Out-Law Guide 5 min. read

IR35: taxation of off-payroll workers explained

Income tax form IR35

When engaging with contractors and off-payroll workers it is common that a business will engage with an individual through a company referred to as a personal service company (PSC) rather than directly with the individual on a self-employed basis.

Changes to the tax rules known as IR35 came into force on 6 April 2021. The new rules make businesses liable for determining the employment tax status of contractors who work through PSCs. The new rules have created significant cost and compliance challenges for businesses that rely heavily on a flexible workforce.

Background – the use of PSCs

Commonly, a PSC is a company where there is only one employee/office holder and the purpose of the PSC is to supply that individual's services to a business. The fee for those services is then paid by the business to the PSC. It is possible for a PSC to have more than one employee/office holder.

Using a PSC can be beneficial to the individual contractor for a number of reasons, including that the individual is protected by the limited liability status of a company. The individual can also achieve tax savings by having more flexibility regarding how profits are withdrawn from the company.

Historically, many businesses have encouraged the use of PSCs when engaging contractors since they provide increased flexibility, particularly for businesses operating in sectors with fluctuating labour demands. Given that individuals engaged through PSCs do not gain employment rights, such as holiday and sickness pay entitlement, the use of PSCs also tends to generate significant HR cost savings for the engaging businesses.

Previously, the use of PSCs also generated tax savings for engaging businesses. Prior to 6 April 2021, when contracting with an off-payroll worker through a PSC, a private sector business did not have to deduct tax under the Pay As You Earn System (PAYE) from payments made to the PSC or pay employer's National Insurance contributions (NICs). Employer's NICs are currently payable at 13.8%.

Under the pre-6 April 2021 regime, in the private sector, the PSC was responsible for applying the IR35 rules, operating PAYE and paying any tax and NICs that may be due.

When does IR35 apply?

Broadly, the IR35 rules apply where the individual would have been an employee for tax purposes if it had engaged directly with the business and not through the PSC.

There is no precise legal test to determine employment status for tax purposes. The test has been developed through court decisions and is based on a number of factors. HM Revenue & Customs (HMRC) has developed guidance on when it considers that an individual would be an employee for tax purposes.

The new rules have created significant cost and compliance challenges for businesses that rely heavily on a flexible workforce

When trying to establish whether an off-payroll worker would be considered to be an employee for tax purposes, HMRC has also developed an online tool - the Check Employment Status for Tax (CEST) tool - that may be useful. HMRC has said that it will stand by a CEST determination, as long as the information inputted into the tool remains true and accurate. CEST may not always provide a determination and it is estimated that it is unable to make a determination in 15% of cases. Therefore, when making status determinations, it is often recommended that a business uses a combination of CEST and its own judgment.

Where an individual is engaged through a PSC to provide services that would be undertaken by an officeholder, such that if the individual had engaged directly with the business they would have been considered to be a director/officeholder, IR35 will apply to the engagement. For example, IR35 would apply where an individual provides its services as a director, including a non-executive director, through a PSC.

How the new IR35 rules work

From 6 April 2021, when a business engages with an individual through a PSC (PSC contractor), the business is required to determine whether the engagement falls inside the IR35 rules and therefore whether the PSC contractor would be considered to be an employee for tax purposes if it had engaged directly with the business. The engaging business, known as the ‘client’, is also required to issue a status determination statement (SDS) to the PSC contractor and any other intermediary that the client contracts with, confirming its determination and providing reasons for it.

If the client determines that an engagement with a PSC contractor falls inside IR35, income tax, NICs (employee and employer) and apprenticeship levy (where applicable) will be payable in respect of payments made to the PSC contractor.

Where the client engages with the PSC contractor directly and not through another intermediary such as a recruitment agency, the client will be the ‘fee payer’ for the purposes of IR35 and will be responsible for deducting and accounting for the relevant taxes. However, if the client engages the PSC contractor through another intermediary, it is the intermediary closest to the PSC in the contractual chain that is the fee payer and is responsible for deducting and accounting for tax.

The new rules do not apply to private sector businesses which are “small”. Where a small business engages a PSC contractor, the PSC remains responsible for determining whether the IR35 rules apply and paying any taxes due under IR35.

What should businesses be doing now?

Since April 2021, businesses engaging with PSC contractors have been exposed to significant tax risks and should take action to address these risks without delay.

When engaging PSC contractors, either directly or through intermediaries, businesses need to review their onboarding processes and introduce systems for making status determinations and issuing SDSs. Contractual agreements with PSC contractors and intermediaries (e.g. agencies) should be reviewed and updated to manage IR35 risks.  

Complex supply chain risks

Managing IR35 risks may be less straightforward in complex supply chains. It may be difficult to identify the client 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: (a) the company engaging the PSC contractor; or (b) 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 (often referred to as the service provider). 

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. Determining whether a supply of services is fully contracted-out can be complex and is a question of fact, based on actual working practices. HMRC has published limited guidance on how to determine whether a service is fully contracted-out; however, confirming the identity of the client remains difficult in complex supply chains.

The client is legally responsible for making status determinations and issuing SDSs. If the client has been wrongly identified then, strictly speaking, the 'true' client will have inadvertently failed to comply with its legal obligations under IR35. Therefore, if HMRC disagrees with a decision regarding whether a service is fully contracted-out and the identity of the client, there is a risk that the business that is the true client could face unexpected tax liabilities and penalties for non-compliance.

When the new rules were first introduced, HMRC took a light touch approach to imposing penalties for the first 12 months until April 2022. Given that grace period has ended, HMRC is increasingly seeking to review IR35 compliance by businesses across a variety of sectors. It is crucial that businesses engaging with large numbers of PSC contractors, whether directly or indirectly, or that are part of complex supply chains have comprehensive processes in place to manage their exposure to IR35 risks.

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