For many consultancy businesses, hiring contractors is a large part of filling skills gaps, or drafting in additional expertise for a specific project; but for firms who fulfil contracts in the public sector, the routine hiring of external freelancers is about to get a lot more complicated.
As of April 2017, new government legislation is in force that firmly places the responsibility for the tax compliance of contractors onto the firm for which they are working. An extension of existing IR35 regulations, the new system is designed to prevent contractors from working in much the same way as they would as an in-house employee, but without paying the same levels of tax.
As such, consultancy firms will now be required to assess the working circumstances of every contractor they employ for public sector projects, and declare them to be either compliant, or outside of IR35. If contractors are seen to be acting in similar ways to standard employees, and thus fall within the IR35 criteria, consultancies will then be required to operate the PAYE (Pay As You Earn) tax system and deduct tax and National Insurance contributions from the contractors accordingly.
Put simply, the government believes that contractors may be paying too little tax, and is introducing the revisions to IR35 law in order to reduce tax avoidance and raise additional revenue. It outlines the belief that contractors who behave as employees should be required to pay tax through the firms that have hired them, as employees would do, and that the self-employed practice of operating as a limited company to take advantage of tax and National Insurance benefits should be curtailed.
"Historically, the rules were aimed at people that worked through a personal services company, and benefitted from an improved, more favourable tax regime - the government felt that a lot of people were doing that simply to avoid paying tax, and in effect, even though they had a company in between them and the employer, they were just acting like a normal employee. Over the years, the government feels that it has not been getting enough tax, and the IR35 legislation that seeks to draw people into that net has not worked - there are too many people who don’t pay employment tax when they should. So the new rules effectively state that all government departments, local authorities and agencies that supply workers must obtain information about those workers, and if they fall within the IR35 test, then the client, agency, or consultancy has to operate PAYE. So it’s putting the responsibility of getting that tax onto the clients and the intermediaries."
"The updated regulations are being imposed to resolve what HMRC see as tax avoidance by engagers and contractors who they believe are abusing the system. The new regulations will force public sector bodies to treat contractors as salaried workers unless they can show they fall outside of IR35 rules.
IR35 has been around for years as legislation. When it was introduced to the statute books in April 2000, the aim was to help determine whether contractors working in a limited company or partnership should be deemed employees of a client rather than a contractor or freelancer. HMRC was trying to crack down on contractors providing professional services to a client through a limited company or LLP in order to save themselves PAYE and associated NICs. HMRC has looked in detail at how they can best combat this practice and make the IR35 rules work better for them as a way of raising tax revenue."
The legislation is currently targeting contractors who are set up as limited companies, and who are engaged for projects within the public sector. Therefore, if your consultancy takes on freelancers who operate as a limited company, and you act as the intermediary for clients who are classified as belonging to the public sector, you will be responsible for assessing IR35 compliance and applying tax contributions to their fees.
"This affects those that supply services to the public sector, such as government agencies – public sector is quite a broad definition, so we have to be careful, as it’s wider than people think. If you’re involved in that sphere and you supply contractors, it potentially impacts on you. Sometimes it will be the end user client responsible for reviewing compliance, but if there is a consultancy that is responsible for paying the worker, it will be the consultancy that is responsible for making the relevant tax deductions."
"The new rules apply where the services of a worker are provided through an intermediary to a public authority. This definition covers government departments and their executive agencies, and many companies owned or controlled by the public sector, such as universities, local authorities, parish councils and the National Health Service."
if you work with public sector clients, hiring contractors for your consultancy will no longer be as simple as choosing the right person for the job. You’ll now need to allocate time and resources for ensuring IR35 compliance for each engagement you make by completing government tests, as well as potentially processing PAYE contributions. Online assessments and official guidelines will help you to monitor how much a contractor behaves and operates like an employee as opposed to a self-employed freelancer in the eyes of HMRC.
Baldwin,
"At present, the onus is on contractors to declare themselves outside of IR35 to avoid being taxed in the same way as permanent employees, and to conduct their business in a way that does not risk them being considered so. When the new regulations come into place in April, consultancies will need to evaluate matters on a case-by-case basis to see whether the relationship between themselves and the contractor is one that looks like employment – there are numerous indicators as to whether an individual is employed or self-employed. More and more, the Inland Revenue is winning dispute cases because they place less emphasis on the written contract and look at what’s actually happening in the workplace with the contractor. A clause in a contract for the sake of avoiding IR35 will not help if HMRC believes that a contractor is behaving like an employee.
HMRC launched an online tool called the Employment Status Service (ESS), which is designed to help public sector organisations or intermediaries work out whether the contractor falls within the new rules. Clients must notify the contractors whether they have determined that the contract falls within the new regime, or not."
"HMRC has put together an online tool, which purports to allow people to go through a series of questions about the supply chain, whether they’re the worker, the consultancy, the agency, or the end user client, and tick various boxes and get an outcome, a statement at the end of it which is indicative of whether or not the legislation applies. Consultancies will need to use this and existing HMRC guidelines to determine the employment status of a contractor.
The reality of employment status is that it is a complicated area – "yes" or "no" tick boxes are not always helpful, and if you’re applying existing HMRC principles, in many cases there is going to be a spectrum whereby people have certain features that make them look like they fall within the legislation, but other features which make them look like they fall outside of it, making it hard to come to the right conclusion. So it’s actually quite a difficult decision to make."
The new IR35 legislation is in force from April 2017, yet many consultancies will already be working with contractors on projects that started before that date, and that will run past it. In such instances, you may find that you need to review existing arrangements, and start looking at your compliance processes for contractor hires that will be made after that time. You’ll find our tips for preparing your consultancy for these changes at the end of this guide.
"Each client will have their own way of dealing with the change. We understand that many clients are seeking to put new contracts in place now, to confirm compliance with the regime. Others may continue to operate under existing contracts, but may need to apply PAYE to payments once the new rules become effective."
"It will apply to and affect existing arrangements. If it’s an existing relationship, then I think you need to be reviewing it."
Consultancy businesses may be looking at an additional outlay in costs and time in order to process IR35 compliance reviews for each of their contractor engagements, as well as handle increased tax admin. Penalties also exist for the incorrect categorisation of contractors, with consultancies facing tax liabilities should they make the wrong call.
"Consultancies need to factor in management time and compliance issues - if they’ve got lots of contractors, are they going to allocate the task of answering the questions on the online tool to hiring managers? If you get it wrong, if you think they’re outside the legislation but actually it is held that they fall within it, then you’ve got a liability for tax, which could be substantial if you have a lot of contractors. And as with all things tax, HMRC and compliance related, there is always the possibility that you are subject to interest and penalties as well. It could be quite a bill."
"There may be some additional admin costs if they have to operate PAYE and indeed it may cost more to employ the contractor as there’s a good chance that contractors will raise their fees in order to cover their larger tax burden. Employers National Insurance will now be payable and contractors will probably not be able to claim so much in travel and accommodation expenses from the client. Somewhere along the line someone will be looking to recover those additional costs, but in terms of where that burden will fall is something that the market will have some input on. There may be a knock-on cost in recruitment if contractors decide to leave the public sector and contract in the private sector."
Terry Baldwin, McBrides Chartered Accountants
Delving into the working practices of self-employed individuals will have implications for both new and existing contractor relationships, and may affect the way you decide to take on or classify your temporary consultants in the future. You may find yourself involved in more project or fee negotiations, lose contractors as they decline public sector work outright, or decide to take on more full time employees – you may even opt to negate the risk of non-compliance by operating P.A.Y.E for all contractors just to be on the side of caution.
"I think there are going to be some difficult discussions – contractors don’t want to be worse off. Will contractors accept the decision if they suddenly find themselves being subject to PAYE? It’s going to cause a lot of problems, and what we’re already seeing is that some end clients and some agencies are simply saying we’re not going to take the risk, and therefore as a default we’re just going to operate PAYE. And sometimes contractors will expect an increase in fees to cancel out the additional tax they’re paying - someone’s going to have to shoulder that burden. Some contractors might say fine, we won’t work in the public sector anymore because we can earn more somewhere else, and there is some anecdotal evidence to suggest that this is already happening. That will be a problem for the clients, and it might not be ideal for the contractor, so there’s going to be a lot of readjusting that will need to go on I suspect.
But equally, it depends where the bargaining position is and who these contractors are – if it’s a very important freelancer, they may negotiate and want to be compensated, and if not they’ll go somewhere else. If they’re in a powerful bargaining position, then they’ll be able to do that. If they’re in a weaker market position, the authority that’s engaging them might not be prepared to pay anymore, leaving the contractor to take the hit. So it will depend on who that person is, and how important the job is - it’s that kind of commercial reality that will dictate how contractor relationships will be impacted."
For freelance consultants, the freedom to work for firms of their choosing and projects that they find interesting adds up to a lifestyle choice that also benefits from working selected hours and earning high rates. If deemed to be subject to PAYE tax costs under the confines of IR35, contractors may find themselves operating more like an employee – without being entitled to official advantages such as sick pay or holiday leave. Contractors will need to clearly define their working practices to ensure they are not seen to be acting as an employee of the intermediary they are engaged by, or simply accept the PAYE charges - others may decide to refuse public sector projects altogether, or move into full time employment.
"Contractors need to be realistic that if they look and feel like an employee, and if their behaviour and working practices are those of an employee, and there’s no material distinction, then they’re going to be caught by the rules. Those who are employed have to pay employment taxes, and that’s an inescapable fact of life. So if you want to be a freelancer, then you have to behave like a freelancer - there needs to be some realism about what’s going on.
One of the big problems here is that contractors may be paying employment tax, but won’t benefit from all the normal employment rights - what you don’t want is the worst of both worlds. They might be forced into employment; some of them may be prepared to become a full employee, but the question will be whether the end client has the budget to make a full time hire. There may be an exodus from the public sector, as consultants might start providing their services elsewhere if they feel they can earn more money, so it’s going to be an interesting situation. But I think it’s going to have an effect at some point - I think maybe a lot more will go into employment umbrella-type arrangements."
"Contractors need to be sure that their situation complies with the IR35 rules and that they can demonstrate this. HMRC has a website tool that can be used to assess the circumstances of a freelancers’ relationship with a public body and decide whether they are deemed to be caught by the rule and deemed an employee. The freelancer could then dispute the public sector bodies decision and get their monies paid gross as they have been up to now, but only if the tool results back up their contention that they remain outside of IR35.
Contractors will suffer increased taxes and/or increased competition in private sector engagements. Some contractors might be offered permanent employment positions and that may be a gain in an insecure job market as it will obviously come with employment rights."
Although these revisions to IR35 are initially being applied to contractor work in the public sector, there is speculation that this will be widened to include the private sector in time – therefore potentially affecting all consultancy firms who utilise the services of contractors.
"I definitely think these regulations will also be rolled out to the private sector eventually. The application of the new rules just to public bodies immediately creates a distortion in the market; public bodies who are not able to increase their rates to compensate contractors will find those contractors moving over to the private sector, and may be unable to fill important roles. The private sector could become awash with contractors looking for new engagements without these restrictions.
In times where the Government is still struggling to balance the books, it’s inevitable that the same rules will be introduced to the private sector on the premise of levelling the playing field and with the added bonus of raising further taxes."
With the implementation of IR35 upon us, consultancy firms need to be taking action immediately in order to ensure they are prepared for the compliance work and decision making processes they will be required to undertake. Even for those who do not have clients within the public sector, research should be carried out in light of the strong likelihood that the regulations will also operate within the private sector at some point in the future.
According to our expert contributors, here are the top five actions that your consultancy should be carrying out.
1. Review your contracts and arrangements - I wouldn’t bury my head in the sand, I would review the number of contractors that are under these sorts of arrangements. I would then work out, as part of that review process, potential tax liabilities, and form a view of what the potential exposure is by perhaps getting some expert advice.
2. Communicate as early as possible with clients and agencies to see if you can work collaboratively to decide what needs to happen - it may be that some contractors are quite happy with PAYE. It might be a discussion that you have to have and that actually resolves itself quite quickly.
3. Longer term, be prepared for this to be an issue even if you don’t supply in the public sector, as I think this will be extended.
4. Take professional advice where appropriate, certainly in relation to contract reviews.
5. Remember that there’s no need to panic – all of these things are happening, we have to deal with them, and life will go on. We just need to take a measured approach and consider what the options are. Ignoring it isn’t going to work – contractors and clients will ask questions, so inevitably there’s going to be a need to engage with the issue.
1. Be aware of and well-informed about the new IR35 regulations.
2. Meet with your engaged contractors and public sector clients to ascertain whether current projects need evaluating.
3. Work out what increase in day rates you’ll need to cover the increased tax costs and reduced travel expenses.
4. Potentially seek other engagements in the private sector!
Terry Baldwin, McBrides Chartered AccountantsTerry is a Chartered Accountant and Chartered Tax Adviser, and has specialised in providing tax planning and advice to owner-managed businesses and corporate groups for almost 30 years. Terry has been a partner in several Top 20 accounting firms and spent 5 years as head of tax at a FTSE 100 company in the late 1990s. He was also Head of Corporate Tax for a large accountancy group. Terry’s wide experience includes particular expertise in M&A, corporate reorganisations, property transactions, capital allowances and employee share schemes.
www.mcbridesllp.com
Oliver advises both employers and employees in connection with various contentious and non-contentious employment issues. His expertise includes issues arising from the use of social media in the workplace, complex employment status and discrimination claims in the employment tribunal as well as High Court claims involving the enforcement of restrictive covenants relating to unfair competition and confidentiality.
Oliver has particular expertise in the recruitment sector. He advises staffing companies and umbrella companies, as well as end user clients of staffing services, in relation to a range of employment and commercial matters such as employment status and TUPE.
Oliver is a key member of Blake Morgan’s Recruitment Sector Group and regularly presents at industry events, such as those organised by the Association of Professional Staffing Companies (APSCo).
www.blakemorgan.co.uk
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