Introduction to IR35
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'IR35' or 'Inland Revenue 35' is the number of the Budget press release issued on 9 March 1999 by the Treasury and the then Inland Revenue (now HMRC) under the then Chancellor of the Exchequer, Gordon Brown. It announced the forthcoming introduction in 2000 of a new tax regime and was entitled 'Countering Avoidance in the Provision of Personal Services'. The tax regime's official title is the 'intermediaries' legislation', but it was simpler just to use the phrase 'IR35'. A further press release was issued by the Inland Revenue on 23 September 1999 after a short consultation period which revealed more detail of the approach to determining employment status and introducing the concept of the 5% expenses allowance.
The new tax regime was designed to ensure that individuals providing services through an intermediary company would be required to operate Pay As You Earn ('PAYE') and National Insurance contributions ('NICs') on any payments they received from the business engaging them to do the work, where, but for the existence of the intermediary company, those individuals would have been classified as employees.
The Government announced changes within Budget 2018 which would take effect from April 2020. These changes would bring the current private sector off-payroll working regime in line with the off-payroll working rules applicable to the public sector which were introduced in April 2017. Due to the different structure and nature of the public and private sectors, the proposed changes have been the subject of intense debate. Draft legislation has been produced which is expected to be part of the Finance Bill of 2020 and draft guidance as well as a revised CEST tool (see below for details) has been produced by HMRC. A response to the consultation document issued in March 2019 has also been set out by HMRC.
This Tax Digest volume looks at how to prepare for the IR35 changes in the private sector.
The evolution of IR35
Having introduced the IR35 legislation in 2000, it became obvious over the following years that it had failed to bring in the anticipated revenues or address associated avoidance behaviours. Therefore, in April 2017 a programme of change was introduced, starting with the public sector. Proposals now exist for the regime to be applied to medium-sized and large businesses in the private sector from 6 April 2020.
In the beginning
The original IR35 legislation in Schedule 12 of Finance Act 2000 was consolidated into Chapter 8 of Part 2 of the Income Tax (Earnings and Pensions) Act 2003 ('ITEPA 2003') and in the Social Security Contributions (Intermediaries) Regulations 2000 (SI 2000/727).
The Inland Revenue had noticed during the 1990s that increasing amounts of individuals were setting up limited companies where they were often the sole director (known as 'one-man limited companies' or 'personal service companies'). The purpose of this was to facilitate provision of their own personal 'consultancy' services to one main client.
New company registrations grew exponentially and were consistent with a corresponding decline in payroll headcount numbers in certain sectors, including the public sector, banking, IT and the NHS, as well as a simultaneous decline in National Insurance receipts according to Inland Revenue, HMRC (post-2005) and HM Treasury statistics in the same period.
Despite the commissioning of two consecutive Office of Tax Simplification reports in March and November 2016 on the alignment of income tax and NICs, many of the recommendations were not taken up by the Chancellor (Philip Hammond) who was in post when the second report was commissioned (the first one was commissioned by George Osborne) and it therefore remains the case that the tax and NIC costs of employment still remain higher than those relating to self-employment (see https://www.gov.uk/government/publications/closer-alignment-of-income-tax-and-national-insurance-contributions and https://www.gov.uk/government/publications/ots-publishes-further-report-on-the-closer-alignment-of-it-and-nics).
A different way of working – the rise of the portfolio career and the gateway to the 'gig' economy
The most often quoted scenario was that an employee would leave the employer business on the Friday and the following Monday be engaged as a consultant, the role not having changed significantly over the intervening weekend, if at all. However, significantly, it was outside HMRC's power to question someone being paid through an intermediary company – HMRC was only able to reclassify workers who had become self-employed but who had not set up a limited company through which to provide their personal services to the client. The interposition of the limited company therefore offered the employer protection from both employment law responsibilities and obligations, but from paying employer's NICs.
In addition to the protection offered to the employer, the worker was also able to shelter income from taxation and NI which they had not been able to do in an employment scenario. The limited company invoiced the engager for the services of the director and income received by the personal service company, then typically paid the director an annual salary equivalent to the UK personal allowance for that tax year. The remaining income could then be extracted by way of dividends. This resulted in the following advantages for the individual:
(1) the individual paid the minimum in PAYE or NICs and yet still qualified for state pension and other state benefits; and (2) the individual paid most of their income tax at the dividend rate, which prior to April 2016 offered a significant tax cost advantage. After 2016, the dividend rates were changed – since then, the advantages are still there, but are somewhat lessened by the rate changes.
HMRC'S CEST tool and guidance
There are concerns that CEST (HMRC's online tool for checking employment status for tax) is both unable to take accurate account of case law in determining employment status and unable to cope with the complex nature of the private sector. HMRC's aim has been to enhance the CEST service and improve related guidance so that organisations can confidently use it to make employment status determinations that can be relied upon. It is unclear whether this has been achieved with the introduction of the revised tool. The enhanced CEST tool and related guidance was issued at the end of November 2019.
The tool was rigorously tested against case law and settled cases by officials and external experts. It provides accurate results and HMRC will stand by the result produced by the tool provided the information input is accurate and the tool is used in accordance with our guidance. To date, the tool has provided a determination in at least 85% of uses. As a minority of employment cases can be less straightforward, we're giving these customers detailed help and guidance, including one-to-one support from specialist advisers on our helpline.'
During 2019, HMRC consulted focus groups on a re-modelling of the CEST tool which HMRC anticipates will provide engagers and contractors with a re-worked fact-based decision-making programme which HMRC says it will stand by as long as they agree that the input information represents an accurate representation of the contractual relationship at the time of completion.
Use of the CEST tool is not mandatory. The engager can choose whether it uses its own status decision-making process (in-house or outsourced) or the CEST tool. Whichever method is chosen, it is clear that to obtain the right decision, the correct facts must be obtained at the outset.
One known downside of the CEST tool is that it can reach an 'inconclusive' result, which does nothing to help the decision-maker. It is therefore more important than ever for a robust audit trail to exist which documents the engager's decision-making process and rationale.
HMRC sought information during the 2019 consultation about typical labour supply chains in different sectors. HMRC is keen to explore alternative methods of short-circuiting a lengthy supply chain, which might allow the fee-payer to receive the determination directly from the client. HMRC wants the off-payroll working rules to be applied properly and consistently, based on the facts of each particular engagement.
One major factor which has been dividing opinion between HMRC and professional and representative bodies is the concept of Mutuality of Obligation ('MoO'). HMRC's interpretation of case law is that MoO is present in every contract regardless of its nature and does not therefore need to be considered. Others have a different view which is that case law demonstrates MoO needs to be established for a contract of employment to exist. A list of cases is shown at the end of this guide which the reader can refer to in this regard (see 'Further reading' below ([44.1])).
The CEST tool can be accessed at https://www.gov.uk/guidance/check-employment-status-for-tax.