UK employers are getting ready for new rules that require them to assess whether their contractors should be treated as employees for purposes of income taxes and National Insurance contributions (NICs). Some rules already apply to public-sector employers, but starting 6 April 2021 medium and large-size private-sector employers also need to apply them.
The new off-payroll working rules will be vigorously enforced, according to Her Majesty’s Revenue and Customs (HMRC), which issued a policy paper on its enforcement approach on 15 February. But HMRC also promised to take a “light touch” approach to penalties during the first 12 months of the new rules.
The long-expected mandate relating to private-sector contractors was originally scheduled to take effect in April 2020 but was postponed for one year due to the COVID-19 pandemic. Frequently referred to as IR35, the rules are designed to ensure that contractors who are working like employees, but through an intermediary such as their own limited company, pay roughly the same NICs and income tax as individuals who are on an organisation’s direct payroll.
In a nutshell, IR35 will shift responsibility for determining employment status (ie, whether a person is an employee or a contractor) from the worker to the engaging organisation. The new rules are necessary because, outside the public sector, “only one in ten people” who are working off-payroll are paying their full tax, according to HMRC.
Organisations below a certain size need not worry about IR35, which applies to employers that meet two or more of the following conditions: (1) more than 50 employees; (2) annual turnover of more than £10.2 million; and (3) balance sheet total of more than £5.1 million. Generally, subsidiaries will be covered if their parent company is.
Enforcement guidance
While couched in mild language about providing support to organisations in implementing the new contracting rules, HMRC’s 15 February policy paper conveys a message that there will be significant enforcement efforts. A “specialist team” will carry out compliance activity and will target sectors of the economy where there is heavy reliance on contractors who work through personal service companies (PSC).
“We may contact you (ie, organisations) to discuss how you are applying the changes to the off-payroll working rules. This won’t necessarily mean we believe you are not complying with the rules,” the policy paper says. “It may be because we are aware the sector in which your organisation operates is impacted by the changes to the rules,” for instance due to high usage of contractors who work through PSCs.
But HMRC also reiterated its previous commitment to take a “light touch” approach to penalties for the first 12 months of new off-payroll working rules, “unless there’s evidence of deliberate non-compliance”.
Some organisations, HMRC acknowledges, may respond to the new rules by requiring contractors to work through agencies or umbrella companies or by totally contracting out the services their contractors are providing to another organisation. HMRC says that “(m)any of these will be commercial choices and will be fully compliant with tax law”.
“However, we will take action if contractors are engaged through artificial, contrived arrangements which are claimed to avoid the application of the off-payroll working rules or result in customers paying less tax than should be the case,” HMRC’s policy paper says.
The basics of IR35
To understand generally how the new off-payroll working rules operate, it is easiest to consider the effect upon a typical contractor. Imagine that Ted has his own PSC that contracts his services as an IT specialist to a large pharmaceutical company. Under the IR35 rules, the pharmaceutical company will become responsible for making an “employment status determination” of whether Ted is indeed a contractor for tax purposes. If it determines instead that he is employed, the pharmaceutical company will be responsible for deducting and paying his associated taxes and NICs to HMRC.
Slightly more complex rules apply if additional intermediaries are involved. Let’s say that Ted’s PSC contracts with an employment agency that, in turn, has a contract with a pharmaceutical company. In this scenario, the pharmaceutical company is still responsible for making an employment status determination. If it finds, however, that Ted is employed rather than a contractor, the employment agency will be the one obliged to deduct and pay Ted’s taxes and NICs to HMRC.
Potential liabilities exist for both the pharmaceutical company and the employment agency under the IR35 rules. For instance, if the pharmaceutical company fails to take reasonable care in determining that Ted is genuinely a contractor, it may be held responsible for his taxes and NICs.
Because disputes can arise, the pharmaceutical company is required to provide an opportunity for Ted and the employment agency to challenge its employment status determination so long as they provide written reasons.
The key point is this: Ted will no longer be the one deciding whether he is a contractor for tax purposes. Instead, his employment status will be determined by the client firm (here, the pharmaceutical company). Ted’s taxes and NICs usually will be deducted and paid to HMRC by the entity in the contracting chain nearest his PSC (here, the employment agency).
The IR35 rules have been planned for some time. At Budget 2018, the government announced that it would expand the off-payroll working rules — which since 2017 have applied to the public sector — to all other sectors beginning 6 April 2020. Because of the COVID-19 pandemic, the date was pushed back one year and, barring a last-minute change, the rules will take effect 6 April 2021.
For detailed guidance about the new contracting rules, see HMRC’s IR35 webpage.
— Dave Strausfeld, J.D., is an FM magazine senior editor. To comment on this article or suggest an idea for another article, contact him at [email protected].