In a surprise announcement, the Government has delayed introduction of the planned IR35 reform by one year because of the COVID-19 pandemic. This means that freelancers will continue to define their IR35 status when working in the private sector until the reform is implemented.
Chancellor Rishi Sunak had confirmed in his first budget that the Government would press ahead with the planned changes to the off-payroll rules (often referred to as ‘IR35’) in April 2020. The latest move, sensible under the circumstances, gives both clients and contractors more time to prepare for the reform.
The new rules are now expected to come into effect in April 2021 and only apply to services carried out from that date. From that point, medium and large organisations in all sectors of the economy will become responsible for assessing the employment status of individuals who work for them through their own limited company.
The reform does not introduce a new tax or apply to genuinely self-employed workers, who are outside the scope of the existing rules.
The changes are designed to reduce the tax avoidance generated by “disguised employment”, where individuals are effectively working like employees, but define themselves as self-employed contractors to reduce their tax liability.
This is a complex field. But stay with us. Contrary to some reports, it’s not all bad news. And you now have additional time to review the impact of the reform on your business.
What are the IR35 rules?
Let’s start with a quick bit of history. The IR35 rules were first introduced by HMRC in 2000. They apply to:
- A worker (often described as a contractor) who provides their services to a client through their intermediary, usually the worker’s personal service company (PSC).
- A client who receives services from a worker through their intermediary.
- An agency providing workers’ services through their intermediary.
In effect, where IR35 applies, it deems there to be a hypothetical contract between a worker and their client even though the worker uses a PSC to contract with their client. Tax and National Insurance contributions must then be deducted from the fees paid to the worker and paid to HMRC.
The rules are designed to tackle tax avoidance and ensure that a worker acting in a similar way to a direct employee of the client, an employee in all but name, pays broadly the same tax and National Insurance contributions as employees. Rather than taking advantage of the lower tax rates applied to companies and avoid national insurance altogether.
Originally, it was up to individuals to assess whether they came within the scope of IR35. But HMRC concluded that the growing number of PSCs was leading to abuse of the system as they considered PSCs could not be relied upon to operate the IR35 rules objectively. In April 2017 the rules were amended to require all public sector clients to identify “disguised employment” situations and decide whether their contractors fall under IR35.
The rules have met with opposition from business groups and professional bodies but HMRC estimates that the cost of non-compliance to the Exchequer will reach £1.3 billion a year by 2023/24.
The planned changes to IR35 will extend the public sector client responsibilities to medium and large firms in the private sector, who then become responsible for determining whether the freelancer should be regarded as a “disguised employee” and therefore deemed for tax purposes to be an employee.
If the client determines that IR35 does not apply, then the client will pay the gross amount of the agreed fee to the PSC. But if it determines that IR35 does apply, the client must apply PAYE and NI and pay the net amount to the PSC.
Helpfully, where private sector clients are defined as “small” entities, they do not have to take responsibility for determining a freelancer’s employment status. And – regardless of whether the client is also the fee payer – neither the client nor fee payer need operate PAYE.
HMRC rules define both a corporate and non-corporate client as “small” if it meets at least two of the following tests:
- Its annual turnover is less than £10.2 million.
- Its balance sheet total is less than £5.1 million.
- The number of its employees is less than an average of 50 in the year.
From April 2021, medium and large private sector clients (in line with public sector clients) will be obliged to inform both the entity they contract with and the freelancer or PSC of their decision (a “Status Determination Statement” (SDS)) and the client’s reasons for it. Importantly, determinations must be made on a case-by-case, not a blanket, basis.
The amended IR35 rules require all intermediary recipients of the SDS (i.e. those in the chain other than the client and the freelancer or PSC) to pass the SDS and the reasons for it on to the person with whom they contract.
The amended IR35 rules for the private sector include provision for a PSC to challenge a decision that the freelancer falls within IR35, along with a mechanism for resolving such disputes (a “Status Disagreement Process”).
Where a party is initially liable to determine status and does not do so, or does so without reasonable care (i.e. it does not take independent legal advice and determine status on an individual basis), or if it does not fulfil any other IR35 obligation, it will be made liable for tax and National Insurance, even if it is not the fee payer. Where a party is liable for tax and NI but if it cannot be collected from that party, the rules have the effect of moving liability to the next entity in the labour supply chain.
How does HMRC determine the application of IR35?
The test of whether a contractor is an employee or a freelancer will vary, depending on the nature of the contract, the type of the project and practical working arrangements. HMRC takes a holistic view of this. But the key factors determining a decision include:
- Whether a “mutuality of obligations” exists, i.e. the employer is obliged to provide work and the worker is then obliged to undertake that work.
- Whether the client has a significant degree of control over how, when and where the contractor carries out the work?
- Whether the worker has to carry out the work personally, rather than being able to supply a substitute?
There are a range of other provisions, covering factors such as the availability of paid leave, pension arrangements and a requirement to work at that business’s premises.
Answering ‘yes’ to a significant proportion of these questions will indicate that a quasi-employment relationship exists and trigger the application of IR35.
By contrast, the arrangement will be considered self-employment if a set of defined factors are met, including a contract for services (not a contract of employment), there is no “mutuality of obligations”, the contractor is in business for her/himself (and is responsible for the success or failure of the business) and is permitted to work for more than one client.
An effective way to test the IR35 status of a contractor working for you is to use HMRC’s online tool, Check Employment Status for Tax (CEST) service, available here: CEST. But note that criticisms have been levelled at the scope of the tool. And that it must be used with care as HMRC has said that it will not abide by its conclusions if incorrect information has been entered.
The impact of these changes on your business
You will need to consider the potential implications of these IR35 changes to your business if you engage freelancers and the freelancer works through a PSC or other intermediary. The reforms might lead to an increase in administration work, with the attached costs of that additional work. They might create practical difficulties as you attempt to operate within the changed rules. And they might have a commercial and financial impact on your business.
If you think you are covered by IR35, we recommend that you identify those freelancers working for you through PSCs or other intermediaries. You will need to identify the labour supply chain in each case, and then determine those freelancers’ status.
It may not be immediately evident that a PSC is involved where the freelancer/PSC deals with you through an agency. So, looking ahead, you might want to make this task easier by requiring any agency or other supplier you work with to inform you when a freelancer is working for you through a PSC or other intermediary.
In general, you will need to ensure that you have taken “reasonable care” in making the assessment as the draft legislation indicates that the liability for any unpaid PAYE and NIC transfers to the party in the supply chain closest to the client and, if necessary, ultimately to the client itself.
If any entity in the contracting chain is based overseas, we recommend you take specific advice as to whether (and how) IR35 applies to you or any other entity in the chain.
You may also want to review contractual arrangements with freelancers to ensure contracts are compliant with the rules. This may have an impact on how work is directed and monitored, and how service delivery is defined. But this could provide better outcomes and longer-term benefit as respective roles, milestones and deliverables are defined with greater clarity.
Some wrinkles remain
The Institute of Chartered Accountants in England and Wales (ICAEW) has welcomed the changes announced by the Government to “support the smooth and successful implementation” of the new off-payroll working rules. These include a softer compliance approach in the first year to avoid penalising businesses trying to get it right. But they have warned that businesses still face several uncertainties about the new rules’ implementation and their impact.
- Whether the contractor will be aware that, if the client is “small’, it is up to them to comply with IR35.
- How a contractor who does not receive a status determination statement will know whether this is because the client has determined that the contractor is not deemed an employee or because the client is offshore which means that the contractor is responsible for applying the IR35 rules.
- The absence of a deadline by which the contractor must initiate the client-led disagreement process, potentially leaving the client exposed to a disagreement being raised for an indefinite period.
Here at Redshield, we also have a concern about the definition of “reasonable care” in making the determination of employment status. The draft legislation recognises that in certain situations it would be inappropriate for HMRC to pursue unpaid liabilities against a client. HMRC is due to issue detailed guidance on this in due course and clarify the steps clients will need to take to meet this test. But, until that guidance emerges, it’s unclear what these steps might constitute.
HMRC has published guidance on the reforms, plan to provide further advice in due course and will commission external research into the impact of the reform six months after implementation. They have also promised to apply a light-touch approach to errors made by clients in the first year. Though it remains to be seen how this policy will be implemented.
The reforms have yet to pass into law. But it is unlikely that there will be any significant alterations to the draft legislation. We therefore recommend that businesses take action now to ensure compliance.
This is a complex area. But the reforms are not as bad as sometimes presented. For those contractors that are genuinely self-employed and operate outside IR35, there should be no change.
Some businesses may feel tempted to ban the use of personal service companies completely. Or simply blanket assess their entire flexible workforce as “disguised employees”, which would then risk the knock-on effect of increased contractor fees or reduced contractor availability. But there’s no need to over-react.
We can minimise the impact on your business by helping you navigate the IR35 process successfully and ensuring you comply with the new rules.
If you have any questions or need advice on what to do please Contact Us for an initial discussion.