Penny Simmons and Chris Thomas from award-winning international infrastructure law firm Pinsent Masons LLP outline the latest consultation proposals for changes to tax rules relating to personal services companies (PSCs) and the steps businesses should be taking to mitigate their increased tax and HR risks.
New rules are being introduced that will make businesses liable for determining the tax status of contractors who work through PSCs. The changes to the tax rules, known as IR35, are being introduced from April 2020 and will create significant cost and compliance challenges for businesses that rely heavily on specialised contractors.
Given the complexity of supply chains in the construction and highways sectors and in particular the use of specialist agency staff, the new rules are expected to have widespread implications and businesses need to take action now to prepare for the changes.
The possibility of changes to IR35 was first discussed in Highways magazine in June last year, when the prevalence of contracting with individuals through PSCs in the highways sector was discussed and we outlined the possible consequences for both businesses and contractors. HM Revenue and Customs (HMRC) has now published a consultation on how the new rules will operate and what businesses should be doing now to prepare for the changes.
Recap – the current rules
In the highways sector, many businesses have encouraged the use of PSCs when engaging with individual contractors; rather than engaging directly with a contractor as a self-employed person, or by on-boarding the contractor as an employee. This provides the highway business with increased flexibility, particularly where its labour demands fluctuate, perhaps depending upon the requirements of particular road projects.
Additionally, engaging with individuals through PSCs can create significant HR cost savings to businesses, since those individuals would not gain employment rights, such as an entitlement to sickness and holiday pay.
The use of PSCs also generates tax savings. Currently, a private sector business (the client) which contracts with a PSC does not deduct tax under PAYE from payments made to the PSC, and importantly, does not have to pay employer’s national insurance contributions (NICs). Employer’s NICs are currently payable at 13.8%, so engaging contractors through a PSC can give a business a significant tax saving on its payroll costs.
However, IR35 requires that employment taxes and NICs be paid in respect of a person who provides services through a PSC, if that person would have been regarded as an employee of the engaging business if it had engaged directly with the business. 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 accounting for tax and NICs, if the contractor would have been regarded as an employee for tax purposes under the IR35 rules.
Proposals for change – what we can expect
In the Budget last October, the Government confirmed it would extend the changes to IR35 to the private sector from April 2020. Consequently, once the new regime is in force, the engaging business will be liable for determining employment tax status and whether the IR35 rules apply.
Businesses may also have to deduct income tax and employees’ NICs and bear the added cost of employers’ NICs, although in more complex supply chains the obligation may sit with an agency. HMRC has confirmed that small businesses will be exempt from the changes and the reforms will not operate retrospectively.
In its latest consultation, which closes on 28 May, HMRC is seeking views on a number of issues, to help design the rules and draft legislation, including: the definition of ‘smallest’ businesses that will be excluded; the responsibility of each party in the labour supply chain, including agencies and other intermediaries; and how disputes over contractor status determinations should be resolved.
HMRC has proposed using the public sector rules as its ‘starting point’, albeit tweaked to take into account the different needs of private sector organisations and the lessons learned since the public sector regime change.
This means that engaging companies would be required to determine the contractor’s employment tax status and communicate that determination. The ‘fee payer’ who pays the PSC will then need to make deductions for income tax and NICs and pay any employer NICs.
The Government intends to legislate to ensure the decision on the contractor’s employment tax status is ‘cascaded to all parties within the labour supply chain’, including any agencies.
It is proposing to do so by requiring clients to provide the determination to the contractor directly, as well as the reasons for that determination on request. The Government’s view is that this system will reduce the potential for disputes and disagreements, but it also intends to introduce a process to allow the contractor, and the fee payer where relevant, to challenge the client’s determination.
In its consultation, HMRC notes that it may be appropriate for clients to apply the same determination to a group of off-payroll workers with the same role, terms and contractual conditions. However, such ‘blanket’ determinations must take account of individual contractual terms and the contractor’s actual working arrangements. Although the ability to make group determinations will provide some comfort to businesses, the proposed requirement that they provide reasons for their assessment directly to the worker is likely to undermine this to some degree.
Providing reasons directly to a contractor could pose a big headache for a business with a large off-payroll labour force – especially where the engager is using an agency or managed service programme (MSP) to source and manage the workers.
The prospect of having to provide reasons to thousands of workers, and deal with multiple objections from individuals who will frequently not understand the complexities of the law, has the potential to be an organisational nightmare and careful thought will be needed as to how this can be managed in conjunction with the agency/MSP.
HMRC notes that private-sector labour supply chains can be ‘long and complex’. On this basis, it is encouraging respondents to share information about the number of parties in the ‘typical’ labour supply chain. It is proposing that liability for unpaid tax should initially rest with the party in the supply chain that fails to fulfil its obligations – for example, to pass on the client’s determination, or to make the necessary deductions – but that liability should transfer back to the first party or agency in the chain where a party ceases to exist or is otherwise unable to pay.
According to the consultation, where HMRC is unable to collect from the first party or agency, it would ultimately be able to seek payment from the client. These proposals reinforce the critical importance of proper due diligence and supply chain oversight by the engager and increase the need for a business to understand its full supply chain, and ensure it has appropriate contractual protections and indemnifications.
It is also worth noting the consultation recognises an engager only has responsibilities under the new rules where there is a supply of labour to it, meaning the worker is obliged personally to perform services for the engager, which will often not be the case in the context of contracted-out services. This is a significant point businesses need to bear in mind when assessing who actually has the responsibilities under the new regime – the ultimate engager or the business supplying it.
What business should be doing now to prepare
Businesses need to start taking action to prepare for the changes to IR35 and the increased tax risks they will face. 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 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 that 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. Now should also be the time to consider what provisions are in place in existing subcontracts and main contracts and templates to consider what, if any, changes may be needed.
Embarking on this compliance exercise as quickly as possible is going to be crucial for businesses in the highways sector, where there is heavy reliance on a flexible workforce and large numbers of contractors are likely to be engaged through PSCs.