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Thursday, March 28th, 2019

Legal update: Employment – PAYE IR35, off-payroll working

The following update has been received from Sandy Adirondack, voluntary sector legal expert: www.sandy-a.co.uk.

To join the legal updates email list, contact legalupdate@sandy-a.co.uk.

PAYE: IR35 (off-payroll working)

If your organisation’s annual income is over £10.2 million, and/or your balance sheet total (the total value of your assets minus liabilities) is over £5.1 million, and/or the average number of employees over the year is more than 50, you need to read this. Ger yourself a cuppa (a big one) and several bikkies.

The IR35 rules (also known as intermediaries legislation or off-payroll working) currently affect public authorities, but are very likely to be extended to the private sector in April 2020. The private sector primarily consists of businesses, but also includes charities, other voluntary organisations and charity trading companies. The good news is that under proposals in a consultation from 5 March to 28 May 2019, it will not apply to businesses/organisations defined as “small”. If your organisation is below the threshold for all the three criteria in the list above (turnover, balance sheet, employees), the organisation will be small and won’t have to comply with IR35. If one or more applies, it may not be small. [For more about the proposed definition of small, see the section on IR35 and the private section: 2020, below.]

Even if your organisation is “not-small”, IR35 will affect you only if it uses self-employed/freelance contractors who have set up their own personal service companies (PSCs). Your organisation has probably been paying these contractors against their invoice, without deducting tax or national insurance. However it could, in some circumstances, find itself responsible for operating PAYE for contractors.

Personal service companies (PSCs)

personal service intermediary is a limited company or partnership set up and controlled by a self-employed/freelance contractor, who then carries out their business (provides their services personally) through the intermediary rather than as a sole trader. Most personal service intermediaries are companies, so all are generally referred to as personal service companies or PSCs.

A PSC is advantageous for the individual, because the PSC enters into contracts with clients, the clients pay the PSC as an intermediary, and the PSC then pays the individual with dividends from the company’s profits, or with a combination of salary and dividend. Dividends are taxed at a lower rate than salary or income earned from self-employment, and are not subject to national insurance (NI).

This arrangement is legitimate for people who are genuinely self-employed, with a number of clients, with choice as to whether they do or do not take work they are offered, and with some control over how they do the work. But by the late 1990s HMRC realised that some individuals operating through PSCs were carrying out what HMRC called disguised employment. The work was so much under their clients’ control that the relationship with the client was, for tax purposes, no different from an employment relationship. HMRC believed such arrangements should be taxed through PAYE, rather than enabling an individual to pay significantly less tax and NI for the same work just because they were doing it through their PSC.

IR35: 2000-2017

IR35 was brought into effect on 6 April 2000 by s.60 of the Finance Act 2000, and applied to situations where – were it not for the intermediary PSC – the individual (referred to in the legislation as the worker) would have been treated for tax purposes as the employee of their client, rather than as a self-employed contractor. IR35 sought to ensure that such workers were basically treated the same for tax purposes as they would have been if they had been directly employed by the client. Their PSC, rather than paying them through dividends, now had to pay them earnings, deducting tax and employee’s national insurance through PAYE and  paying employer’s national insurance.

IR35 only applies where the individual’s relationship with the client would have been – were it not for the PSC – treated as employment for tax purposes. IR35 does not apply to arrangements where the individual, working through their PSC, has several or many clients and meets HMRC criteria for being genuinely self-employed even if they are not working through their PSC. Nor does it apply where a self-employed person does not work through a PSC – in that case, if the relationship with the client is in effect disguised employment, the client should properly employ the individual.

Once IR35 came into effect, if the PSC had clients where the relationship could have been disguised employment, it was up to the PSC to decide whether payments to the individual had to be paid as earnings rather than dividends, with tax and NI paid through PAYE. However, this individual was usually the sole director of the PSC, or was director with a family member or members. Not surprisingly, in many (most?) cases they continued to be paid with dividends rather than receiving earnings taxed under PAYE.

IR35 and public authorities: 2017-present

Also not surprisingly, the government was not happy with this non-compliance. So since 6 April 2017, under changes brought in by s.15 of the Finance Act 2017, the PSC is no longer responsible for deciding whether an arrangement is in fact disguised employment and thus subject to PAYE. Instead, this must be done by the PSC’s client (now referred to in legislation at the engager). If the engager decides that the worker would have been – were it not for the PSC – their employee for tax purposes, the engager has to operate PAYE (including employer’s NI and apprenticeship levy) on payments to the PSC. Where an agency or other third party, such as an outsourcing company or consultancy firm, contracts with a PSC and supplies a worker to the engager, this third party, rather than the engager, has to operate PAYE.

At present, this applies only where the engager is a public authority. Public authorities include not only government departments and agencies, local authorities, NHS, police, BBC etc, but also other bodies defined as public authorities under the Freedom of Information Act 2000 or Freedom of Information (Scotland) Act 2002. The Freedom of Information Acts also include universities, some large national museums, and a small number of other charities.

The 2017 change in IR35 did not, as some people thought, create any new tax. But it shifted the burden of assessing tax status from the PSC to the public authority, and shifted the burden of administering PAYE to the public authority or third party. These changes created confusion, and led to many contractors leaving the public sector or explicitly becoming employees. (In October 2017, the Treasury reported that in the three months from April to June 2017, public authorities added 90,000 people to their payroll – most of whom had been working as contractors.)

A report by IPSE (Independent Association of Independent Professionals and the Self-Employed) and CIPD (Chartered Institute of Personnel and Development) in June 2018 found 51% of public sector hiring managers thought they had lost skilled contractors because of the IR35 changes, 71% were facing challenges in retaining their contractors, and the workload of 80% had an increased because of engaging and paying contractors. IPSE’s chief executive said the changes had caused serious damage to the public sector, including stalling major Transport for London projects and contributing to the NHS staffing crisis. Such complaints and concerns have continued.

Check employment status for tax (CEST) service

Prior to the 2017 change, HMRC had an online employment status indicator, renamed the employment status service, to help employers assess whether an individual was, for tax purposes, an employee or self-employed. This was adapted in 2017 to become the check employment status for tax (CEST) online service. Like the ESI/ESS this can be used by a worker providing a service, a person or organisation hiring a worker, or an agency or other body that is placing a worker. It is not directly related to IR35 or personal service companies, but was revised to assist public authorities’ compliance with their new IR35 responsibilities.

CEST is anonymous and does not store any information provided or the result given. If the information provided is accurate, HMRC will stand by the result – but in order to have a record of the result, it is essential for the enquirer to print out the result after going through the online questions.

CEST has been heavily criticised as inconsistent and unable to determine IR35 status much of the time, with the questions open to differing interpretations. Significantly, when used by the engager, there is no input from the worker, who may be more aware of how the relationship operates in practice than the HR person or manager who is replying to the questions. A consistent complaint is that CEST seems to veer towards a worker being an employee and therefore the engager having to operate PAYE for them. 

Never one to resist a challenge, I went through CEST myself. I have been self-employed since 1980, and have worked for hundreds of clients as a trainer, consultant, author, editor and more. I am not expert in tax or employment law, but know that for both I would be treated as self-employed rather than employed, whether working as a sole trader (as I do) or if I had set up a PSC. So I imagined a realistic piece of work – a series of training days, once a month for six months, for an organisation – and went through CEST.

CEST questions are tailored depending on responses. Despite saying I would be doing the work as a sole trader, would introduce myself as a freelance when interacting with participants and would be paid a fixed price for a specific piece of work, I was asked nothing about the nature of the work, the duration or how many hours per week/month. In response to the questions I was asked, I said I would work both at venues of the client’s choice and at home; would be able to change work content by agreement with the client; would be able to provide a substitute who could be rejected by the client for any reason; would not receive sick pay, holiday pay, pension or any other benefits; and if the work was unsatisfactory, would have to put it right without charging anything to the client. To me, it screams self-employment.

The result? “This engagement should be classed as employed for tax purposes. The answers you have given tell us that the worker is directly engaged, and the working practices of this engagement means that they are employed for tax purposes. If you are the worker you should tell your engager to operate PAYE for you. If you are the engager you need to operate PAYE for this worker.”  WHAT??????

HMRC is aware of the criticisms of CEST and has said it will make “enhancements” to make it more suitable to the private sector – to which IR35 is likely to be extended next year.

IR35 and the private sector: April 2020?

When the 2017 changes were introduced, the government said it did not intend “at present” to extend IR35 to the private sector. But by autumn 2017 they were talking about it, and by early 2018 there were hints it might happen in April 2019. But following a consultation from May to August 2018, it was announced in the government’s October 2018 budget that IR35 would apply to the private sector from April 2020, and would not apply to “small” businesses and organisations.

A further consultation is taking place from 5 March to 28 May 2019 [details under Resources, below]. The consultation uses the term “client”, rather than engager, for private sector businesses and organisations. There are two proposed definitions of “small” clients. The first is for corporate (incorporated) clients, which would include companies (whether charitable or not), charitable incorporated organisations (CIOs), community benefit societies, and some other bodies. The second is for non-corporate clients, which in the voluntary sector would include unincorporated associations and charitable trusts.

For corporate clients, it is proposed that small is defined as in the Companies Act, with the client satisfying at least two of the following conditions for a tax year:

  • annual turnover not more than £10.2 million;
  • balance sheet total not more than £5.1 million;
  • number of employees not more than 50 average during the year.

So a corporate client is not small and will have to comply with IR35 if it has at least two of turnover more than £10.2m, balance sheet more than £5m, and/or more than 50 employees.

For non-corporate clients, there are two proposed definitions. 

Option 1 is that the client is small and exempt from IR35 if at least one of the following conditions apply:

  • annual turnover not more than £10.2 million;
  • number of employees not more than 50.

So under this option, an unincorporated organisation is not small and will have to comply with IR35 if it has turnover more than £10m and/or  more than 50 employees.

Option 2 is that the client is small and exempt from IR35 if neither of the above conditions apply.

For corporate clients, it is proposed that small is defined as in the Companies Act, with the client satisfying any two of the following conditions for a tax year:

  • annual turnover not more than £10.2 million;
  • balance sheet total not more than £5.1 million;
  • number of employees not more than 50 average during the year.

So a corporate client is not small and will have to comply with IR35 if it has two or all three of turnover more than £10.2m, balance sheet more than £5m, and/or more than 50 employees.

For non-corporate clients, there are two proposed definitions. 

Option 1 is that the client is small and exempt from IR35 if one or both of the following conditions apply:

  • annual turnover not more than £10.2 million;
  • number of employees not more than 50.

So under this option, an unincorporated organisation is not small and will have to comply with IR35 if it has turnover more than £10m and/or  more than 50 employees.

Option 2 is that the client is small and exempt from IR35 if neither of the above conditions apply.

So under this option, the client is not small and will have to comply with IR35 if it has turnover more than £10.2m and more than 50 employees.

For non-corporate organisations that may be affected, this part of the consultation may be of most concern. Other consultation issues cover information requirements; making the correct determination of employment status; and matters to do with tax treatment and how IR35 affects other legislation.

If an organisation is small and IR35 does not apply, the PSC will continue to be responsible, as it is now, for determining whether the arrangement with the client is in effect employment and if so, to operate PAYE.

The government has said that the extension of IR35 to the private sector is not retrospective, and “HMRC will not carry out targeted campaigns into previous years when individuals start paying employment taxes under IR35 for the first time following the reform.”

Preparing for 2020

For organisations which may be affected by the extension of IR35 to the private sector, here is a compilation of recommended actions from various sources. I am not acknowledging sources because there are too many.

  • Respond to the consultation.
  • Audit your existing workforce to establish how reliant you are on workers supplied via PSCs, either directly or via a third party such as an agency, outsourcing company or consultancy firm – as opposed to directly engaged self-employed contractors.
  • Consider any future plans which might affect this number.
  • Provide internal education about IR35 and its implications.
  • Establish a process to help staff determine contractors’ employment status and whether IR35 applies. Ensure they understand the importance of printing out and keeping CEST results, in case HMRC challenges a decision that the contractor is not subject to IR35.
  • If the numbers of contractors are large, use CEST to assess a representative sample to determine whether you believe that the new rules will apply and require you to operate PAYE. If the numbers are small enough, assess all of them.
  • Consider, in light of the assessments, the fundamental question of whether to continue engaging PSCs as before (reviewing on a case-by-case basis whether tax and NICs will be payable) or to more fundamentally redesign your non-employed workforce.
  • Implement strategies, for example the development of relevant internal processes, and appointment of dedicated teams to deal with employment status issues and the increased administration around these.
  • Redesigning the workforce could involve identifying adjustments to working practices that would result in contractors genuinely falling outside IR35.
  • For contractors falling within IR35, consider whether the contractors are business critical and if so, budget for the extra costs. For contractors who are not business critical, consider whether to renegotiate or terminate contracts.
  • Consider replacing positions currently filled by contractors with employees, possibly on a fixed term basis. This would bring certainty around tax status and employment rights, but would incur additional costs, for example in relation to paid holiday, pension contributions and benefits as well as increased statutory employment protection. This might also affect an organisation’s ability to attract the relevant specialist skills and flexibility that the contractor population can provide.
  • Ensure that when new contractors are appointed – whether as individuals or through their PSC – the work is structured in a way that is genuinely self-employment rather than equivalent to employment, so is not within IR35. Or if it is equivalent to employment, ensure the contract is compliant with IR35.
  • Identify and review contracts with PSCs (or with agencies or other third parties which supply workers through the workers’ PSCs). Where the contract will still be in place in April 2020 and IR35 is likely to apply, consider who will bear the additional costs.
  • Ensure there is a properly drafted contract for each engagement which reflects the working arrangements and IR35 decision, gives the fee payer (the client, or the agency or other third party) the right to deduct PAYE and employee’s national insurance, and includes indemnities and warranties.
  • Develop a consistent communication plan for current and future arrangements with contractors.
  • Put in place joined-up procurement, HR, management, accounts payable and PAYE systems and procedures for the changes.
  • Consider using third party contractors to provide PSC workers who are subject to PAYE, so they are responsible for operating PAYE.
  • Consider whether contractors to whom IR35 apply might challenge your determination of their employment status – or, if they accept that they are an employee for tax purposes, consider whether they might decide to claim employment rights.
  • Put in place procedures for regularly monitoring contractors IR35′ status. Even if their work is not currently disguised employment, it could change into this if the nature of the work or the relationship with your organisation changes.

Footnote: Employment status for tax versus employment status for employment rights

It is important to understand that tax law definitions of employment status overlap with, but are different from, definitions for the purposes of employment rights such as anti-discrimination, sickness and parental pay, redundancy rights, unfair dismissal rights etc.

Tax law has two basic categories: employees and self-employed. Employees are taxed through PAYE. Self-employed individuals are taxed through self-assessment.

Employment law has three basic categories: employees, workers and self-employed. Employees are entitled to all employment rights (subject to any requirements such as length of service). Workers such as casuals are entitled to anti-discrimination protection and some employment rights, including national minimum wage and working time rights (holiday pay, rest breaks), but not most other employment rights. Self-employed people are protected by anti-discrimination legislation but have no rights under employment law.

The same individual, doing the same work with the same arrangements for the same organisation, could be in one category for tax purposes, and another for the purpose of employment rights. IR35 may require an engager to operate PAYE and treat someone as an employee for tax purposes, but this does not mean that the person meets the employment law criteria for being an employee of the engager and qualifying for the full range of employment rights. 

Resources