UK employers are preparing for new rules to judge whether their contractors should be treated as employees for income taxes and social security contributions (NICs). Some regulations already apply to public sector employers, but from 6 April 2021 medium and large private sector employers will also have to apply them.
The new work rules for off-site payroll are being vigorously enforced, according to Her Majesty’s Revenue and Customs (HMRC), which issued a strategy paper on February 15 on its enforcement approach. However, HMRC also promised to take a “light” approach to penalties for the first 12 months of the new rules.
The long-awaited mandate for private sector contractors was originally due to go into effect in April 2020 but has been postponed for a year due to the COVID-19 pandemic. Often referred to as the IR35, the rules are designed to ensure that contractors who work like white-collar workers but through an intermediary such as their own limited company pay roughly the same NICs and income taxes as those on an organization’s direct payroll.
In short, IR35 will shift the responsibility for determining employment status (i.e. whether an individual is an employee or a contractor) from the employee to the employing organization. The new rules are necessary because outside the public sector, according to HMRC, “only one in ten people” who work outside of payroll pays their full tax.
Companies under a certain size do not need to worry about IR35, which is the case for employers who meet two or more of the following conditions: (1) more than 50 employees; (2) annual sales in excess of £ 10.2 million; and (3) total assets in excess of £ 5.1 million. Subsidiaries are usually insured if this is their parent company.
HMRC’s February 15 strategy paper, formulated in mild language on helping organizations to implement the new treaty rules, sends the message that significant enforcement efforts are being made. A “team of specialists” will conduct compliance activities and target industries that are heavily reliant on contractors working through Personal Service Companies (PSC).
“We can contact you [ie, organisations] to discuss how to apply the changes to work rules outside of payroll. This does not necessarily mean that we believe that you are not following the rules, ”says the strategy paper. “This may be because we are aware that the sector in which your organization operates is affected by the changes in the rules,” for example due to the high level of contractors working through PSCs.
However, the HMRC also reiterated its previous commitment to follow the penalties for the first 12 months of the new labor rules outside of payroll with a “slight touch” “unless there are indications of intentional violations”.
Some organizations, the HMRC acknowledges, may respond to the new rules by requiring contractors to work through agencies or umbrella companies, or by subcontracting the services their contractors provide in full to another organization. HMRC says that “[m]Each of these decisions are made commercially and fully compliant with tax law. “
“We will take action, however, when contractors are hired through artificial, made-up agreements that allegedly avoid the application of work rules outside of payroll or result in customers paying less tax than they should,” it said in the strategy paper of the HMRC.
The basics of IR35
To broadly understand how the new work rules work outside of payroll, the easiest way is to consider the implications for a typical contractor. Imagine if Ted has his own PSC that outsources his IT specialist services to a large pharmaceutical company. Under the IR35 rules, the drug company will be responsible for making an “employment status assessment” of whether Ted is actually a contractor for tax purposes. If instead he is found to be employed, the drug company is responsible for deducting and paying associated taxes and NICs to HMRC.
Slightly more complex rules apply when additional intermediaries are involved. Let’s say Ted’s PSC has contracts with an employment agency, which in turn has a contract with a pharmaceutical company. In this scenario, the pharmaceutical company is still responsible for determining the employment status. However, if Ted turns out to be employed in lieu of a contractor, the labor exchange is required to deduct Ted’s taxes and NICs and pay them to HMRC.
Potential liabilities exist for both the pharmaceutical company and the employment agency in accordance with the IR35 rules. For example, if the drug company does not take reasonable care to determine that Ted is really a contractor, it could be held responsible for its taxes and NICs.
Since disputes can arise, the pharmaceutical company must give Ted and the employment agency the opportunity to contest the determination of employment status, provided that they state reasons in writing.
The bottom line is this: Ted will no longer be the one who decides if he is a tax contractor. Instead, his employment status is determined by the customer company (here the pharmaceutical company). Ted’s taxes and NICs are usually deducted and paid to HMRC by the company in the chain of contracts that is closest to his PSC (here the employment agency).
The IR35 rules have been planned for some time. In the 2018 budget, the government announced that it would extend the rules for extra-company payroll that have been in force in the public sector since 2017 to all other sectors from April 6, 2020. Due to the COVID-19 pandemic, the date has been postponed one year and, subject to a last-minute change, the rules will come into effect on April 6, 2021.
Detailed instructions on the new contractual rules can be found on the HMRC IR35 website.
– Dave Strausfeld, JD, is Senior Editor of FM Magazine. To comment on this article or suggest an idea for another article, contact him at David.Strausfeld@aicpa-cima.com.