Art collector's court case signals potential legal and contractual issues with NFTs
Out-Law Analysis | 21 Jun 2021 | 3:10 pm | 7 min. read
Widespread changes to the UK’s IR35 off-payroll working rules came into force on 6 April 2021, and despite a 12-month delay to implementation, detailed HM Revenue and Customs (HMRC) guidance and subsequent amendments to the legislation, areas of uncertainty remain.
In addition to the complicated test for determining employment tax status and therefore whether an engagement falls within the scope of IR35, complex supply chains face significant uncertainties regarding whether a supply is ‘fully contracted out’ and therefore the identity of the client bearing ultimate responsibility for IR35 compliance.
Introduced in 2000, IR35 is essentially an anti-avoidance rule targeting the use of personal service companies (PSCs) to avoid employment taxes. Broadly, where an individual is engaged ‘off-payroll’ and through a PSC, the PSC contractor can achieve employment tax savings, while the engaging business is not required to pay employer national insurance contributions, currently at 13.8%.
The basic premise of IR35 is that when a business engages with an individual through an intermediary such as a PSC, if the individual would have been considered to be an employee for tax purposes if they had engaged directly with the business, then the individual should be taxed as an employee.
Under the previous regime, the PSC was responsible for assessing the tax status and paying any employment taxes if arrangements were deemed to fall within the rules.
However, in response to widespread non-compliance, the government decided to shift responsibility for assessing IR35 to the business engaging the PSC contractor, often referred to as the ‘client’. The rationale was that it is easier to investigate one business to collect unpaid tax in respect of multiple contractors, rather than pursue individual contractors. Large businesses also tend to be more risk averse and therefore more likely to comply with the rules.
Changes were originally introduced in 2017 for public sector organisations. Changes in 2021 imposed new compliance requirements and extended the regime to medium and large private sector organisations.
From 6 April 2021, when a busines engages with an individual through a PSC, the business as the client is now required to determine if the arrangement falls inside IR35 and therefore, whether the individual would be an employee for tax purposes if they had engaged directly with the business. The client must also issue a status determination statement (SDS) to the PSC contractor and any other intermediary the client contracts with, confirming its determination and providing the reasons.
If the client determines that a PSC contractor is inside IR35, income tax, employee and employer national insurance contributions and apprenticeship levy, where applicable, will be payable.
Where the client engages with the PSC contractor directly and not through another intermediary such as a recruitment agency, the client as the fee payer will be responsible for deducting and accounting for the relevant taxes.
In contrast, if the client engages the PSC contractor through another intermediary, it is the intermediary closest to the PSC in the contractual chain which is the fee payer.
In many respects, the new process appears clear-cut and can be easily summarised – when a client onboards a PSC contractor, they have to determine whether IR35 applies, issue an SDS and deduct tax where applicable. However, IR35 is far from straightforward and significant uncertainties remain.
The new rules made no changes to the employment tax status test, which determines if a PSC contractor falls inside IR35. However, the test is complicated and can lead to uncertainties regarding whether IR35 applies to a contractor.
There is no single test to determine employment status for tax purposes and the concept has been developed through caselaw. It is necessary to consider a range of factors, including whether the PSC contractor can provide a substitute, the level of control that the client exerts over the individual and whether mutuality of obligation exists between the parties. HMRC and the courts will focus on the practical reality of an engagement rather than written contractual terms.
In an attempt to reduce uncertainty and assist businesses when making determinations, HMRC developed the 'Check Employment Status for Tax (CEST)' online tool. Although useful, the tool has been widely criticised for its inability to provide a response in certain circumstances. Despite efforts to introduce improvements, CEST fails to provide an outcome in approximately 15% of cases.
However, given that HMRC has confirmed that it will stand by a CEST result if the information provided is true and accurate, using the tool may ultimately reduce the risk of an HMRC enquiry and also satisfy the requirement to take reasonable care when making status determinations. On balance, using CEST in combination with exercising judgement in complex cases, may be preferable to reduce risks.
In complex supply chains, another key uncertainty remains regarding who is the ‘client’ and therefore legally required to apply the IR35 rules and bear the ultimate legal and tax risks of non-compliance.
Identifying the client is straightforward where a company contracts directly with a PSC contractor, or where a company contracts with a PSC contractor through a recruitment agency. However, the client’s identity may be harder to ascertain in more complex supply chains, where a business engages a PSC contractor as part of a wider supply of services to another company, since it may be unclear whether the client is the company engaging the PSC contractor or the company which is the ultimate recipient of the services being supplied.
If the services are ‘fully contracted out’ of IR35, the client is the business engaging the PSC contractor as part of the wider supply of services.
Determining whether services are fully contracted out can be complex. HMRC distinguishes between businesses that enter into a contract for a supply of labour and are clearly clients under IR35 and those which contract with a service provider for the supply of a fully contracted out service and are not clients, since they do not exercise sufficient control, or have access to the information required to make status determinations.
Determining whether a supply is a fully contracted out service is a question of fact, based on actual working practices. However, in complex supply chains where multiple services may be provided under a single framework agreement, given that contractual terms alone are insufficient, drawing the distinction can prove difficult.
HMRC's guidance details three relevant factors when determining whether a service is fully contracted out and whether the business receiving the services, or the service provider will be the client:
Given that this list is not exhaustive, other unspecified factors may also be relevant when determining whether a service is fully contracted out and identifying the client for IR35 purposes.
Worked examples are also provided, however these are basic and have limited benefit when applied to complex supply chains. Here lies the main problem – modern supply chains are rarely straightforward and often involve multiple parties. The lack of clarity in the legislation and guidance has generated widespread uncertainty as to who bears IR35 risks across supply chains where businesses engage with service providers to deliver major complex projects that will usually involve some form of provision of labour.
Given that the client is legally responsible for making status determinations and issuing SDSs under IR35, if the client has been wrongly identified, then strictly, the ‘true’ client will have inadvertently failed to comply with its legal obligations under IR35. So what are the risks to a business if HMRC disagrees with a decision regarding whether a service is fully contracted out and considers the business to be the client for IR35 purposes?
Where a client fails to issue an SDS, the responsibility for deducting and accounting for tax will pass back up the chain from the fee-payer to the client. Therefore, if a client is wrongly identified, there is a risk that the ‘true’ client could face unexpected tax liabilities.
This risk may never materialise if a status determination has been correctly reached, an SDS issued and correct tax paid. However, given that the test for determining employment tax status is complex and different conclusions could be reached on the same facts, then it is possible that HMRC may disagree with a determination that IR35 does not apply and require employment taxes and penalties to be paid by the true client. This risk is difficult to quantify but undoubtedly exists and even more so if the true client adopts a more risk-averse approach and determines that IR35 applies in a broader set of circumstances.
The lack of clarity when determining whether services are fully contracted out is not a new issue and was foreseen long before the rules took effect. Nonetheless, it was not seen as a priority by businesses heavily reliant on off-payroll contractors and therefore focussed on introducing IR35 compliant onboarding processes and completing large numbers of status determinations. However, as the dust settles, businesses are increasingly turning their attention to larger supply contracts and the thorny issue of who bears responsibility for IR35 risks.
Some businesses have opted to manage prevailing uncertainties by adopting embargoes on the use of PSC contractors across their supply chains and extending this approach to all agreements with service providers, regardless of whether the service is likely to be fully contracted out. However, such an approach is often met with frustration by service providers, insistent that they are the client for IR35 purposes.
Determining whether a contract for services is outside the scope of IR35 may give rise to difficult and protracted negotiations between the parties, resulting in contractual protections and indemnities safeguarding one party against the risk that HMRC ultimately disagrees with the decision. Tax insurance policies are also increasingly being explored as an option to manage these risks.
Businesses may take comfort in repeated assurances from HMRC that it will take a light touch approach to penalties until April 2022. However, ultimately, businesses want clarity, which is unlikely to be achieved without further detailed guidance from HMRC.
This is based on an article which appeared in Tax Journal on 4 June 2021. Co-written by Rachel McConnell.
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Art collector's court case signals potential legal and contractual issues with NFTs