IR35 REALITY CHECK
On April 06th 2021, the Off-Payroll legislation (often referred to as IR35) reform changes come into effect. What does it really mean for the organisations and individuals affected?
What is the Off-payroll legislation?
Since 2000, when IR35 legislation was implemented, contractors that sell services via their own limited companies have been deciding whether to sell them as a limited company and treat and pay tax on the revenue as a company (outside IR35), or treat revenue as PAYE income and pay tax and National Insurance accordingly (inside IR35). If they choose the former, and are deemed by HMRC to be doing so contrary to IR35 legislation, it is the contractor that HMRC pursues for unpaid back tax and National Insurance.
However, from April 06th 2021, medium and large private sector clients (HMRC definition here: https://www.gov.uk/guidance/april-2020-changes-to-off-payroll-working-for-clients#conditions) will become responsible for determining the IR35 status of engagements of contractors. They will have a legal obligation to take reasonable care in doing so. If they are proven by HMRC to have failed in that obligation, they will be liable for back tax, National Insurance and possibly penalties. Public sector clients became liable for IR35 status determination in 2017.
There are some highly exceptional, even improbable scenarios, in which the deemed employer, the company that directly pays the contractor’s limited company (often a recruitment agent), could instead be liable for uncollected taxes and National Insurance. One such case is where a client determines an engagement is outside IR35, and is deemed by HMRC to have taken reasonable care in reaching their conclusion, but still managed to get it wrong.
What’s the purpose of IR35?
HMRC’s main agenda was to stop large corporates from engaging contractors for roles that would traditionally be permanent employee positions, to avoid employer national insurance and other fiscal responsibilities and disadvantages associated with hiring employees.
How does IR35 work?
The determination of inside or outside IR35 is based upon a known set of contractual and working practices criteria. If HMRC disputes an outside IR35 status, they do so based upon those known criteria and a considerable weight of case law. You may have encountered a compelling weight of expert opinion that fuels the notion IR35 status determination is complex, difficult to understand and involves analysis of a multitude of intertwined and interdependent factors. There are a large number of companies offering assessment services, often with tools that engage the user in answering a list of anywhere between a dozen and over a hundred questions in order to ascertain status.
It’s true that it CAN be complex if engagements are borderline i.e. not overwhelmingly inside or outside. So, in the face of this perceived complexity, combined with the financial risks associated with getting outside IR35 wrong, a large number of client organisations and even some recruitment companies are refusing to engage contractors outside IR35. Some are putting engagements through assessment processes with contractual terms and working practices that result unerringly in an inside IR35 conclusion. Some are abandoning contractors in favour of fixed term contracts.
Many contractors are high earners. There’s unlikely to be widespread sympathy at the idea of them being forced inside IR35 and earning significantly less. Doubtless few that hold that belief have chosen to be an independent contractor. There are over twenty million full time permanent employees in the UK and perhaps around two hundred thousand contractor limited companies. One percent. So, is it really that cushy? It’s much higher risk than permanent employment. Contractors are expected to be already fully qualified to deliver. They receive no training from clients. They have no career path. There is no investment by clients in their future prospects. They have no employee rights protection. They are expendable and can be disposed of at will. They cannot get sick pay, claim any unemployment benefits, or receive large tax-free redundancy payments. If there’s no higher reward, why would anyone accept the higher risks and lack of protection?
What’s the Contractor impact of PAYE-based solutions?
Outside IR35, contractors can utilise revenues more flexibly, choosing what percentage they draw as income, when. Also how they draw it. If they extract income in dividends they avoid national insurance contributions. However, HMRC now taxes dividend income at an extra 7.5%, largely eradicating the national insurance benefit. The major benefit for contractors outside IR35 is they don’t have to extract all of their income immediately. If they generate revenue from July to March and then none from April to June, they can spread their twelve months revenue across fifteen months income and two tax years. Contractors also generally incur .significant expenditure in the delivery of their services. Operating through a limited company enables immediate offset of that expenditure against tax.
Why should clients and industry care?
There will still be clients beyond April 2021 that will embrace outside IR35. There will be a large number of contractors unwilling to deliver services via any PAYE vehicle and swallow income reductions normally in the range of 15-25%. The result? Those clients that do not embrace outside IR35 will be engaging contractors from a far smaller pool of resources than those that do. This in turn will compromise their ability to acquire and retain top contractor talent, often relied upon to deliver their most critical business transformations and initiatives.
Why should recruiters care?
Those recruiters that provide client-friendly solutions to safely engage contractors outside IR35, accrue a substantial competitive advantage in cost, margin and quality terms over those that do not.
What’s the answer?
The answer is in the reality check I promised at the outset:
- It no doubt serves HMRC for IR35 to be perceived as complex and risky. A generous interpretation would be that it deters corporates from exploiting the system with pseudo-employees. A less charitable interpretation might be that it intentionally scares corporates sufficiently that they fail to harness outside IR35 even when they legitimately can.
- It does not have to be complex. It is entirely plausible and simple to construct contractual terms and working practices for an outside IR35 status that cannot possibly be successfully disputed by HMRC.
- Whilst it may be naïve to rely entirely upon it, a watertight right of substitution, all on its own, can qualify an engagement as outside IR35, irrespective of any other factors. This is categorically supported by a weight of case law and by HMRC’s own IR35 assessment logic.
- HMRC wants to maximise compliance, not dispute wins. They will take a risk-based approach in determining which engagements they dispute. They will not pursue disputes in which they have little or no probability of success.
- The single simplest solution is for clients to properly understand and embrace right of substitution. One barrier to this is a widely held view that right of substitution is and has always been simply a loophole line in contracts. Even if clients want to sign up to it, they fear it will in any case be a sham and HMRC will destroy it in a dispute.
- If contractors are in an indisputable position to implement a substitution where their limited company engages and pays the substitute, and the client acknowledges that right, it is not a sham. That’s even the case if it is never likely to be used. Why? Because it gives the contractor’s limited company the legal right to retain the legal obligation to fulfil the contract even if the main resource is not available. It renders the engagement a contract for services and not a contract of service i.e. the concept of personal service is entirely absent.
- HMRC cannot legally make any distinction between intent to substitute if needed, and actually having initiated a substitution. They cannot force a contractor to take time off, nor can they force a client to utilise an alternate resource in such an event. So, if intent to substitute if needed, can be proven beyond doubt, it’s as defining as an actual substitution.
Reality Check Spotlight
- IR35 status determination is only complex where engagements are not overwhelmingly inside or outside.
- Recruiters and clients should seek the right, impartial advice when making decisions and implementing policies about how they engage critical resources.
- Recruiters and clients that do not embrace outside IR35 will doubtless suffer competitive disadvantage in the battle to secure and harness talent.
- In the majority of cases it is simple to avoid borderline contractual terms and working practices.
- A watertight right of substitution can eradicate borderline complexity.
- Recruiters should seek to encourage contractors they engage to acquire the genuine capability to execute a substitution correctly.
- Clients should demand their recruiters step up and provide them with a robust, compliant outside IR35 engagement solution.
- Very little has to change. The principal driver of the perceived requirement to change is perceived high risk, caused largely by a lack of understanding.