The changes to off payroll working (commonly known as IR35) for contractors operating in the private sector via limited companies, which were due to take effect in April 2020 but have now been postponed by twelve months due to the Coronavirus pandemic, will have a major impact on both the contractors and the organisations that engage them. A significant proportion of the contractors are sourced via agencies and this article considers the impact on such supply chains in light of experiences from the previous changes to IR35. An earlier version of this article was published in the March 2019 edition of Tax Adviser magazine.
Robert Woodward - Tax Associate Director, Global Employer Services.
Prior to 6 April 2017 where a contractor was not engaged as an employee but instead through a limited company of which they possess least 5% of the share capital/dividend rights (known colloquially as a Personal Service Company, PSC), the contractor (and by implication the PSC) was required to determine whether or not that working relationship would result in an employment being deemed. In cases where the contractor concluded that their working relationship with the end client was one of employment, the PSC was required to treat the payments received in respect of services provided as employment income with PAYE and Class 1 NIC operated accordingly.
This was the case whether the PSC engaged directly with the end client or the supply chain included an agency. Regardless of the complexity or length of the supply chain, all parties were clear in the knowledge that the tax compliance risk resided with the contractor and the PSC.
The first shift in the PAYE/NIC risk began on 6 April 2014 with the introduction of the Offshore Intermediaries legislation. Under this legislation where the supply chain involved an employment relationship with the contractor being employed by a non-UK company, the UK agency would be liable to operate PAYE/NIC in the event that those obligations were not already being operated elsewhere in the supply chain. Even where the agency was not liable for PAYE/NIC, since 6 April 2015 quarterly reporting of contractors supplied by the agency on a non-employed basis (including those via PSCs) have been required under the Employment Intermediaries reporting regime.
On 6 April 2017 the most significant change to date took place in respect of contractors providing services to an end client who was a public sector entity. Public sector in this context means any public body organisation as covered by the Freedom of Information legislation. In these situations the public sector end client has been required to determine whether an employment would be deemed. If the public sector body concluded the relationship was actually one of employment, unless the contractor was supplied via an agency, that body would be required to make the payments in respect of the services provided via the payroll with PAYE and Class 1 NIC operated accordingly.
Where an agency is involved – which represents a significant proportion of cases for contractors supplying services to the public sector via PSCs – should the public sector body conclude an employment would be deemed the agency would be required to operate PAYE/NIC. For agencies this change resulted in a reassessment of the relationship with both the end client and contractors and a number of practical impacts of this change had to be considered.
Beyond changes to processes to determine whether a contractor would be deemed to be an employee, adaptations which inevitably resulted in Increased costs, where the contractor was deemed to be an employee, the agency is now required to payroll the contractor and is responsible for paying employment tax costs such as employer NIC and the Apprenticeship Levy. While in some cases agencies have been able to pass on these costs through an increase to the margin charged to the end client, that has not always been possible (at least not without renegotiation of contract terms) and therefore those costs hit the agencies’ profitability.
Operating a payroll for contractors (and bearing responsibility for the consequential tax/NIC costs) changed the nature of the commercial arrangements between agencies and their clients. The working relationship may also have altered as it is the client who makes the determination but the agency who operates PAYE/NIC based on that decision. Situations where the agency and the client disagreed with the assessment as to whether an employment would be deemed may have had an adverse impact on the ongoing working relationship between agencies and their clients.
Some of these disputes have arisen due to the HMRC Check Employment Status for Tax (CEST) tool. While HMRC have confirmed they will stand by the result produced by CEST, that position will only stands where the fact pattern matches the answers given and leaving aside changes of circumstances, ambiguity in the questions asked have resulted in differences of opinion as to whether the facts exactly match the questions asked. This article will not dwell on problems encountered with this tool, such as the range of questions asked and the absence of questions on key factors such as mutuality of obligation, beyond the fact that these opinions have often been assumed to be binding by the public sector body without any separate qualitative assessment by tax professionals to support (or otherwise) the opinions.
Exacerbating this problem has been the scenario under the rules relevant to the public sector where there is no formal mechanism for appealing the decision or dispute resolution. In the absence of an appeal process, agencies disputing determinations and not willing to operate PAYE/NIC must effectively invite an enquiry from HMRC to resolve the matter. This route is time consuming and increases the agency’s risk profile with HMRC – increasing the likelihood of further future enquiries on other tax matters. Should HMRC be successful in those enquiries, the agency would also be liable for interest on late paid duties and penalties for failure to operate, report and pay those duties on time.
As well as managing the relationship with the end client, a determination that an employment would be deemed has also had an impact on the relationship between agencies and contractor, especially where a contractor joined before April 2017 and there was a change in the tax/NIC basis during contract. This is particularly the case where the contractor’s expectation on joining the agency was they expected to be outside IR35 and/or the contractor disagreed with the determination of employment (whether or not that determination was made using CEST).
Managing the relationship in both directions of a supply chain where the dynamic has shifted clearly involves additional time and resources but the alternative is the loss of contactors – something many agencies experienced as a result of the April 2017 public sector reforms. This included the loss of contractors not only to other organisations giving an agreement to which the contractor concurs but also to the private sector. It is anticipated that the impact of the April 2021 reforms will not be as significant in this respect due to a combination of consistency of the application of IR35 across both the public and private sector, as well as the issue of blanket assessments (a problem with parts of the public sector) for whole classes of contractors being less prevalent.
As alluded to above, one of the challenges faced by agencies following the introduction of the public sector specific IR35 legislation in April 2017 was the number of determinations of employment status being issued on blanket basis rather than individual assessments per contractor. The reason for this approach varied – in some cases it was simply lack of time and resources: the determination needed to be made and communicated within thirty one days otherwise any PAYE/NIC risk would remain with the end user. Whatever the underlying reason for making blanket assessments the fact remains they are counter to the obligations placed on the public body and have a negative impact on themes we have already covered such as relationship management, budgeting/squeezed margins and the lack of an appeals process. There is obvious concern amongst agencies that these issues will recur where they are placing contractors in the private sector.
As a final practical point, while the IR35 rules take precedence over both the Offshore Intermediaries legislation and the Employment Intermediaries reporting obligations, agencies must nonetheless consider these requirements in cases where the contractor was not deemed to be engaged under a relationship where an employment would be deemed.
While the April 2017 IR35 changes were specific to the public sector, it was widely expected that those changes would be extended to the private sector. At the 2018 Budget the Chancellor announced that following consultation, these rules would be extended to the private sector with effect from 6 April 2020, except for businesses with no connection to the UK or for small businesses (whose position would remain unchanged – i.e. the determination of employment status and PAYE/NIC obligation would remain with the contractor/PSC).
Preparations for the expected changes had been taken by many organisations, some of which had already implemented final plans, when it was announced the new IR35 rules would be delayed for 12 months until 6 April 2021 due to the Coronavirus crisis. For organisations and agencies that had not completed their preparations, this delay was welcome as it allows further preparation time while for those that had completed their preparation they were simply ready early and able to tweak their updated policies and processes.
The delay also allows for scope for further updates to the draft legislation underpinning the changes as well as HMRC guidance supporting the changes. As of 18 March 2020 when it was announced the changes would be deferred, the legislation was still in draft and had not been subject to Parliamentary scrutiny. Furthermore, the draft legislation on HMRC power to transfer unpaid PAYE/NIC along the labour supply chain which was of particular interest to recruitment sector businesses was still open to consultation.
Adding to this mix, on 27 April 2020 the House of Lords’ Economic Affairs Committee issued their report following a review of the proposed IR35 changes. The report was critical of the IR35 changes, especially in respect of its lack of connectivity with other reforms of employment status more generally following the Taylor Review. In addition, concerns surround the complexity of determining employment status for tax, which are not assisted by flaws in CEST, and the failure by the Government to fully assess the impact of the 2017 IR35 reforms on the public sector.
The delay now gives an opportunity for the Government to fully consider the consultation responses as well as score for potentially updating the legislation in light of the House of Lords comments and for Parliament to scrutinise the legislation.
The delay also allows the opportunity for further fine tuning of CEST. Since the public sector IR35 reforms were introduced there have been a number of updates to CEST and while each change must be viewed as improvements, scope exists for further enhancements.
The exemption for small businesses is designed to ease the burden on small organisations from the obligation to assess employment status and operate PAYE/NIC where required and so should be viewed as a positive matter. However in the context of agencies the exemption is based on whether the end client is a small business rather than the agency. Agencies will therefore need to have an even greater understanding of a client to determine whether they would be deemed a small business for these purposes but also an understanding of a client’s growth strategy and business goals to recognise where currently small businesses would cease to be such (and the consequences for the application of the IR35 legislation). In short up to date client knowledge will be even more important, especially because contractors have the right to request confirmation from the end client if they are “small” and it is expected that many such requests will be routed via the agency they contract with.
The 2017 changes for public sector clients added both technical and practical complexities for agencies supplying contractors via PSCs. These technical and practical issues continue and look set to be rolled out into the private sector from April 2021. Agencies need to bear this in mind and build on the lessons learnt from the impact of those 2017 changes in planning for the 2021 changes. Due to the scale of and experiences from the 2017 changes and the original scheduled start date was 6 April 2020, that planning should be well underway.
We have a strong team of experienced IR35 experts who are already helping businesses assess the impact of the new rules and prepare for their introduction. Our IR35 in the private sector hub outlines our support services and details BDO’s off payroll labour tools that you may find useful.