Changes to IR35 to go ahead
The Chancellor confirmed in the 2016 Autumn Statement that the proposed changes to the IR35 tax legislation for public sector assignments will go ahead in April 2017. Key provisions in the draft legislation intended to implement the changes are:
- the requirement for public sector end user clients to inform staffing companies that supply the services of company contractors to them whether they would regard the individual worker as their employee if they engaged the worker directly;
- the removal of the 5% deduction currently allowed to company contractors for notional expenses; and
- the application of the new IR35 tax legislation to payments made on or after 6 April 2017, even if the payment relates to services provided before that date.
HMRC is proposing to transfer responsibility for assessing IR35 tax status from personal service company ("PSC") contractors to staffing companies when they place these contractors on public sector assignments. If the assignment is within IR35, the staffing company will be responsible for deducting and paying deemed employment income tax and employee's National Insurance contributions from the fees it pays for the PSC contractor's services and for paying employer's National Insurance contributions. The staffing company will also be treated as the employer for employment allowance purposes. Payments the staffing company makes to PSC contractors within IR35 will count towards the staffing company's pay bill for the purposes of the apprenticeship levy, which it will have to pay if its annual pay bill is more than £3 million.
The changes to IR35 for public sector assignments will take effect from 6 April 2017. Draft legislation and guidance on the new rules were published on 5 December 2016. The closing date for submitting comments on the draft legislation is 1 February 2017.
There will be no changes for private sector assignments in relation to which the PSC contractor will remain responsible for applying the IR35 rules. The reforms will not extend to private companies carrying out public functions for the state.
In what circumstances will the new rules apply?
Whether or not an assignment is within IR35 is based on a number of factors. The draft legislation for public sector assignments provides that an assignment will be within IR35 where:
- a worker personally performs, or is under an obligation personally to perform, services for a client;
- the client is a public authority;
- the services are provided not under a contract directly between the client and the worker but under arrangements involving a third party; and
- the circumstances (including the reality on the ground and all the contracts in the supply chain) are such that if the services were provided under a contract directly between the client and the worker, the worker would be regarded for income tax purposes as an employee of the client or the holder of an office under the client; or the worker actually is an office-holder with the client.
Condition (c) above will obviously be satisfied if services are being provided to a client via a PSC contractor and a staffing company. Staffing companies will therefore first have to establish whether the end user of the PSC contractor's services is a public authority. The draft legislation uses the very broad definitions of "public authority" set out in the Freedom of Information Act 2000 and the Freedom of Information (Scotland) Act 2002. Organisations covered include:
- government departments, executive agencies and non-departmental public bodies; local authorities and devolved administrations;
- many companies owned or controlled by the public sector;
- the armed forces; the NHS; police and fire authorities; educational establishments including universities; and
- the BBC and Channel 4; and the Bank of England.
Outsourced services are excluded
The new rules will not apply when outsourced or fully contracted-out services rather than a worker's or workers' services are provided to a public authority. This is because the new legislation requires each entity in the supply chain to make a "chain payment". The draft legislation defines a "chain payment" as "a payment, or money's worth or any other benefit, that can reasonably be taken to be for the worker's services to the client".
The guidance provides the example of a PSC contractor who provides project management services to a private construction company which has a contract to build a new wing for a hospital managed by an NHS Trust. The private construction company's contract with the NHS Trust is a building contract, not a contract to deliver workers' services, and the PSC contractor reports to the private construction company not the NHS Trust. The new IR35 legislation will not apply because the payment the NHS Trust makes to the private construction company will not fall within the definition of a "chain payment". The PSC contractor will therefore be responsible for assessing IR35 status under the existing rules.
If, however, the end user client is a public authority and each entity in the supply chain makes a chain payment, the next step will be to consider condition (a) above, in other words, to establish whether the worker personally performs, or is under an obligation personally to perform, services for the public sector end user client. Often the client only wants the individual worker they have interviewed and chosen for the assignment to perform the services. However, can more than one person perform the assignment services? Can the worker have a helper or helpers? Can a substitute be sent to perform the assignment services? Will a substitute ever be sent? Does the client have the right to refuse a substitute and is that right exercised on a regular basis? Are helpers and substitutes paid out of the fees the PSC contractor receives for the services? There must be a genuine ability to populate the assignment with more than one worker and/or send a substitute and ideally this must happen in practice in order for the assignment to be outside IR35.
End user client must determine employee status
As part of the consultation process, HMRC queried whether a statutory obligation should be placed on the public sector end user client to provide information about the assignment so that IR35 status can be assessed. This has been addressed in the draft legislation by what appears at first glance to be a straightforward obligation on the client to say whether or not the worker would be regarded as its employee if it engaged the worker directly. However, making this assessment is immensely complex and may lead clients to adopt a blanket policy of simply saying that all PSC contractor workers would be regarded as their employees or, as has already been reported in the case of entities like Transport for London, refuse to engage PSC contractors.
The draft legislation provides that, if conditions (a) to (c) above are met, the end user client must inform the entity in the supply chain with which it contracts (in the contract or by another means) of its conclusion as to whether or not condition (d) above is met, in other words, whether or not the circumstances are such that if the services were provided under a contract directly between the client and the worker, the worker would be regarded for income tax purposes as an employee of the client or the holder of an office under the client; or the worker actually is an office-holder with the client.
It is relatively straightforward to establish whether the worker is an office-holder. Examples include a company director or club treasurer. Far less easy to establish is whether, if there was a direct contract between the worker and the end user client, the worker would be regarded for income tax purposes as the end user client's employee. HMRC has previously published comprehensive guidance on how to determine status for tax and NICs purposes. However, this is only guidance and does not have the force of law, nor can it provide a definitive answer. The IR35 tax legislation came into force in April 2000, so there is a fair amount of case law specific to IR35 tax status. One can also look to other tax cases and cases relating to protection of employment law rights. However, status can be different for different purposes and, despite the vast body of case law, all cases turn on their specific facts and the outcome is never certain. HMRC is developing an online tool for assessing IR35 status and end user clients will probably use this to ease the burden of assessing employment status even though a number of commentators believe that the tool will be biased towards an inside IR35 assessment.
As currently drafted, the new obligation on public sector end user clients to inform staffing companies of their decision on employment status does not have much bite. The client has to inform the staffing company (or the entity with which the client has a contract to provide the services) of its conclusion "in the contract or otherwise", but no deadline is specified. The staffing company can raise questions in writing about the client's reasons for reaching its conclusion on status and the client must provide a written response to such questions within 31 days of its receipt of the request. If the client does not give the staffing company the information at all, the staffing company can request it in writing and the client must provide the staffing company with a written response giving the information within the same 31 day timeframe. If an assignment is within IR35, the staffing company must pay the relevant tax and NICs through the Real Time Information system. Clearly, revised drafting of the legislation is needed so that the client is required to provide the information before the assignment starts, although for commercial reasons the client ought to be considering IR35 status before resourcing the assignment. Even if the legislation is amended in this respect, staffing companies should consider including a contractual obligation on the public sector client to provide its status determination and reasons within a certain timeframe. If a staffing company contracts indirectly with a public sector client, for example, via a managed service provider, the staffing company should definitely include contractual obligations on the managed service provider to obtain the status determination from the client and to pass it on to the staffing company before the assignment commences.
The ultimate sanction for the client's failure to provide its conclusion on status within 31 days of the staffing company's written request is that the client becomes responsible for payment of the deemed employment income tax and NICs if the assignment is within IR35.
PSC liable if fraudulent information provided
If the PSC, or a person connected with the PSC, provides a fraudulent document intended to constitute evidence that the assignment is outside IR35, the PSC will be liable for payment of the deemed employment income tax and NICs if the assignment is within IR35.
Removal of the 5% expenses allowance
The 5% deduction currently allowed to personal service companies for notional expenses will no longer be available in relation to public sector assignments. The removal of this allowance is to take account of the fact that PSC contractors will cease to have responsibility for assessing IR35 tax status and to simplify administration.
Application to pre-April 2017 assignments
The new rules will apply to payments made on or after 6 April 2017. This means that for assignments that began before 6 April 2017, even if the assignment is completed before that date, any payment relating to that assignment made on or after 6 April 2017 will be caught by the new rules.
Staffing companies wishing to submit comments on the draft legislation should do so by 1 February 2017.
HMRC's online tool for assessing IR35 status is currently being tested privately. HMRC expects to release the tool for wider testing by the end of February with a view to reliance on its assessment of status to be possible from mid-March 2017. The tool will provide HMRC's view on IR35 status, which HMRC will support if the questions are answered honestly and correctly. It will be interesting to see how it assists the assessment of status, although cynics believe that it will be biased towards a finding of within IR35 status. Staffing companies should give feedback while HMRC continues to test the tool. HMRC will recommend that it is used, but this is not a requirement under the draft legislation. Unless clients insist, staffing companies will be able to decide whether or not to use the tool. However, staffing companies should be aware that public sector bodies will probably be expected to use it.
Although it is rumoured that there may be some movement on timing in the finalised legislation, this is not certain and planning for the new regime should not be delayed until final legislation is published.
Staffing companies may want to consider different contracting models. Some may choose to avoid the tax risk by treating all public sector assignments as being within IR35. Engaging contractors as PAYE workers may be another route for the risk averse, although this model brings with it increased compliance burdens in relation to social security benefits and certain employment law protection rights, such as the entitlement to paid holiday and the 48 hour weekly working time limit. Engaging contractors via umbrella companies which employ them is another alternative for those who want to avoid the tax risk. However, a blanket adoption of one of these routes will drive PSC contractors with outside IR35 status elsewhere, resulting in the loss of key clients and the erosion of key skills and contractor bases.
"Margin only" contracts are another potential route. Under this model, the end user client engages and pays the PSC directly and pays the staffing company its margin only. This moves the new IR35 liability to the end user client. It also makes the Agency Workers Regulations an irrelevant consideration because the "margin only" model takes PSCs completely out of scope of these Regulations. The downside to this model is that the staffing company potentially loses ownership of the contractors. However, appropriately drafted restrictions in client contracts and, where the Conduct Regulations do not apply, in contractors' contracts could prevent this.
Historically, contractors and clients have been reluctant to enter into project-based contracts rather than time and materials consultancy contracts. However, contracting on a project basis with fixed prices for the provision of pre-defined deliverables should be outside the scope of the new rules.
Staffing companies that intend to brave the challenges and continue to engage and supply the services of PSC contractors are advised to assess their public sector client base, work with clients and contractors to assess status and, ultimately, make their own decisions on whether assignments are within or outside IR35. However, making a decision on IR35 status that differs from the client's assessment would probably prove problematic for staffing companies in a number of respects including in relation to negotiation of fee rates.
Communication, education and planning will be key over the next couple of months. Staffing companies should prioritise a review of current public sector assignments with end dates and/or payment dates later than 5 April 2017 and also start planning in relation to future public sector assignments.