All systems go on extension of IR35 to the private sector from April 2020

It published draft legislation yesterday, following a second Government consultation on the reforms, which closed in May 2019. 

What is IR35?

IR35 applies where an individual is what HMRC calls a “disguised employee”. In other words, if that individual personally provides labour to a client via a personal services company or partnership (“Intermediary”) and:

• ignoring the existence of the Intermediary, the individual would be an employee or office-holder (e.g. director) of the client; or
• the individual is an officeholder and the services provided through the Intermediary relate to that office.

Under current rules, if the client is in the private sector, the Intermediary must determine whether IR35 applies and, if so, account for income tax and national insurance contributions (NICs) on its fees (excluding VAT) less certain statutory deductions. 

How is IR35 changing?

With effect from 6 April 2020, large and medium-sized clients in the private sector will be responsible for determining whether the IR35 rules apply.  This change will very broadly align the IR35 position in the private and public sectors – public sector clients have been required to determine whether IR35 applies since April 2017. 

If a client decides that IR35 applies, generally the person paying the Intermediary (the “Fee Payer”) will be responsible for deducting income tax and employee NICs and accounting for employer NICs on the fees paid to the Intermediary (excluding VAT).  The employer NICs paid are also taken into account in determining the Fee Payer’s liability for the Apprenticeship Levy.

If the client decides that IR35 does not apply, the Fee Payer will, as currently, continue to pay the Intermediary gross.  

What are the latest proposals?

Particular points to note from the draft legislation are:

• Having decided – using reasonable care – whether IR35 applies, clients will be required to provide a Status Determination Statement (“SDS”), confirming their IR35 determination, to both the individual and the party with which the client contracts (i.e. the Intermediary or the relevant agency).The SDS will only be valid if it specifies the reasons for the client’s determination.Until the client provides a valid SDS to the individual, it is liable for any PAYE, NICs and Apprenticeship Levy, even if there is a separate Fee Payer in the supply chain.
• Many responses to the consultation asked HMRC to provide a procedure to enable the parties to verify IR35 decisions with HMRC during the tax year. Under the draft legislation, however, the responsibility for providing a status disagreement procedure during the tax year will fall on the client rather than HMRC. If the individual considers the client’s IR35 decision is incorrect, the individual may make representations to the client. The client will then have 45 days to review the individual’s representations and either inform the individual that its initial SDS was correct or issue a new SDS withdrawing the previous one. Again, the client must provide reasons for its decision.If the client fails to comply within the 45-day time frame, it is liable for any PAYE, NICs and Apprenticeship Levy, even if there is a separate Fee Payer in the supply chain.
• There is a power for HMRC to transfer PAYE and NICs liabilities to another entity in the labour supply chain if HMRC consider that the other person should have paid those liabilities.In its response to the second consultation on the reforms, the Government has confirmed that where there is non-compliance in the supply chain, the PAYE and NICs liabilities will initially sit with the non-compliant party.However, if it is not possible to recover the tax due from that party, the liability will be transferred to the first agency in the supply chain and then to the client.It seems that HMRC does not intend to use these powers in circumstances where an otherwise tax compliant supply chain breaks down and this will be confirmed in guidance.

These rules will also apply to public sector clients.

Are there any exemptions?

Subject to anti-avoidance rules, if the client is small the current IR35 rules will continue to apply. In other words, the Intermediary – rather than the client – must decide whether IR35 applies.

A corporate client will be treated as “small” in its first financial year and will remain small until it ceases to be so.    Small companies will become medium or large if they fail to meet at least two of the following conditions:

• Its annual turnover was not more than £10.2 million;
• its balance sheet total was not more than £5.1 million; or
• its number of employees was not more than 50.

In this situation, the client will be brought into the scope of the rules from the start of the tax year following the filing date on which it ceases to be small.

Non-corporate clients will be treated as “small” for a tax year if their annual turnover in the relevant financial year was not more than £10.2 million.

How do clients determine whether IR35 applies?

A key issue is the methodology that clients should use for determining whether IR35 applies.

In working out whether the contractor would be an employee of the client if the Intermediary did not exist, clients need to apply the normal employment status tests. These look at various factors, such as: whether the contractor is subject to control; has a right of substitution; is integrated into the client’s business or is carrying on business on their own account; and whether there is mutuality of obligation between the parties.  These tests are case-law based and are notoriously difficult to apply in different factual situations.

To help public sector clients make the IR35 determination, HMRC launched Check Employment Status Tool (“CEST”). While clients are not obliged to use CEST, it has the advantage that the CEST result is binding on HMRC provided the relevant information has been entered correctly.

CEST has been subject to widespread criticism as not fit for purpose. Whilst HMRC are in the process of revising it (an updated version is anticipated to be available later this year), HMRC appears to be of the view that CEST accurately reflects its opinion on employment status.  It is therefore unclear whether any substantial changes will be made.  Clients will need to ensure that they have a robust system in place for assessing employment status, particularly in view of the requirement to provide reasons for its IR35 determination.

What next?

The IR35 reforms are probably the most significant change to employment tax in decades,  substantially increasing the administrative burden on businesses and, for those arrangements that fall within IR35, significantly increasing the costs of all parties in the supply chain.

With only nine months to go, businesses need to ramp up their preparations by following the steps set out in our previous article.

Consultation on the draft legislation is open until 5 September 2019.  If you would like us to include any of your comments in our consultation response, please get in touch with your usual Lewis Silkin contact.