HM Revenue & Customs has confirmed that the IR35 employment tax changes, which had been postponed due to the coronavirus crisis, are set to take effect from April 2021. On this date IR35, the UK tax law applicable to the engagement of contractors through a personal service company or other intermediary, will expand significantly.
The impact will be seismic for those who are affected. It will be the biggest disruptor we have seen within UK private sector contracting for 20 years.
If you hold a leadership role in finance or HR within any business which engages independent contractors from time to time and has an annual turnover in excess of £10m and a workforce of 50 or more employees- which obviously includes many in the construction sector- you need to take note.
What is IR35 all about?
In law, a contract of employment can only exist if there is a direct contractual relationship between the employer and the employee.
So, if an individual is engaged to supply their services through some other intermediary (such as a private limited company from which they take a small salary plus dividends) and the intermediary (not the individual) has the contract with the end user client, this will not be an employment relationship in the legal sense. Such devices obviously give rise to opportunity to disguise true employment and avoid employment tax and other employment obligations.
IR35 is the common name given to the legislation that became law in 1999 which had the aim of reducing large-scale tax avoidance when engaging people to work through a limited company or other intermediary in circumstances where they might otherwise be regarded as employees or workers under our domestic employment laws. The problem with the old law is that HMRC’s enforcement powers were for the most part limited to enforcement against the personal service company or intermediary. That was often a shell company with little or no assets, so enforcement was often seen as fruitless exercise. Pre-April 2021, end user clients of contractors have no responsibility to operate a payroll or to pay income tax or national insurance contributions for the contractors they engage in that way.
What is changing?
By April 2021, end user clients of independent contractors must do something they have not been legally been required to do before: undertake detailed assessments to determine whether each contractor is caught by IR35 and so, in turn, should be taxed as if they were an employee. Given the complex legal tests that need to be applied in order to get those assessments right, for which an understanding of past case law is a must, this will not be a straightforward exercise and end users would benefit from taking specialist legal and tax advice.
If, following any particular assessment, the end user considers that IR35 does apply to a particular contractor relationship, the end user will have the obligation to notify the intermediary and, if the engagement continues, operate PAYE; taxing the payments to the intermediary as if it were income from employment.
Where contractors are engaged by the client via some other additional third party, such as an agency, the client could pass the PAYE obligation to them.
The new laws will also provide a time limited dispute resolution process for affected parties to follow, on which it is likely that further advice may be needed.
What are the risks?
The costs of getting it wrong can be severe with penalties as high as 100% of the income tax and NIC that has been avoided.
A “one size fits all” audit process will not be possible because the relevant legal tests to be applied by the end user client when making its assessment necessitates an examination of each individual contractor relationship. This will not simply involve an analysis of the black and white contractual terms but a much closer examination of the way that relationship operates in practice. The challenge is to determine what the terms of a hypothetical contract between the individual contractor and end user client would be and ask whether the circumstances are such that under that contract the individual would be the end user’s employee or a worker for the purpose of s 230 of the Employment Rights Act 1996.
The elephant in the room
For many years, contracting has been a comparatively safe, low risk and low-cost method of engaging services from individuals. Providing, at least in theory, greater flexibility for all parties: including greater freedom to end or change the contract, no obligations for holiday pay, sick pay, pension contributions and no risks of redundancy or unfair dismissal rights accruing to the individual doing the work.
In the world of construction companies, it is not at all uncommon for contractors to work exclusively within their clients’ businesses for significant periods of time. One successful project leads seamlessly to another…. and another. Before you know it, it feels to everyone involved like the contractor is part of (or at least an extension of) the client’s workforce. They will often have access to the same or broadly similar facilities and working arrangements as the client’s employees but they believe / hope that the contractor can be let go on short notice without any significant risks: the elephant in the room.
Soon, the legal reality will be very different for cases such as these. With each week that passes the elephant in the room - the risk of deemed employment and of all the associated rights and liabilities that will go hand in hand with employment - gets bigger and bigger.
But what if, as a result of your preparations for April 2021, you reach the inescapable conclusion that your long-term contractor is in fact caught by IR35 and should be taxed as an employee? What if you reach that conclusion based on the way the relationship has consistently operated for months or even years? How will they react?
Taking a step back from tax law and a step into employment law, we see a significant risk of retaliatory claims on the horizon. In laymen’s terms, if you tell a contractor they should be taxed as an employee, won’t they eventually ask, “Where’s my holiday pay ?”, “Where’s my pension contributions ?” and “Where’s my sick pay ??”…….Just how big will the elephant become?
Whatever you take from this article, make sure you plan for April 2021 well in advance. Make sure your business develops effective strategies to manage the conjoined employment and tax questions risks before addressing the IR35 elephants in your room.