During the 2018 Autumn Budget, Philip Hammond announced that the IR35 rules will be extended to large and medium-sized businesses from 6 April 2020. The question which arises for the uninitiated is, what are the IR35 rules, and how might they impact my business?
The off-payroll working rules, IR35 (named after a press release by the Inland Revenue, as HMRC was then known) and often referred to as the 'intermediaries' legislation', was anti-avoidance legislation introduced in 2000 which was designed to stop 'disguised' or 'false' self-employment.
The objective was to ensure that someone working like an employee, but through a company, paid similar taxes to other 'real' employees. IR35 is specifically targeted at individuals who cease employment on a Friday and then provide their services to a client through a limited company (often referred to as a personal services company) on the Monday.
Limited company contractors
The benefits of being a limited company contractor lie in the taxation system. If you are a full-time employee the way you are taxed is quite rigid and is handled by your employer through the PAYE system. By contrast, if you are the director of a limited company you have more flexibility in the way you extract profits from the business. The differences in the way that profits are taxed compared to how employment income is taxed means that it is more tax efficient to be outside of the IR35 regime. By contrast, being inside IR35 would reduce a limited company contractor's take-home pay by about 20% to 25%.
Ever since it was created the IR35 legislation has been criticised as unworkable and HMRC has has been reluctant to reveal how much tax revenue IR35 has generated. Current estimates put the non-compliance cost to the Treasury at over £400m every year.
The IR35 hokey cokey
Part of the problem for determining whether someone is inside or outside of IR35 is that HMRC has to prove that the relationship between the contractor and the end-client is, at the end of the day, an employer-employee relationship. This means that case law and the various associated employment/self-employment tests (control, financial risk, personal service, mutuality of obligation and the provision of equipment etc.) must be applied to determine the correct relationship. There is no statutory definition of self-employment.
Unfortunately the tests are complex and subjective, making it difficult for HMRC to enforce them.Ultimately, it is difficult for contractors to know with any certainty whether the IR35 rules actually apply to them in the first place.
In short, at the moment, it is up to the limited company contractor to determine whether they are inside or outside of IR35 and given the difficulties of adequately demonstrating that the nexus is that of employer-employee, it is fair to say that most contractual relationships sit outside of IR35.
IR35 and the public sector
Undeterred, HMRC continues to believe that there is revenue to be raised from better IR35 enforcement and it estimates that only about 10% of limited company contractors that should apply the IR35 rules actually do so. The solution which HMRC developed was simply to shift the responsibility for IR35 compliance.
Since April 2017 and for the public sector only, whilst the underlying IR35 rules did not change, the responsibility for determining whether a limited company contractor was inside or outside of IR35 rules shifted from the contractor to the public sector end-client. So if a public body such as a school, hospital, police force or a local authority decides that IR35 does indeed apply to a locum doctor, supply teacher or IT contractor who provides their services through a limited company, payments to the limited company of that doctor, teacher, IT contractor, are taxed at source exactly as if they were an employee.
IR35 and the private sector
Published in May 2018, HMRC issued a consultation document, Off-payroll working in the private sector, with suggestions to further improve IR35 compliance.
Despite the different compliance suggestions made in the consultation the overwhelming impression is that HMRC sees the public sector IR35 rules as a dress rehearsal for the main event _ namely, doing the same in the private sector - meaning of course that when implemented it will be the private sector company (not the limited company contractor) that will be responsible for determining whether IR35 applies when it engages that contractor and indeed throughout the term of the contract. And if it does apply, the private sector company will be responsible for applying PAYE and NICs (both employee AND employer).
Shifting the compliance responsibility to the private sector company is a big change from how things are currently done.
Given the very high standards which certain parts of the private sector are subject to _ for example, the Code of Practice on Taxation for Banks _ establishing an effective IR35 internal policy will be crucial.
Getting ready for the big shift
From 6 April 2020, IR35 changes affecting the private sector will be extended to large and medium sized businesses, which have yet to be defined. While sixteen months may seem like a long time to get ready for these changes coming into effect, early planning is crucial.
Based on our experience of advising public sector bodies when the public sector IR35 reforms came into effect, we cannot overstate enough how much of a shock it will be for private sector clients and contractors alike to get to grips with equivalent IR35 reform in the private sector.
So given the public sector experience, what tips and advice can we pass on now?
Prepare in advance
The Government did not leave much time for the public sector to get grips with the new IR35 reforms. Spurred on by the tax liability risk many public sector bodies panicked, making rushed and blanket decisions about both the contractors they were engaging and the type of service requirement they were addressing. The decision not to bring IR35 into force for the private sector until 2020 is to be welcomed, but should not be an excuse for complacency.
To avoid making rushed decisions, start to think about formulating an internal IR35 policy. What are the IR35 risks (e.g. tax risk, risk of increased contractor rates, reputational risks, the legal risks of a successful challenge by HMRC, the flight risk of contractors preferring to work elsewhere if inside IR35) of engaging limited company contractors? How will you determine whether or not IR35 applies to your contractors? What tools will you use (including any made available by HMRC, such as the 'Check employment status for tax (CEST)') to determine this? How reliable would the result be?
Questions have arisen in the public sector over the actual mechanism for deducting tax, emphasising the need to develop a clear and coherent approach to IR35 based on professional advice, for both the public and private sectors.
Teams work
Once you have your IR35 policy, who is best placed to implement it? Hiring teams will need to know what the IR35 parameters are. Workers applying for new roles will need to understand the implications in advance as will employment agencies. Procurement and legal teams may want or need to change existing or standard contracts (see below). Payroll may need to deduct the correct amount of PAYE in real time and the finance function may wish to model the cost implications of taking additional workers onto the payroll.
Certainly what we observed when working with our public sector clients was just how disparate the internal practices and policies of contractor engagement were, making it very difficult for any one team to own the overall IR35 policy. All teams need to cooperate and come together to determine what IR35 best practice looks like for that organisation. Moreover, and quite separate from identifying any real or potential IR35 compliance failures, it is surprising how many organisations discover there are cost savings to be made from having a consistent hiring practice.
It's the contract stupid
In large part, determining IR35 status requires an analysis of the contractual terms of the engagement. Furthermore, the contractor's actual working practices should mirror as much as possible those contractual terms. A mistake often made is to approach the contract as if it were an employment contract but with 'refinements' to reflect the contractor engagement. This is a bad idea. HMRC place a lot of significance on the length of a particular engagement not the length of each contract. It is important that the details of the services being provided are properly set out and not referred to in generalised terms.
In raising any IR35 challenge HMRC would seek to impose a hypothetical contract between the contractor and the client. It then asks the question whether this deemed contract gives rise to an employer-employee relationship. To head-off any such challenge, to be outside of IR35, both the contract and the actual arrangements between the parties should contain as many attributes providing strong indications of self-employment (of a business-to-business arrangement) as possible.
Tax lawyers are ideally placed to get the balance right.
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