCs along with the PAYE/NIC for its normal workforce etc. by the 22nd of the following tax month.
Worked example 1
Adrián owns 100% of Reds Ltd (his PSC) through which he provides his services. During 2021/22, he works on a six month contract with Andalusia Group plc (‘AG plc) - which is not a small company.
On 1 May 2021, AG plc provides Adrián with an ‘employment’ SDS – which he accepts.
On 31 May 2021, Reds Ltd invoices AG plc £6,000 (being £5,000 for IT services in May 2021 plus 20% VAT £1,000) to Andalusia Group plc.
When paying Reds Ltd’s May invoice, AG plc deducts (say) PAYE of £1,000 (£5,000 x 20%) and Employee’s NIC of £505 (using 2020/21 NIC rates). These deductions are accounted for under the RTI process. The amount paid to Reds Ltd is therefore £4,495, made up as follows:
|Total ‘May 2021’ invoice
The net payment includes the VAT of £1,000 and the net income is £3,395 (gross income is £5,000)
13 How does the PSC account for the income in its accounts?
The recommended accounting treatment is for the PSC to record the gross amount (i.e before PAYE/NIC deductions) as fee income, turnover or similar. The PAYE and NIC deductions should generally be recorded as staff costs.
Worked example 2
Taking the facts in Worked example 1 above, a summary of the final entries in Reds Ltd books to record the May 2021 invoice are as follows
14 Where a PSC’s income is subject to offpayroll working tax/NIC deductions, how is that treated for corporation tax purposes in its hands?
Where the PSC’s income is subject to offpayroll working withholding tax/NICs, the legislation excludes the income from corporation tax. Instead, HMRC require the income to be shown in as ‘deemed employment’ income in the worker’s/contractor’s personal self-assessment return on the ‘employment page’ (the engager/fee-payer is recorded as the ‘employer).
In the same way as ‘normal’ PAYE, the PAYE withheld by the engager is credited in arriving at the worker’s/subcontractor’s income tax liability for the relevant tax year.
The PSC is effectively treated as ‘transparent’ in relation to income that has been subject to offpayroll treatment. Thus PSC income can be subsequently extracted as salary or dividend on a tax-free basis. From a Companies Act 2006 viewpoint, the normal legal constraints etc must still be considered when determining the amount of lawful dividends etc.
The original IR 35 legislation still remains in place, but is trumped by the offpayroll working regime.
From 6 April 2021, workers and contractors may still be paid gross by ‘small business’ engagers (see Q5). However, this does not mean that the income received by their PSCs is not caught by the IR 35 rules.
Consequently, they still have the obligation to consider whether or not the income from each relevant engagement is deemed to be ‘employment income (see Q1). If it is, then the PSC must account for PAYE/Class 1 NICs on the deemed salary (computed under IR 35 rules with specified deductions for certain ‘employment’ expenses).
16 What if the engagement is found to be genuine self-employment?
If an engager issues a ‘self-employment’ SDS, it will pay the PSC gross and this should be the end of the matter. The income would get booked in the PSC as fee income/sales and (after deducting allowable trading expenses) be included in the trading profit subject to corporation tax.
The outcome would effectively be the same where the engager is a small business and the PSC concludes that the engagement represents self-employment and is therefore outside IR 35.
17 How do umbrella companies fit in to the offpayroll working regime?
Some clients/engagers may look towards an agency or other intermediary (for example, an umbrella company) to provide the PSC workers and deal with the PAYE/NIC compliance obligations. The umbrella/intermediary will employ the worker and provide full employment rights, pensions, all statutory benefits including holiday pay, maternity pay, and so. This provides the worker with stability and also the flexibility to provide services to various engagers/clients.
Workers should look to choose a long-established umbrella that has FCSA Accreditation. It is very important to choose an ‘umbrella’ company/intermediary that provides all the normal HR functions and is fully tax-compliant. The agency uses the engagers’ SDSs to account to HMRC for the relevant PAYE/NIC for employment taxes.
However, HMRC has the ability to seek to recover the tax liabilities under the ‘secondary liability’ rules if the agency/intermediary ceases to exist or cannot pay. It has confirmed that.
It will initially seek to recover any unpaid tax liabilities from those UK-based agencies that contract with the engager/client. Where HMRC considers that there is no realistic prospect of recovering the tax, it will then go after the engager for the tax. It appears that HMRC would not use these ‘secondary liability’ powers in cases of genuine business failure, but further confirmation is currently awaited.
Workers should avoid ‘umbrellas’ that do not apply full PAYE/NIC deductions and be wary of those operating offshore and/or offering tax breaks involving the use of loans. Workers can be responsible for the lack of proper tax compliance by such umbrellas, and they therefore carry significant personal financial risk.
About the author
Peter Rayney FCA CTA (Fellow) TEP
Peter Rayney is an independent tax consultant who advises owner-managed companies, accountants, lawyers and tax practitioners on a wide range of tax issues. He specialises in company sales/acquisitions, reconstructions, succession planning and all aspects of owner managed business taxation.
Peter authors various books and journals including Rayney’s Tax Planning for Family and Owner Managed Companies available on Bloomsbury Professional. He has won ‘Tax Writer of the year’ at the Taxation Awards an unprecedented three times.
Peter is Deputy President of the Chartered Institute of Taxation and immediate past chairman of the ICAEW Tax ‘s Technical Committee.