The introduction of IR35 for the private sector took effect from
April 2021 and represented the biggest change to employment tax for
decades.
Before then, businesses in the private sector were able to
engage contractors using personal services companies (or other
intermediaries) without having to give too much thought to the
contractor’s employment status for tax purposes. This changed
for “medium and large”-sized private-sector businesses in
April 2021 when the responsibility for determining a
contractor’s status and, if appropriate, operating PAYE and
National Insurance contributions (“NICs”) switched from
the personal services company to the end-user business.
Inside
Which end users does this affect?
Which contractors does this affect?
How to carry out the status determination
The dispute resolution process
Consequences if the status assessment is incorrect
Processes and documentation
What is IR35?
IR35 is a tax anti-avoidance rule designed to combat
“disguised employment” in situations where an individual
contractor is providing their personal services (i.e., their
labour) to an end-user via their own intermediary, such as a
personal services company or partnership (referred to collectively
as “PSC” in this Inbrief).
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.
Since April 2021, for large and medium-sized private-sector
businesses, responsibility for assessing whether IR35 applies has
been with the end-user. If the end-user determines that IR35
applies, the responsibility for operating PAYE and NICs will move
from the PSC to the “fee payer” – that is,
generally, the entity which contracts directly with and pays the
PSC.
Overview of the process
The end-user is required to assess whether the contractor is
employed or self-employed for tax purposes. It must take reasonable
care in making that assessment and confirm its assessment together
with reasons in a Status Determination Statement
(“SDS”).
The end-user must provide the SDS to the next party in the
contractual chain before making the first payment. This is next
party will be the contractor themselves, unless there is another
party in the chain such as an agency. If there is an agency in the
chain (see below), the SDS must be provided to the agency, who must
then pass the SDS down the chain in turn. In practice, contractors
accepting a new assignment are likely to want to know in advance
whether they will be assessed as within the scope of IR35.
The end-user is required to have a dispute resolution procedure
to enable the contractor to challenge the assessment. In practice,
a contractor is unlikely to challenge an SDS which assesses them as
falling outside the scope of IR35. HMRC may review the assessment,
however, so it is important that the SDS sets out in sufficient
detail the basis on which the decision is made, showing that
reasonable care has been taken.
If the assessment concludes that the contractor is out of scope
of IR35, the PSC can continue to be paid gross. If, however, the
contractor is assessed as within IR35, the fee payer (which is the
last party in the contractual chain before the PSC) is responsible
for operating PAYE and deducting employee NICs on the fees it pays
to the PSC (excluding VAT). The fee payer must also pay employer
NICs and, where applicable, the apprenticeship levy.
If there is a UK agency in the chain
If there is a UK agency in the chain which supplies the
contractor via a PSC, the agency is the “fee payer”
because it is the party that contracts with and pays the PSC. As
the fee payer, the agency will have the obligation to operate
PAYE/NICs and pay employer NICs and, where applicable, the
apprenticeship levy.
However, the end-user retains responsibility for issuing an SDS
and providing a dispute resolution procedure. It must provide the
SDS to the agency as well as the contractor and the agency must
also be allowed to appeal against the assessment.
The obligation to operate PAYE/NICs remains with the end user if
it does not meet its responsibilities, e.g., if it fails to provide
an SDS before the first payment is made. In addition, HMRC has
power to transfer PAYE/NICs liability from the agency to the
end-user if there is no realistic prospect of recovery from the
agency within a reasonable period. HMRC has confirmed in its
guidance that it will generally not exercise this power if the
failure to account for the PAYE//NICs is due to a genuine
commercial business failure.
There are more complex rules for offshore agencies. If in doubt,
please contact us for advice.
What is the wider impact of IR35?
IR35 is a tax rule. Crucially, it does not change the
contractor’s status for employment law purposes.
It is still legitimate for contractors to use PSCs – it is not
tax evasion to do so. End-users and fee payers should bear in mind
their obligation under the Criminal Finances Act 2017 to have
reasonable procedures in place to prevent tax evasion and the
facilitation of tax evasion by their employees and contractors
while performing services for or on behalf of the end-user. If in
doubt, please contact us for advice.
Which end users are affected?
Subject to anti-avoidance provisions, “small”
private-sector end-users are exempt from the new rules and are not
required to determine whether IR35 applies. Instead, the old rules
continue to apply – the contractor/PSC remains responsible for
determining whether IR35 applies and the fee payer can still pay
the PSC 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:
annual turnover of more than £10.2 million
balance sheet total of more than £5.1 million
If two of these conditions are 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.
These thresholds increase from April 2026, with the annual
turnover limit increasing to £15 million, and the balance
sheet total limit increasing to £7.5 million, though it is
worth nothing that because of the two year “look back”
period, these new thresholds will not have practical application
until April 2027 at the earliest.
Where the small company is part of a larger group of companies, the
group turnover and revenue will need to be considered – please
contact us for advice.
Where the small company is part of a larger group of companies,
the group turnover and revenue will need to be considered – please
contact us for advice.
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 not
more than £10.2 million.
In addition, IR35 does not apply to end-users who are based
wholly overseas. In this situation, the PSC will still be paid
gross and it will be for the contractor/PSC to determine whether
IR35 applies and, if so, to operate PAYE/NICs. An end user is based
wholly overseas if immediately prior to the start of the relevant
tax year it was not resident in the UK and did not have a permanent
establishment in the UK.
Which contractors are affected?
IR35 affects 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 (e.g., as
a sole trader, though in such cases end-users are generally
required to make employment status assessments under general
principles).
Contractors who are not tax resident in the UK and who are
supplying their services exclusively outside the UK are unaffected.
If they supply some services within the UK, the rules are more
complex and you should contact us for advice.
IR35 is focused on the provision of labour rather than services.
Fully outsourced services are therefore out of scope. For example,
if a company fully outsources its IT helpdesk or catering services
to a third party, it does not need to determine whether IR35
applies to any contractors working for that third-party service
provider. Businesses who provide managed services rather than staff
should be seeking to educate their customers about the fact that
IR35 does not apply to them at all.
How to carry out the status determination
The law requires end-users to exercise “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 several 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/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/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 the contractor’s time? Have
they previously worked for the company? What is the intention of
the parties?
The SDS will only be valid if it includes the reasons for the
determination.
The status determination assessment needs to be repeated if the
contractor’s assignment continues for any significant period of
time (we think at least every 12 months, although there is no
guidance on this) or if the circumstances change.
HMRC’s CEST tool
HMRC’s Check Employment Status for Tax
(“CEST”) tool is designed to assess whether a contractor
would be an employee for tax purposes if they were hired
directly.
The CEST tool has been revised a number of times but it still
has flaws. Specifically, it still fails to test whether there is
sufficient “mutuality of obligation” in the relationship
between the end-user and contractor – one of the necessary
conditions of employment (HMRC’s view is that it is invariably
present). The CEST tool also fails to produce any result in a
significant number of cases.
The end-user is not obliged to use the CEST tool, but it
highlights the main issues that HMRC are concerned about when
considering status for tax purposes. It also has the advantage
that, so long as the end-user enters the information correctly and
keeps it up to date, HMRC is bound by the result. Note, however,
that the end-user must take responsibility for using the tool. A
CEST assessment that is carried out by the contractor personally is
not binding on HMRC.
Given this, we consider that it is sensible to make the CEST
tool the starting point in most cases. However, end-users still
bear responsibility for making a status determination, even when
the CEST tool produces no answer. Businesses therefore need an
additional way to make such determinations in at least some
cases.
Large businesses which are subject to the Uncertain Tax
Treatments (“UTT”) rules may also need to think carefully
before using CEST, particularly if the CEST tool is being used to
determine the status of a number of contractors operating under the
same terms and in broadly the same manner. The UTT rules require
such business to notify HMRC if: (i) the business has interpreted
the law in a way which is different from HMRC’s “known
position”; and (ii) the tax/NICs advantage as a result of the
businesses interpretation is expected to be more than £5m in
a 12 month period. HMRC has made it clear in UTT guidance that CEST
tool outputs indicating that a contractor is within or outside IR35
constitute HMRC’s “known position”.
The dispute resolution process
When the IR35 changes were first discussed, there were calls for
HMRC to provide a procedure for verifying decisions. Instead,
however, it is the end-user’s responsibility to provide a
process for resolving disputes.
If a contractor or the fee payer considers that the
end-user’s IR35 decision is incorrect, they may make
representations before the final payment under the arrangement is
made. The end-user then has 45 days to review the representations
and either:
inform the contractor (and any agency with which the end-user
contracts) that their initial SDS was correct; or
issue a new SDS, withdrawing the previous one.
The end-user must provide reasons for its decision but cannot be
compelled by a contractor or agency to change it.
Consequences if the status assessment is incorrect
If HMRC disagree with an end user’s determination that a
contractor falls outside IR35, HMRC will seek arrears of PAYE,
employee and employer NICs and apprenticeship levy (if applicable)
together with interest and potentially penalties from the deemed
employer The deemed employer is generally the fee payer unless the
end user has failed in any of its IR35 obligations, in which case
the end user will be the deemed employer even if there is a UK
agency in the chain.
In calculating the deemed employer’s liability for PAYE/NICs
arrears, if certain conditions are satisfied, HMRC will offset: (i)
any corporation tax paid by the PSC on its fees from the relevant
engagement; (ii) any income tax paid by the contractor on their
employment earnings or dividend income from the PSC in relation to
the relevant engagement; and (iii) any employee NICs paid by the
contractor on their employment earnings from the PSC in relation to
the relevant engagement. Under the offset mechanism, there is no
offset of employer NICs (or apprenticeship levy if any) paid by the
PSC, so the PSC should continue to apply for a refund of these
amounts.
Cost impact of IR35
If IR35 applies, the fee payer needs to deduct PAYE and employee
NICs 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
given the marginal employment tax rates as compared with
alternative arrangements under the PSC (e.g., extracting profits as
dividends).
On top of this, if IR35 applies, the fee payer needs to pay
employer NICs and apprenticeship levy costs on the fees paid to the
PSC. This means an additional cost of as much as 15.54%, which
cannot be passed on to the PSC. It may be possible, however -
depending on the contractual terms – to enter into in a new
contract with the PSC under which the fees are renegotiated to
ensure the net costs do not increase.
If the end-user uses an agency to engage the contractor, the
agency will be responsible for operating PAYE/NICS and the
apprenticeship levy, although it is likely to seek to negotiate
reimbursement from the end-user.
Processes and documentation
The end-user needs to have robust processes and controls for
identifying and recording the use of contractors, including those
supplied via an agency. It will also need clear and
well-communicated policies for hiring contractors which ensure that
appropriate authority is given before they are appointed. In
addition, the end-user should have a clear and consistent
methodology for making status determinations, especially in
situations where the CEST tool does not produce a result. The end
user will need to ensure that its SDS sets out the reasons for the
determination. Where the CEST tool has provided a result, attaching
the output to the SDS will be sufficient to provide the required
reasons.
Contracts with PSCs should reflect the IR35 reforms. For
example:
The terms of the contract with the PSC should not contradict
the basis of the status assessment made by the end-user (e.g., 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.
The contract should include clear tax warranties and
indemnities.
If the end-user is also the “fee payer” (i.e., there
is no UK agency or other relevant intermediary in the contractual
claim), it will also need to adapt its payroll and accounts payable
systems for IR35 compliance. For contractors in scope of IR35, the
payroll system will need to add the contractor to the system and
operate PAYE/NICs on the fees excluding VAT, while the accounts
payable system will need to pay the PSC the fees net of income tax
and employee NICs plus VAT on the gross fees. The system also needs
to 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 IR35 position:
Will the agency be precluded from supplying individuals via
PSCs, or will they just have to notify the end-user in advance if
they do 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 SDS.
The end-user will need to communicate the outcome of the status
assessment to the agency and should always make sure they do so in
writing.
Agencies will need to pass the statement to the entity with
which they are contracting.
The terms and conditions of any businesses supplying staff or
managed services should contain IR35 compliant terms. Different
wording will be needed depending on whether the business is
supplying staff or managed services. Some firms run various
business models including secondment of staff, supply of staff to
clients and/or managed services while using very similar or even
identical terms and conditions. It is advisable for such businesses
to delineate their business models, create separate terms for each
model and train those who use them on when to use which terms.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.