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Off-payroll working in the private sector

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HMRC and HM Treasury have published a consultation document considering a number of potential options for improving levels of compliance with the off-payroll working rules (IR35) in the private sector. The lead proposal is to extend to the private sector the off-payroll rules that now apply to the public sector. Private businesses would therefore be responsible for assessing the status of their personal service company contractors and bear the risk if their classification is wrong. Implementing any of the proposals will impose a serious administrative burden on businesses which engage contractors through intermediaries. The consultation document gives no indication of when any new rules could come into force, but April 2020 seems a likely start date.

What is this consultation about?

The government wants to change the way the tax rules work for individuals who provide services through an intermediary, such as a personal service company (PSC), rather than contracting directly with a business as a self-employed person or being an employee of the business. In this article, we will focus on PSCs as they are the most widespread type of intermediary.

Under the current rules, a private sector business (the client) which contracts with a PSC for an individual to provide services, does not have to deduct tax under PAYE from payments made to the PSC, and importantly, does not have to pay employer’s national insurance contributions (NICs). The individual can then extract the money from the PSC in a tax efficient way, perhaps by paying him or herself a small salary below the thresholds for NICs and then extracting the remainder of the money by way of dividend. This enables the individual to pay less tax than if they were an employee of the client or self-employed. For higher earners, the PSC may need to register for VAT. Neither the intermediaries legislation nor these proposals affect the VAT position.

Tax is not the only reason for an individual to operate through a PSC or for a client to engage an individual in this way. Operating through a company, rather than contracting directly as a self-employed individual can provide limited liability. For clients, it enables greater flexibility in the workforce.

The intermediaries rules introduced in 2000, commonly referred to as ‘IR35’, were designed to ensure that someone operating through a PSC, who would have been an employee if engaged directly by the client, will broadly pay the same amount of tax and NICs as if they were employed. The rules impose an obligation on the PSC to decide whether the individual would have been an employee if they were engaged directly. If the answer is that the individual would have been an employee, there is a deemed payment of employment income by the PSC, which must then account for both tax and employer and employee NICs charges (calculated by reference to the actual payments made to the PSC by the client).

From the client’s perspective, this is similar to the situation where the client engages a self-employed individual. However, one big advantage to the client in contracting with a PSC, rather than a self-employed individual directly, is that if HMRC disagrees with the individual’s tax status, barring the PSC being a sham, HMRC has to pursue the PSC for the tax and not the client.

Why does the government want to change the rules?

HMRC estimates that only 10% of PSCs that should pay tax under IR35 actually do so. It estimates that the cost of non-compliance will increase from £700m in 2017/18 to £1.2bn as the number of people working through PSCs continues to grow. Clients can take on contractors with little consideration or concern as to their ‘real’ employment status. Indeed, the government is concerned that some businesses pressurise contractors to use a PSC. This saves the client NICs but also means that the contractor does not benefit from employment rights.

It is very labour intensive to investigate PSCs. A single client may have thousands of individuals using PSCs. In order to enforce IR35 compliance, HMRC needs to enquire into the tax affairs of each individual PSC. If irregularities are found, it then has to collect the back tax from the PSC, which may well not be able to pay it. HMRC thinks (probably correctly) that this has led to a feeling among contractors that there is a low risk of being caught if you don’t comply with IR35, making it more likely that they will not comply.

In April 2017, the rules were changed for the public sector, making public authorities responsible for accounting for tax and NICs if the contractor would have been regarded as an employee for income tax and NICs purposes if they were engaged directly.

What is the government proposing?

The government’s lead proposal is to extend to the private sector the off-payroll rules that now apply to the public sector. Private businesses would therefore have the responsibility for assessing the status of their PSC contractors and bear the risk if their classification is wrong. Further, if HMRC wants to enquire into PSCs, it will be able to run an enquiry into all the client’s PSCs and not have to pick them off one by one.

HMRC accepts that public authorities ‘faced challenges in implementing the reform’ and wants to explore ‘whether the design of the reform and the implementation process could be improved’. The consultation document asks specific questions about how the rules could be applied to the private sector, focusing on the practicalities of implementation. It asks, for instance, if there are parts of the private sector which will struggle to implement the changes. It also asks for evidence of the cost implications.

The document also suggests that the government wants to tinker with the public sector rules. One particular beef from HMRC’s perspective seems to be that where PSCs are engaged through an agency (and therefore it is the agency’s responsibility to apply PAYE, but based on the client’s classification), some agencies have disregarded the public authority’s determination that the contractor is a deemed employee and have not applied PAYE. The government asks whether the agency should be forced to accept the client’s conclusion.

As an alternative to rolling out the public sector rules, the document suggests measures to ‘encourage or require’ businesses to help to ensure that their off-payroll contractors are complying with IR35. Clients could be required to perform more due diligence on off-payroll contractors, including some of the checks in HMRC’s guidance on due diligence on labour providers (see These include adding a clause in the contract with the PSC requiring evidence of PAYE returns filed and tax paid.

The consultation suggests that clients could also be required to ask the PSC to provide a completed CEST determination that they can check to ensure the answers given by the PSC reflect the reality of what happens in practice. CEST is HMRC’s online ‘check employment status for tax’ tool. If the checks were made compulsory, the document suggests there could be some form of penalty for those who fail to comply, or that the sanction could be denying a deduction for the costs of using labour from a supply chain they have not checked. An alternative would be making the checks optional, but ‘naming and shaming’ clients that have not performed them and are later found to be using contractors who have not complied with their tax obligations.

The government admits that making clients perform these checks would put a ‘relatively large administrative burden’ on businesses and would not directly tackle IR35 compliance. Such a measure also fails to solve HMRC’s problem as regards having to launch enquiries into the affairs of each individual PSC. The document therefore suggests the imposition of additional record keeping obligations on the client, to make it easier for HMRC to gather information about the PSCs they contract with. It is suggested that clients could be obliged to keep contracts, shift rotas, and line management reporting requirements relating to the individuals they engage through PSCs. The document notes that this would also represent an additional administrative burden for the client, and again would not directly ensure compliance by the PSC.

The consultation also asks for any other ideas that could ensure compliance with the rules, possibly drawing on lessons from other countries. However, the document warns that some options, which might change the current employment status test for tax, are out of scope of the consultation. Although changes to the employment status test are of course being separately considered under a different consultation.

How have the public sector rules worked out?

As the government’s favoured proposal has already been rolled out to the public sector, private sector businesses will be keen to know how the rules have worked in practice. HMRC has looked at the statistics regarding tax collected and also commissioned independent research (see on the experiences of public authorities in implementing the changes.

HMRC estimates that income tax and NICs are now being paid in respect of around 58,000 extra individuals working for a public authority and that an additional £410m of income tax and NICs has been paid by the public sector, since the reforms.

The research states that, although a considerable proportion of public authorities experienced early difficulties in complying with the rules, almost all of those surveyed said they were now confident they were complying with the rules. However, the government acknowledges that many public authorities would have preferred more time to prepare and adapt. Some public authorities reported difficulties in filling vacancies after the reforms came into effect and some had to pay contractors more to compensate for the reduction in take home pay, no doubt partly due to the uneven playing field that the public sector rules created.

We’ve been here before. Will the changes happen this time?

Although the consultation does consider other options, the document does not express much enthusiasm for any of the alternatives. Rolling out the public sector rules to the private sector seem to be very much the government’s favoured option. It ticks all the boxes in terms of collecting the tax and fits well with other initiatives to reduce differences in tax treatment, as a result of different ways of working and removing the incentive for engagers to effectively force contractors into structures where they do not have employment rights.

You may be thinking, we’ve been here before. When the original IR35 proposals were announced back in March 1999, the obligation to account for PAYE and NICs was intended to fall on the client. However, extensive lobbying from bodies representing the contractors succeeded in getting the government to climb down and move the duty to determine the tax position and account for tax to the PSC and not the client. Could this happen again?

We don’t think so. The system has already been rolled out to the public sector and HMRC could argue that PSCs have had their chance and have failed to apply the existing rules properly. From the government’s perspective, this change in itself does not prevent genuine contractors from using PSCs. Where the contractor is not genuinely self-employed then using a PSC can be seen as tax avoidance and the public attitude to this has shifted considerably since 1999. There is also a lot of momentum coming from the wider Taylor review. It seems likely therefore that the main proposal in the consultation will go ahead.

How would the changes affect businesses?

As mentioned in our previous article (see ‘Employment tax issues and the corporate criminal offences’, Tax Journal, 6 April 2018), employment status is a risk area for the new corporate criminal offence of failing to prevent the facilitation of tax evasion. However, leaving aside cases where fraud is involved, contracting through a PSC involves very little risk for a client. If it turns out that the PSC should have been accounting for PAYE, it is the PSC and not the client which is on the hook for the back tax. And, of course, the client saves NICs.

The key is that HMRC is not proposing to change the substantive law under IR35 as to whether an individual in a PSC should be treated as an employee or how much tax is paid – or at least not yet. All that HMRC proposes changing is who should pay the tax that arises. The point is to shift the risk onto businesses, which are easier to find, more likely to pay and, in practice, more risk averse.

Implementing any of the proposals will impose a serious administrative burden on businesses which engage contractors through intermediaries. None of the options are attractive from the point of view of the client. The government might point to experience in the public sector and say that although it was tricky at first, public authorities are now on the whole quite happy with applying the rules. However, rolling out the changes to the private sector is totally different. The public authorities surveyed would probably have had large payroll departments. There is no suggestion that the new rules would only catch large businesses. These changes would apply to any business, no matter how small and how limited their resources.

If the public sector rules are extended to the private sector, businesses would have to look at the position of each contractor they engage through an intermediary. A practical question is how clients will carry out checks. Apparently, 91% of public authorities were making decisions on a case by case basis. This may well not be practical for some large corporates. A form of risk based approach might be necessary; for example, setting up model form engagements and testing them through CEST.

However, CEST is controversial. HMRC says it has been ‘rigorously tested ... against live and settled cases and reflects employment status case law’. HMRC claims it gives a clear answer in 85% of cases, and gives a self-employed outcome around 60% of the time, and employed around 40%. It only works though if the person using it knows exactly how the contractor’s engagement operates in practice. Case law on employment status for tax purposes has been built up over very many years and is nuanced, so it is unlikely that an online tool can give the correct answer every time – though, at least HMRC agrees to be bound by the answer given by the tool if you complete it accurately. Nevertheless, even using HMRC’s numbers, there are 15% of cases where there isn’t a clear answer, and some would say that answering the questions with the accuracy that HMRC might expect requires a reasonable degree of sophistication and an understanding of the underlying case law tests.

Given the variability of each engagement, it will often be difficult to be confident that the model treatment cleared through CEST will apply to actual contractors as engaged. Also, of course, contract terms might well not reflect what actually happens (e.g. would a substitute really be accepted?), so the ‘real world’ nature of arrangements on the ground would need to be built in to any classification system. The process would also need to monitor variations to the engagement, for example where the control exercised is in fact greater than anticipated or the contract is extended.

If there is any doubt about the position, the least risky option for the client is to err on the side of caution and either treat the contractor as employed or insist on employing them directly. However, reclassifying contractors as deemed employees can lead to a disgruntled workforce, as the BBC has found with some of its ‘talent’. HR teams will need to be ready for the fallout, and for dealing with the questions that contractors will inevitably have. Further, for VAT exempt clients engaging higher paid contractors, contracting with PSCs but taking the NIC and PAYE hit becomes worse than employing individuals directly because of a 20% VAT cost on payroll. There is therefore a tax driver to bringing contractors in as employees. However, that is to ignore all the non-tax reasons for not having employees. Businesses clearly will have to make a decision.

For those contractors falling on the employment side of the line, the changes will increase the cost for the client as employer’s NICs will have to be paid. For clients in the construction industry acting as contractors (in the construction sense), there may need to be a review of the terms and pricing of long-term contracts.

Contractors will also see a reduction in their take home pay as a result of the operation of PAYE. According to HMRC’s research, 28% of public authorities had to increase off-payroll contractor rates as a result of the new rules.

There is also the wider question of whether changes can be made to contract terms and working practices in order to improve the IR35 analysis. Clients should be starting to consider and identify those roles where that might realistically be feasible, and how much risk might remain.

How will contractors be affected?

Contractors are in a difficult position. If their client errs on the side of caution and treats them as a deemed employee, there is little they can do. HMRC is unlikely to intervene where a business is paying NICs and applying PAYE, and there is no appeal mechanism for the contractor.

Being a deemed employee under the rules may be very unattractive, as the individual would suffer the tax disadvantages but would not obtain employment rights. Becoming an employee could be a better option, if the client is prepared to do this.

The changes will prompt HMRC to look not just at the future but at past tax compliance. If the individual contracts through a PSC and the client decides that under the new rules they are a deemed employee, that calls into question their past compliance with IR35. If the PSC has not been applying PAYE, HMRC is likely to come calling.

When are the changes likely to come into force?

The consultation document gives no indication of when any new rules could come into force. The earliest possible date would be April 2019. However, we think this is unlikely as it does not comply with the government’s new budget timetable. This makes April 2020 a more realistic date.

Next steps

The closing date for responses to the consultation is 10 August. Anyone who may be affected should consider responding. Businesses engaging contractors through intermediaries (and contractors themselves) should consider how the proposed changes could affect them. Dealing with these changes is going to be a major exercise for many clients, and forward planning will be key in mitigating the resulting costs and business disruption. 

For details of the consultation, see