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.