IR35: the basics, and expected changes to the rules

Out-Law Guide | 19 Jun 2019 | 3:26 pm | 4 min. read

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.

New tax rules are being introduced that will make businesses liable for determining the tax status of contractors who work through PSCs. The changes to the rules known as IR35 are being introduced from April 2020 and will create significant cost and compliance challenges for businesses which rely heavily on a flexible workforce. This guide provides an overview of the current rules and the proposals for change.

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.

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 The individual can also achieve tax savings, by having more flexibility regarding how profits are withdrawn from the company.

Many businesses have encouraged the use of PSCs when engaging contractors, since they provide increased flexibility, particularly where a business operates in a sector with fluctuating labour demands. Engaging with individuals through PSCs can also create significant HR costs savings to businesses, since those individuals would not gain employment rights, such as an entitlement to sickness and holiday pay.

The use of PSCs also generates tax savings for businesses. Currently, a private sector business which contracts with a PSC does not deduct tax under the Pay As You Earn System (PAYE) from payments made to the PSC, and importantly, does not have to pay employer's national insurance contributions (NICs). Employer's NICs are currently payable at 13.8% so engaging contractors through a PSC can result in a significant tax saving on a business's payroll costs.

However, the IR35 rules require that employment taxes and NICs be paid in respect of a person who provides services through a PSC if that person would have been regarded as an employee of the engaging business if it had engaged directly with the business.

When does IR35 apply?

Broadly, the IR35 rules will only apply where there would have been an employment relationship between the engaging business and the individual if the individual had engaged directly with the business, rather than through the PSC.  The IR35 rules do not apply where there is a genuine self-employment/consultant relationship.

When a business engages with contractors through PSCs, it will be exposed to significant tax risks and businesses need to start taking action to prepare for this.

There is no precise legal test to determine whether an individual is an employee; rather the test has been developed through court decisions and is based on a number of factors. HMRC has also developed guidance on when it considers an employment relationship exists.  The Check Employment Status for Tax (CEST) Tool may also be useful when trying to establish whether a contactor would be considered to be an employee. However, HMRC has acknowledged that the CEST tool is limited and fails to give the correct answer in 15% of cases. CEST is currently being reformed as part of HMRC's preparations for the IR35 changes being introduced in April 2020.

IR35 also applies where an individual is engaged through a company to provide services to a client and the individual would have been regarded as the holder of an office with the client if the individual had been engaged directly. For example, IR35 would apply to PSCs providing the services of an individual as a director of the client, including a non-executive director.

How the IR35 rules work

Currently, where a private sector business engages a contractor through a PSC, liability to decide whether IR35 applies and to pay any employment taxes rests with the PSC.

This is in contrast to the public sector, where following changes to the rules in April 2017, public authorities and other public sector engagers are now responsible for determining whether the IR35 rules apply and accounting for tax and NICs if the contractor would have been regarded as an employee if the PSC had not been used.

Proposals for change - what we can expect?

At the autumn Budget in October 2018 the government confirmed that it would extend the changes to IR35 in the public sector to the private sector from April 2020. HMRC has confirmed that small businesses will be exempt from the changes, and that the reforms will not operate retrospectively.

Consequently, once the new regime is introduced, the engaging business (known as the end-client) will be liable for determining employment tax status and whether the IR35 rules apply. Where an engagement falls within IR35, the liability to operate PAYE and pay employers' NICs will sit with the entity that pays the PSC (the "fee payer"). In more complex supply chains this entity is likely to be an agency. However, under the current proposals, if the fee payer fails to pay tax due under IR35, liability for any outstanding amount will shift back to the end-client. Ultimately, therefore, the risk of non-compliance sits with the end-client. This approach will be consistent with the changes already introduced in the public sector.

What should businesses be doing now?

When a business engages with contractors through PSCs, it will be exposed to significant tax risks and businesses need to start taking action to prepare for this.

The consultation outlines four actions that businesses should take now to prepare for the reforms. These include: identifying and reviewing "current engagements with intermediaries", including personal service companies (PSCs) and labour supply agencies, and putting in place "comprehensive" processes to determine the employment status of contractors. HMRC also recommends that businesses should start reviewing internal systems such as payroll software, process maps, HR and on-boarding policies to see if they need to make any changes.

By including a section in the consultation outlining the actions businesses should take to prepare for the reforms, HMRC has issued a clear warning to businesses not to wait until April 2020 to respond. Businesses can expect HMRC to begin robustly reviewing compliance as soon as the new rules become law.

In the first instance, a business needs to identify how many PSCs it engages and which areas of the business are engaging PSCs. Once a business has identified its PSC population, it needs to undertake a comprehensive risk assessment to establish its exposure to IR35 and to review whether changes need to be made to HR and procurement processes when engaging with contractors through PSCs.

Embarking on this compliance exercise as quickly as possible is going to be crucial for businesses in sectors where there is heavy reliance on a flexible workforce and large numbers of contractors are likely to be engaged through PSCs.