An accountant explains to a contractor. Companies should ensure IR35 compliance from contractors.

The challenges of keeping off-payroll contractors outside IR35 taxation rules

The extension of the IR35 tax avoidance regulations to most private sector contractors presents potential pitfalls for unwary businesses in the recruitment sector according to Kevin Barrow, Partner with international law firm Osborne Clarke LLP.

New rules, new challenges

The complexities and nuances of the IR35 tax regime can mean contractors and the agencies and companies hiring them may find themselves subject to the new rules in unexpected ways, says Kevin.

Essentially, IR35 assesses and determines if a contractor is genuinely ‘self-employed’ and is therefore able to benefit from the tax and national insurance advantages associated with running their own business, or whether they are effectively working as an ‘employee’ and should be taxed accordingly – known as being ‘inside IR35.’

Broadly speaking, a contractor is considered to be inside IR35 if they offer ‘personal services’ to a hirer above a certain size via an intermediary, usually the contractor’s own ‘personal services company’ (PSC), and the relationship between the contractor and the hirer has what HMRC describes as the “hallmarks of employment.” Where this is the case, the person who pays the PSC is liable, as ‘fee payer’, to account to HMRC for PAYE and NICs in respect of the payments to the PSC.

Potential pitfalls

Kevin says there are a number of potential pitfalls that need to be identified and avoided if contractors are to be classed as genuinely self-employed by HMRC and therefore ‘outside IR35’.

Firstly, it is important to understand that HMRC’s definition of personal services is wide ranging and captures anything which involves a personal obligation to perform services. For example, consultancy services are subject to IR35 if the consultancy is using PSC contractors.

Even if ‘substitution rights’ are inserted in contracts to avoid the personal services label by stating that a client does not need that specific contractor to complete a project, recent legal cases have shown this approach is not always accepted by HMRC.

Kevin says: “It’s possible to escape the personal service classification by creating ‘hirer pays’ contracts, featuring a ‘statement of work’ where a fixed fee is paid for a specified outcome. I see many staffing companies and consultancies moving over to genuine arrangements like that, but while ‘rebadging’ contracts in this way can sometimes get you out of IR35, in most situations it won’t and HMRC is hot on it.”

Common misconceptions

A common misconception is that end-clients can simply issue a Status Determination Statement (SDS) saying a contractor is outside IR35 and everyone is off the hook. However, if the correct tax is not paid by the fee-payer for any reason, HMRC can then recover tax from entities higher up the chain, whether that be a recruitment agency, staffing agency, consultancy, managed service provider (MSP) or the end-client.

So, everyone in the chain needs to carry out more due diligence to ensure they are dealing with IR35-compliant contractors and, according to Kevin, intermediary companies that carry this out to reassure end clients are more likely to see their market share increase.

Some companies are also having SDS checks carried out by third parties. While broadly a good idea, if third party checkers are offering insurance to cover any IR35 liabilities, it could trigger tax liabilities for hirers and suppliers under Managed Service Company (MSC) anti-tax avoidance legislation. Providing tax insurance is a specific trigger for MSC liability, so companies following this route should take legal advice to avoid the risk of being landed with an even greater tax liability than IR35, along with personal liability for directors.

Another misconception is that it’s okay to put all contactors outside IR35 for now to save some money because hard-pressed HMRC is unlikely to take enforcement action within the first few years of IR35 coming into force on 6 April 2021.

This is risky because HMRC has four years to raise an assessment for underpaid tax and NICs – and might not decide to start any enforcement action until 2024. In the meantime, therefore, it’s important to keep evidence of any SDS decisions and carry out regular updates and checks on them and also ensure the ongoing compliance of the supply chain. Even if HMRC do not pick up on it, the point will be checked by prospective investors and buyers if supplier shareholders decide to try to raise funds or sell up.

Questionable risk reduction

Many end-clients mistakenly think they can simplify and reduce their IR35 risks by simply issuing a blanket ban on PSCs.

This effectively enforces a pay cut of 15% to 30% on contractors ‘inside IR35’. That may be acceptable for less critical roles, but can potentially drive away in-demand talent – possibly to rival businesses – which means upping contractor’s gross salaries to maintain take-home pay and retain them.

Furthermore, some business-critical contractors will only work via a PSC, so in reality exceptions to the blanket ban often have to be made and, consequently, Kevin is seeing more contractors continuing to work outside IR35 than expected in many industries.

Some hirers and suppliers of staff are looking at alternative models to avoid the risks, such as pushing inside IR35 contractors into umbrella companies that apply PAYE tax.

However, some of these umbrella companies operate aggressive tax avoidance and evasion schemes, meaning careful checks need to be carried out to ensure full PAYE tax and NICs are being paid and deducted. Kevin warns that engaging people through umbrellas following dubious practices could ultimately make hirers liable for unpaid taxation in the eyes of HMRC.

Another IR35 risk-reducing model, popular with agencies supplying the construction industry for example, is for contractors to move from PSC to sole trader arrangements – but this carries a big risk of agencies falling foul of some very strict HMRC ‘intermediary’ rules, potentially resulting in fines.

Wider impact

Kevin says that IR35-related issues are likely to have an impact on company values in mergers and acquisitions.

Indeed, they are already arising in due diligence exercises being carried out in connection with merger and acquisition deals in the recruitment sector, which is seeing a lot of M&A activity.

So, for staffing companies it’s important to ensure all PSC contracts have been terminated and reissued, either on a PAYE basis with appropriate gross pay rates or with new terms in line with being outside IR35, and decide how inside IR35 contractors will be handled.

Checks should be carried out on second-tier suppliers and umbrella companies and those using insurance-backed checking services should seek legal advice.

Finally, in addition to proactively helping clients to find their contractors, offering to take over the task of ensuring IR35 compliance could be a key differentiator for recruiters.

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