One of the significant announcements in the Budget was the change in responsibility for dealing with the IR35 legislation for personal service companies. Anyone operating a personal service company, or employing someone through a personal service company, needs to understand the change as the impact could be significant and change how business is done.
The legislation on personal service companies(PSCs) is complex and the new changes (which don’t come into effect until April 2020 to allow time for companies to get ready) move the responsibility for the tax impact of PSC's from the PSC to the fee payer (employer) of the PSC. This is consistent with what was done last year in the public sector.
What will does this mean, first for the PSC and then the employer?
In order to answer this, it's worth revisiting the rules for PSCs as defined in the IR35 legislation. The intent of this legislation is to look at companies that provide personal services, such as individual IT consultancy companies, and determine whether the person providing the service is really employed rather than self employed and tax them accordingly. The aim (as you would expect) is for HMRC to get more money as the tax legislation for self employed is more beneficial than employed under PAYE. This is done by looking at the contract primarily and seeing if it is between the employer and individual (rather than the company) asking whether the individual is effectively employed.
To determine employment status however has been notoriously difficult. HMRC believe that just 10% of people correctly comply with the legislation. This equates to 30% of the PSCs operating today which results in a significant gap in potential revenue to HRMC (and why they want to close the gap by getting the employers to manage the issue). In reality, as we will come onto shortly, this will be harder for employers to do as opposed to the PSC's. However, in my opinion, it is being done for two main reasons:
1. Employers currently have the benefit of not paying the Employers NI which they will be forced to do under the new rules (although the PSCs should be able to charge higher fees as a result).
2. There are far less companies employing PSCs then there are PSCs (for example, think of a bank employing 100 IT contractors for a project all operating their own PSCs) and so coming after the bank for non-compliance will be significantly easier and more profitable then going after all the small PSCs.
What is the definition of employed versus self employed?
From an employment perspective this is based on case law and primarily relates to three conditions as determined by the Ready Mix Concrete case in 1968.
These are:
1. Mutuality of Obligation - both parties are obliged to do something i.e one is obliged to provide work and pay for it and the other is obliged to do the work.
2. Rights of Substitution - the person required to do the work can not be substituted for someone else without agreement.
3. Level of Control - the amount of control that the employer has over the worker (i.e: where they work, what hours, etc).
Recent case law provides some additional clarity on what is determined to be 'employed' under this legislation. In HMRC v. Christia Ackroyd Media Ltd (a media presenter), HMRC won the case. It was determined that Christia Ackroyd was in employment for the BBC rather than self employed on the basis that the BBC had ultimate control over where and when she worked even though she had a high degree of autonomy in her role. Another factor in HMRC's favour was the length of time of the contract . The contract had been ongoing for seven years making it difficult to argue no mutuality of obligation, especially given the contract required a minimum of hours worked which would be paid irrespective of whether there was work to do.
However, two other key cases (HMRC v. MDMC Ltd and HMRC v. Jendal Software) resulted in HMRC losing. In these cases, it was determined that the individuals exercised autonomy of key decisions such as when and where they worked and so exhibited enough control to be deemed self employed.
Therefore I would strongly recommend that anyone operating PSCs should seek advice from their accountant or advisor to review determine where their particular circumstances stand in relation to the findings of these recent cases and document accordingly.
It is worth noting that HMRC has created a test to help determine what, in HMRC's view, will be determined to be employment.
It is worthwhile doing this test because it takes you through the process of assessing unfettered right of substitution, control and financial risk in the eyes of HMRC, to determine whether you would be considered to be employed. However, I would also stress that it shouldn't be treated as foolproof because, as outlined above, the HMRC has lost two key cases where they viewed the contract was one of employment yet the Court ruled otherwise. The test also assumes mutality of obligation and ignores the situation of having multiple contracts where you may need to look outside the individual contract to demonstrate that you conduct business in your own account. If you do fail the test (i.e you are deemed to be in employment) as a business employing a PSC or as a PSC I would recommend that you urgently seek professional advice because you could be at risk of non-compliance.
Given the complexity of determining employment, what is the new legislation announced in the budget expected to achieve?
The main change is the movement of responsibility for assessing employment by applying the legislation to the employer. You note though, this this responsibility only applies to large and medium sized companies. This means that a PSC may end up being still responsible for some of their contracts but not for others, depending on the size of their clients.
This change was implemented last year for public sector firms and so the issues highlighted by them are likely to be compounded given the enormity of PSCs in the private sector. The main issues highlighted have been:
1. Blanket assessments being made ignoring specific contractual arrangements.
2. Workers having to bear employers' NI.
3. CEST (the online employment tool) being too simplistic. It also doesn’t deal with the PSC's business on its own account and, in many situations, it may be impossible for an employer to determine as they may not be able to determine what other contracts the PSC has.
4. How to account for tax deducted in PSC.
5. Right of appeal and the timelines to do so, especially given multiple taxes impacted.
An issue which has always existed, but is likely increase as more people are affected, is the cost to the PSC if it is determined the individual providing the services is deemed to be employed. This can be significant and shouldn’t be underestimated. Not only is there likely to be higher PAYE and NI tax to pay when paying a salary versus dividend (the main way that the money is extracted from the firm), but the interest for late payment may also be significant. This is because for overpayment of tax HMRC currently will pay you 0.5% interest but underpayment is 3.5%. In most cases, the corporation tax will be overpaid (as there wasn't a large salary deduction) and PAYE and NI underpaid which would partially net off. However with the difference in interest being charged on overpayment versus an underpayment you would end up paying 3% on the gross PAYE/NI amount rather than the net difference. This, as you might imagine, could be very significant.
What next?
If you are a personal service company, or employ a personal service company, you should revisit your contracts and assess whether it is an employment contract or a service contract. For the employers who haven't had to do this before, this could involve a lot of work and result in adjusted pricing and recreating the payroll process to manage the changes.
If you are thinking of becoming self employed then you also need to assess whether you would be impacted by the legislation.
Don't delay if you think the changes will affect you as the implications for the structure and tax of your business can be immense and the costs of non-compliance are high.