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How to prepare for IR35 tax rules

Major changes have now occurred for IR35 tax rules as businesses become responsible for deciding the employment status of the contractors they engage through an agency or the contractor’s own limited company, known as a Personal Service Company or PSC.

Businesses will assume PAYE liability on the payments it makes for the contractor’s services – if it decides the contractor is really a ‘disguised employee’ rather than a genuinely independent contractor.  These businesses will be known as the ‘fee-payer’.

These changes – known as the Off-Payroll Working Rules and sometimes called IR35 – will affect all medium to large private sector companies with a UK connection from 6 April 2021. (IR35 has been in force in the public sector 2017). Many businesses have underestimated how much preparation is needed to be ready for these new rules.

This Q&A covers key points and details some of the complexities which lie ahead for business and contractors, in order to manage risks and liabilities.

When does the IR35 tax rules come into effect?

It applied to all payments made to contractors on or after 6 April 2021 for services they have supplied personally on or after 6 April 2021. If the services are provided before 6 April 2021 but payment is made afterwards, the payment is not affected by the new rules.

What is the purpose behind IR35 and the Off-Payroll Working Rules?

HMRC is trying to clamp down on what it regards as tax avoidance. Owner-directors of limited companies enjoy various tax advantages over employees (such as paying themselves minimum salaries and the rest as dividends on profits). The government wants to ensure that people who are really working like employees but through their own limited PSC broadly pay the same tax and national insurance contributions (NICS) as people who are employed directly.

Under the current system the contractor’s own PSC is responsible for deciding the deemed employment status of the contractor it hires out to its business clients. If the contractor would be regarded as an employee if engaged directly by the client rather than engaged through their PSC, the IR35 rules say the contractor should be taxed as an employee. The contractor will be ‘inside IR35’, which means they will have to pay tax and NICs on a par with employees.

You will have spotted that the owner-director of the PSC currently making the decision about the contractor’s deemed employment status, and the contractor themselves, are one and the same person.  It is usually therefore in the best interests of this individual to deem the working relationship with the client as not being akin to an employment relationship. That puts the contractor outside of the IR35 Rules, allowing them to retain the tax advantages of the genuinely self-employed contractor.

Under the current system there are also advantages to the business client in agreeing with the contractor’s assessment that they are not a ‘disguised employee’. For example, the business saves the 13.8% on the class 1 NICs it pays on an employee’s salary and potentially on other employment related costs too.

Does HMRC believe that contractors and the businesses which engage them are ‘manipulating’ the current system?

In many cases, yes. HMRC has estimated that there is around 80% non-compliance with the IR35 Rules in the private sector. That is why HMRC is now shifting responsibility for determining employment status to the end user medium and large business client. Since IR35 came into effect in the public sector in 2017 HMRC have collected £millions more in tax and NICs.

What is the definition of a medium or large business?  

HMRC applies the Companies Act 2008 definition of a medium or large company as meeting 2 of the following 3 tests:

  • Annual turnover of more than £10.2 million
  • Balance sheet total of more than £5.1 million
  • More than 50 employees.

Groups of companies are combined for this test.

How does the business client set about determining a contractor’s employment status?

The place to start is by answering the questions on HMRC’s online CEST tool. CEST stands for ‘Check Employment Status for Tax’ and it was introduced in 2017 to help employers, workers and hirers determine how work being done should be determined for tax purposes.

CEST was updated in December 2020 so if you ran the test before then you may want to run it again.

How long does it take to work through the HMRC’s on-line CEST tool?    

It only takes around ten minutes or so to complete CEST online in respect of each contractor and the result, in an estimated 80% of cases, will be given at the end.

However, HMRC warns that businesses must take ‘all reasonable care’ when assessing employment status. The answers inputted into CEST must be a true reflection of the actual working relationship with the contractor and so some advance preparation time might be required. This is especially so for businesses who may assign the task of running the CEST tool for many contractors it engages to one person or department (for example in procurement or accounts) who may not have the necessary knowledge of the true working relationship.

Can businesses rely on the CEST employment status determination?  

Yes. HMRC has stated that it will stand by its CEST determination unless it is found to be inaccurate or the results have been achieved through contrived arrangements designed to get a particular outcome. That would be treated as deliberate non-compliance which could attract penalties.

If I use HMRC’s CEST tool will HMRC collect and store the data I have entered?

No, it is anonymous and HMRC say they will not store your data (but you should print out or screen shot your answers).

How should employment status be decided if CEST delivers an undetermined result?

This is probably one of the most challenging parts of the process and most businesses will want to involve their HR departments and/or legal advisers to help make the determination. There is no single straightforward test to determine whether someone is genuinely self-employed and in its official Employment Status Manual [ESM500] HMRC lists 13 separate indicators which should be taken into account.

Even the courts themselves remain resolutely non-committal. In the case of Hall v Lorimer the Court of Appeal warned against running through the list of indicators in a mechanical fashion, checking them off to see if they are present. Instead, the Court tells us that we must ‘stand back from the detailed picture which has been painted and make an informed, considered and qualitative appreciation of the picture as a whole’. So that’s helpful…..

Fortunately, there are some indicators which are usually more important than others, such as personal service, mutuality of obligation, substitution, control and financial risk. This is especially so when these factors are combined together.  For example, the facts that an individual has to provide personal service to the business client; cannot appoint a substitute to provide that service in their place; is subject to a large degree of control by the business, and does not bear any risk of real financial loss if the work they provide is substandard, all point to an employment situation. The opposite, and especially financial risk and substitution, suggests genuine self-employment.

These changes – known as the Off-Payroll Working Rules and sometimes called IR35 – will affect all medium to large private sector companies with a UK connection from 6 April 2021.

What’s the next step once a business has made a decision about its contractor’s employment status?

The business client must give a copy of their ‘Status Determination Statement’ (SDS) to the contractor and their PSC. Sometimes the contractor’s services will be engaged via an agency. In that case the business client must give a copy of their SDS to the agency.

Is there a set format for the Status Determination Statement?  

No, there is no set format but the SDS must set out reasons for the business’ decision. Where businesses want to rely on the outcome from the CEST tool they can send a copy of the questions and answers produced during the on-line test and this will qualify as a valid SDS.

Are there any deadlines by which businesses must send their Status Determination Statements to the contractor and its PSC (or agency)?

For existing contracts, the SDS must be issued before the first payment under the contract on or after 6 April 2021. For new contracts, status should be determined before services are performed under the contract and, ideally, before the contract is signed. This is because the deemed employment status is likely to affect negotiation of the contract price.

What happens if a contractor and/or their PSC objects to their business client’s Status Determination Statement?

The business client must respond within 45 days of the objection either:

  • Confirming its original determination and giving its reasons for so doing.
  • Reversing its original decision, giving the date from which the new status determination applies and confirming that its previous SDS is withdrawn,

If an employment agency is involved in providing the contactor’s services to the business client how do the Off-Payroll Working Rules affect them?

If an agency is part of the supply chain, providing the services of the contractor who has their own PSC, to the end user business client, – and the end user client has determined that the contractor is a deemed employee – the agency assumes liability for PAYE. The agency in this case becomes ‘the fee payer’.

Once the client business and contractor have agreed the Status Determination Statement is that final, at least for the rest of the tax year?

No. Each contract with the same contractor must be reviewed separately. That is because it is possible for the contractor to be providing services to client as a deemed employee but provide different services to the same client as a genuinely independent contractor.

Will HMRC impose any penalties if we make a mistake about the employee status?

HMRC has confirmed that, during the first year, it will not impose inaccuracy penalties unless there is deliberate non-compliance. It has also reiterated its pledge not to use information under the Off-Payroll Working Rules to open IR35 investigations for earlier years.

If the contractor is to deemed to have employee status for tax purposes will that also give them employment rights and benefits?

No. The classification of a contractor as a deemed employee for tax purposes will not confer any employee rights on the individual. And the contractor’s PSC -or agency if that is the intermediary – will remain responsible for the payment of benefits such as Statutory Sick Pay, Statutory Maternity or Paternity Pay and for the operation of pensions auto-enrolment.

If contractors must lose the tax advantages they enjoyed when classified as self-employed aren’t they going object to also being denied the benefits of being a ‘real’ employee?

Yes, indeed, some contractors may do exactly that. It could prompt a lot of future litigation, especially as there are differences in the legal tests used by HMRC and the employment tribunals when determining employee status and rights. Businesses may start to receive claims from contractors they have engaged for two or more years for employee claims such as unfair dismissal or redundancy pay.

If businesses and contractors are going to be renegotiating contracts in light of the Off-Payroll Rules over the next few months or years they may wish to take legal advice about any provisions that will point to employee status, such as those involving mutuality of obligation, substitution and control.

About this article

This information is for guidance purposes only and should not be regarded as a substitute for taking legal advice. Please refer to the full General Notices on our website.

About this article

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