Off-payroll rules: how “IR35” works for businesses using contractors

IR35 had its origins back in 1999 when the then Inland Revenue issued a press release (number IR35) saying that it was targeting ‘disguised employment’ to prevent tax and NIC avoidance. Since then, the term IR35 has become shorthand for all situations where any worker who is engaged, directly or indirectly via a Personal Service Company (‘PSC’), by an organisation and is paid outside the payroll of that organisation.

What are the current rules?

The original IR35 rules targeted individuals providing services through a Personal Service Company (PSC). As these proved largely ineffective, HMRC has also created the Off-payroll labour (OPL) rules which target both the end engager organisation (ie the entity for whom the work is done) and any intermediaries in the labour supply chain - such as an agency or ‘umbrella company’. The OPL rules now apply where a contract worker engagement is direct with a PSC or indirectly - such as a business engaging workers via an agency, which contracts a PSC and onward supplies the services via the PSC.

Both the OPL and IR35 rules are designed to make sure that if an individual works like an employee, but provides services through their PSC, broadly the same tax and NIC is paid as if they were a direct employee. Where the OPL rules don’t apply, (eg where the end engager is exempt as a ‘small’ entity), the individual running the PSC may still be affected by the original IR35 rules. Where contracted services are provided by a sole trader, there will still be employment status issues for the end engager organisation to consider – see our flowchart for end engagers illustrating which of these regimes applies depending on the specific circumstances.

Who do the rules apply to?

The rules affect all end engager organisations, private and public, charities and not for profit organisations that do not fall into the small companies’ exemption. It is the responsibility of the end engager organisation receiving the worker’s services to determine whether the exemption applies.
 

How to identify your OPL/IR35 risks

The primary data source for a risk assessment is your purchase ledger – this provides the record of supplier invoices received from PSCs, agencies and intermediaries, and is the main mechanism through which individuals can receive payments outside the payroll process. Only suppliers that provide personal services of an individual need to be considered.

Once you have identified each worker that has provided personal services to your organisation, you must identify and consider the whole labour supply chain for that individual and demonstrate an understanding of how the relationship works in practice, looking beyond the wording of the contract.

Your labour supply chain may not always be straightforward. A common scenario is that a company engages with an agency to appoint an individual. The agency in turn engages with a personal service company (PSC) through which the individual provides services. However, more complex scenarios can arise involving more than one agency, umbrella companies or cross-border activities.

Employment status assessments

Where an end engager organisation falls withing the OPL rules, it is legally required to  assess the employment status of the worker to determine if the reality of their work makes them a ‘deemed employee’.

To support businesses, HMRC has provided a Check Employment Status for Tax (CEST) tool. Although this is helpful, it needs to be completed with care. If you include incomplete or inaccurate data, the assessment may be incorrect. In all cases, you will need to retain sufficient records to show how you reached the outcome of the assessment. For some individuals and complex cases, specialist advice may be needed.

Following this assessment, the end engager organisation must issue a formal Status Determination Statement (SDS) to both the worker’s PSC and any intermediary involved in the contract, which must include the outcome and the basis of the assessment decision. In addition, the end engager must implement an appeal process, including a commitment to respond within 45 days. If there are changes to an individual’s contract terms or practical arrangements, you will need to perform a new assessment.

If an assessment concludes that the worker is a deemed employee, the responsibility for then applying the correct tax treatment to payments made to the PSC lies with the organisation paying the PSC, defined as the ‘fee payer’. The end engager (user) of the services and the fee payer may or may not be the same organisation, for example where agencies are involved.

The fee payer must implement payroll and payment procedures to deduct PAYE and NIC as if the worker was an employee (and account for the Apprenticeship Levy where relevant, but not student loan deductions). There are special boxes to declare this PAYE and NIC for deemed employees on the organisations monthly RTI payroll returns.

Although central functions such as Finance and HR play a key role in establishing and overseeing the approach, in practice the assessment may be outsourced or undertaken by a budget holder or manager within the business. You will need robust quality assurance mechanisms and ensure that assessors have sufficient training and guidance to make sure that they are complying with the requirements.

Indicators of employment

There are some typical indicators that an individual should be treated as an employee for tax purposes:

KEY INDICATORS OF EMPLOYEE STATUS
Personal service	The contractor is required to provide a personal service and is not permitted to provide a substitute or subcontract the work
Control	The end engager organisation has contractual right of control over the work, what will be done, how, when and where it will be done
Mutuality of obligation	The end engager organisation has an obligation to provide the work, and the contractor has an obligation to perform it
Nature and length of engagement	The contractor is engaged on a permanent basis rather than for a single discrete piece of work
Exlusive service	The contractor is restricted from working for others
Financial risk and pay	The end engager organisation bears the financial risk of the work
Integration	The contractor is or becomes integrated within the client’s organisation e.g. has line management responsibilities, enjoys the same benefits as permanent employees
Office holder	The contractor is appointed to a post to which he or she can vacate and a successor can be appointed, for example as a director

HMRC compliance expectations

HMRC expects that entities will exercise reasonable care in identifying off-payroll workers and in performing these status assessments. You will need a structured and methodical approach for identifying individuals that could be deemed to be employed, and for conducting the assessment of their employment status.

We have seen HMRC issuing 'nudge letters' to employers, requesting numerous pieces of information regarding their engagement of contractors.

You need to have processes and policies in place to assess the tax status of all off-payroll workers, issue an SDS to each worker and deduct PAYE/NIC where appropriate.

In all instances, before you make payment to a contractor, you must ensure an employment status review has taken place, and a SDS has been communicated correctly through the labour supply chain. You must also be able to track the assessments made, and deal with any disagreements by the worker within a 45-day deadline.

Finally, you must have undertaken a robust due diligence exercise to support a decision that a procured supplier falls outside these rules on the grounds that no personal service is supplied, which can be difficult to evidence.