A business is allowed to set the majority of its costs of operation and materials against its sales receipts before tax is paid on the remainder.
For an employee selling their services under a contract of employment, the option of setting off expenses is not available. Expenses such travel costs are not generally allowable against their tax liability.
To take advantage of the expense offset and benefit from limited liability for their work, many sole traders or contractors have formed service companies. As a director and shareholder, the contractor can offset business expenses and then choose whether to draw money from the company as employment income or dividends to reduce their tax liability.
This device has been used at all commercial levels and particularly in the IT sector.
IR35 - Intermediaries legislation
IR35 is the tax and National Insurance contributions law that may apply if you're working as a contractor through an intermediary company. It aims to make sure that you pay the same amount of tax as if you had been directly employed.
IR35 provides that anyone using a limited company intermediary for his contract work, (we will call them a consultant from now), who fails the self-employed test is now deemed to be in 'disguised employment' and will no longer be able to take advantage of the tax regime available to a business. Accordingly, they (or the business) will have to pay income tax and National Insurance contributions on the money they have received from the company (less certain small allowable expenses).
HMRC decides whether IR35 applies or not. It does not matter what written agreement is in place, nor what the parties have agreed, but instead on the relevant facts about the contract.
The basis of a decision is many years of case law. Therefore, it is possible to make a considered judgment as to whether a particular set of facts constitutes employment or self-employment.
The starting point is that the consultant must work under the terms of a proper contract for services - a consultancy agreement of some sort. Whilst the existence of such a document is not conclusive evidence of the status of the parties, any such agreement will be drawn in a way that tends to show the relationship as being that of consultant-client, not of employee-employer.
The agreement matters only because of the terms it contains. The terms only matter, first if they tend to show a contract for services and secondly if the parties are complying with them.
If a consultant works through an agency, it is particularly important that the agreement is in the right form, because agency employment tends to fall short of the rules.
Factors to take into account include:
- Is there a business beyond merely the sale of services of one person? For example, does the business have a bank account? Does it have stationery and business cards? Is there an ongoing provision for selling the services to new clients? Does the business own equipment such as computers, but also other larger items such as photocopiers?
- Are there other employees working for the consultant under contracts of employment? This is a very strong marker. We have never come across a case where a business employing others was deemed to be the self-employment of one or more individuals.
- Is the consultant at risk in the performance of the contract? The provisions of the agreement relating to liability, indemnity and insurance should make this clear. This is another strong indicator. Employees cannot generally be sued for an accidental disaster, but consultants can.
- Is the subject matter of the contract expressed in terms whereby the client pays for an outcome or merely for work to be done in accordance with his direction? This includes the timing and method of payment and the degree of control enjoyed by the client. Does the client say how many hours a week shall be worked or where the work will be done?
- Is the consultant at financial risk? Could he make a loss if things go wrong? Can he make more profit if they go well?
- Is the consultant restricted from working for others? Employees are not generally allowed to have two jobs. Consultants can work for numerous clients simultaneously. Some restriction to prevent assisting a competitor is normal and should make no difference. It is good if the consultant has more than one client at once, and preferably several. Generally speaking, the more clients, the more clearly the business is just that, and not a disguised employment.
- What overhead expenses are incurred? If the consultant operates from a self contained purpose built office, that points to a business. If he works from home, the matter is still open. Even for a home worker, the exclusivity of space is important. But beware of allocating space exclusively to business use, 365 days a year, or that proportion will be subject to capital gains tax when you sell the house.
- To what extent can the consultant subcontract the work? This is not the most important item because it is quite common for a client to insist that the work is not subcontracted.
Who has to pay the tax and NI?
The responsibility for payment of tax (and subsequent liability for penalties for non-payment) falls on both the service company employing the consultant and (if it does not pay), the consultant himself. Note that he or she is not protected by the limited liability of his company! The employing client is not responsible. Note that this is different from a normal situation where HMRC deems a relationship to be that of employer-employee, and where accordingly, the employer has to pay the amount due as PAYE.
Our general advice
Play fair. If your work really is employment, accept that you will have to pay the tax.
If you are in any doubt, put your case to HMRC for an opinion. Take a budgeted account; showing what overheads you will have to pay and a narrative explanation of how you will operate. It is likely the outcome will be favourable. Yes, HMRC does try to collect as much tax as possible, but they have better things to do than to take on "no hoper" cases where you will make then look foolish before the commissioners.
If HMRC do not give the answer you want and you feel they are wrong, do appeal. The commissioners will give you a fair run. When your appeal has been made, go back to HMRC with some additional information. If you give then half a chance to change their mind, they may do so.
If you really do not want to be a business and you want an intermediary employer so as to show a consultant presence to a client, and then choose a properly qualified firm of accountants who run such a scheme. Above all, obtain references you can speak to on the phone.
Don't hesitate for a moment in operating as a business. You do not need a company to qualify for the less unfavourable tax regime enjoyed by businesses. If you can operate a simple piece of accounts software, that is great. If not, just record everything carefully and find an accountant to put it together each month. You will enjoy greater prestige and may be able to charge higher fees for the same work.
Example case law
Issues of substitution and control were key factors in Tilbury Consulting Limited v Margaret Getting (Her Majesty's Inspector of Taxes). The Inland Revenue sought to show that the director, Mr Tilbury, was a disguised employee of his end client, Ford Motor Company.
Tilbury Consulting Limited won the case based on an examination of three relevant areas: the written agreement; the actual working practice and the situation in the round. A good agreement was a crucial feature.
It was noted:
- Tilbury Consulting had the 'qualified right' to send a substitute, although it was never exercised;
- it was not part of the direct manager from Ford's function to tell Tilbury how to do the work, and;
- Mr Tilbury had a different colour pass from the Ford employee pass, which did not entitle him to use of the gym.
Mr Tilbury was paid by the hour, and that it was not a matter of concern to Ford who provided the services, or that some of the work was undertaken at Tilbury Consulting Premises.
Mr Tilbury would not have been regarded as Ford's employee:
- firstly because neither Tilbury Consulting nor Mr Tilbury did not have operational control over how the project was undertaken.
- secondly, because Tilbury Consulting was not part of Ford's business or undertaking.
Changes to off-payroll working rules (IR35)
Changes to IR35 will be implemented in April 2021 for private sector contractors that will transfer responsibility from contractors to large and medium companies to assess IR35. The 2020 reform will bring private sector IR35 in line with the public sector.
What the changes mean if you are contractor or intermediary
From 6 April 2021, if you or your worker provide services to a client in the public sector and medium or large-sized private sector clients, the clients will be responsible for deciding your worker's employment status.
The same will also be true for some charities and third sector organisations.
Employment status determination
Therefore, if you or your worker is providing services to a public sector client, or a medium or large-sized private sector client, they:
- should get an employment status determination from the client, as well as the reasons behind their determination.
- Will be able to dispute the determination made, if they disagree with it.
If your worker is providing services to a small-sized client in the private sector, then you will be responsible for determining your worker's status and check whether the off-payroll working rules apply.
Tax and National Insurance
Suppose your worker provides services to a small sized client in the private sector and the off payroll working rules apply. In that case, you will be responsible for deducting tax and National Insurance from your worker's fee and paying them to HMRC.
Conversely, if your worker is providing services to a public sector client, a medium or large-sized client in the private sector and the off-payroll working rules apply, the client will be responsible for deducting tax and National Insurance contribution.
Disagreeing with determination made by the client
If the worker disagrees with the employment status determination made by the client, the following will have to be done:
- Obtain details of the employment status determination from the client
- Give reasons for their disagreement with the determination
- Make copies of the record about disagreement.
You should also note that a disagreement can be raised until the last payment is made. Thereafter, the client will have 45 days from the date of receiving of the disagreement to respond.
Further, during the time the client takes to respond, the fee payer has to continue working based on the determination so made by the client.
If the employment status determination has been changed after review, the client will give a new status determination and confirm the date from which the determination is valid.
What the changes mean if you are the client
From 6 April 2021, all public sector clients and medium and large-sized private sector clients will be responsible for determining workers' employment status. You must meet two of the following conditions for the rules to apply::
- Have an annual turnover of more than £10.2 million
- Have a balance sheet of more than £5.1 million
- Have more than 50 employees
To some clients, the Simplified test applies, which considers annual turnover. Basically, you will meet the Simplified test and have to apply the off-payroll working rules if you have an annual turnover of more than £10.2 million and are not:
- A company
- A limited liability partnership
- An unregistered company
- An overseas company
With regards to affiliated and associated companies, if the parent of a group is a medium or large-sized client, their subsidiaries will also have to apply the off-payroll working rules.
When do the rules come into effect?
All public sector clients will continue to apply the rules; however, they will have additional responsibilities from 6 April 2021.
Private sector clients
Private sector clients, which are medium or large-sized, will have to start applying the rules starting 6 April 2021, if they meet the simplified test. Further, if you are using the simplified test to determine your size, you will have to start applying the rules from the start of the tax year which follows the end of the calendar year when you met the simplified test conditions.
What you will have to do
If you are a medium or large-sized client in the private industry, you will have to decide the employment status of every worker operating through their intermediary, even if you acquired their service through an agency.
You will have to communicate your employment status determination using the Status Determination Statement (SDC). The SDC must:
- Be given to the worker and the person or organisation you have contracted with
- Provide your conclusion and your reason behind it.
Consequently, you will have to:
- Ensure to keep detailed records of your determinations, which includes the reasons for the determination and the fees paid.
- Put a process in place to deal with the disagreements which may arise from your determination
- If asked by the person or organisation you are contracting with, confirm the size of your organisation.
You will also become responsible for deducting and paying tax and National Insurance contributions to HMRC if you are the fee payer and the off-payroll working rules apply.
Who is the fee payer
In most cases, the organisation paying the worker's intermediary will be the fee payer. To be a fee payer, you must meet the following conditions:
- be a resident of the UK or have a place of business in the UK
- are paying an intermediary which is controlled by the worker or associate of the worker
- the intermediary is not controlled by the worker or an associate of the worker.
If you do not meet the conditions mentioned above, the responsibility of deducting tax and National insurance contributions will pass to the next party.
You can check your employment status for tax to if you want help to decide whether the off-payroll working rules apply.
What if you are small-sized private sector clients?
If you are small-sized clients operating in the private sector, you do not have to worry about the changes to the off-roll payroll working rules. Just confirm to the intermediaries you contract with that you are a small-sized client.
What if you an overseas client?
If your organisation is wholly based overseas, the off-payroll working rules will not apply. It will remain the intermediary's responsibility to determine if the rules apply.
How to deal with disagreements by worker over employment status determination?
If the worker disagrees with your determination, you will need to do the following:
- Consider the reasons given for disagreeing with your determinations by the worker or the agency paying the intermediary
- Determine whether you want to stick by your determination if you feel it is correct and give reasons behind it. If you decide that you were wrong in your initial determination, you must provide reasons for it as well.
- Maintain all the record of the determinations you have made and the reasons given for them
- Maintain copies of all representations made to you
Disagreements can be raised until the last payment is made for the service of the worker. If you receive notification of a disagreement from the worker or the deemed employer, you must provide a response within 45 days of receiving the notification. If you fail to respond within that time frame, you will become responsible for the worker's tax and National Insurance contributions.
Further information and useful documents
If you are considering becoming a consultant under a company structure, you will need legal documents for the new company. You will also need to work under a consultancy agreement that sets out as clearly as possible your relationship with your client as one not of employment.
If you work in the construction industry, you may wish to read about the CIS scheme.