The
controversial IR35 legislation may be here to stay, but it needn’t prevent
firms buying in skills from personal service companies. It just requires a
little more craft and cooperation, says David Andrews
Many
businesses have traditionally sourced skilled workers by engaging them through
personal service companies operated by consultants. This arrangement minimises
the risk of the consultants obtaining employment law rights against the
relevant business. It also reduces the overall labour costs involved in
sourcing skilled workers, because the relevant business does not pay employer’s
National Insurance Contributions (NICs), the consultants are not given employee
benefits (such as pensions contributions or private medical expenses cover),
and they are usually excluded from participating in any share option schemes.
Until
recently, this arrangement was also beneficial to consultants as they were able
to reduce their tax and NIC liabilities by means of their service companies
off-setting operating costs against the fees they generated, paying a salary to
their spouses (in order to take advantage of the spouse’s lower-rate tax bands)
and distributing part or all of the fees generated by paying dividends (which
do not attract NICs) to the consultant as the owner of the service company. Â
However,
controversial new tax legislation, generally referred to as IR35, has
significantly reduced the tax advantages for consultants providing their
services through a personal service company. A judicial review challenging the
Government’s implementation of IR35 recently failed and many consultants are
now abandoning this method of operating. The scope of the legislation is
far-reaching, but it is still possible to engage consultants through personal
service companies, provided you take certain practical steps.
The
scope of IR35
IR35
is the reference number of the press release issued by the Inland Revenue on 9
March 1999 announcing the intention to change the tax laws. The legislation
came into force on 6 April 2000 and applies to a particular engagement where
either:
–
The consultant, alone or with any associates (family and unmarried partners),
has a "material interest" in the service company, meaning ownership
of more than 5 per cent of the issued ordinary share capital of the service
company, an entitlement to more than 5 per cent of the dividends declared by
the service company or (in the case of a closed company) to more than 5 per
cent of the assets on the winding up of the service company or
–
The consultant receives a payment from the service company, which is not
taxable under Schedule E, that could reasonably be taken to represent payment
for services provided by the consultant to a client; and the consultant would,
under the normal common-law test of employment status, be deemed an employee of
the client if he or she carried out the work directly for the client and not
through the service company.
Helping
consultants avoid legislation
Any
business that wishes to continue to benefit from engaging consultants through
personal service companies will need to provide their consultants with
assistance in trying to avoid the IR35 legislation. There are in effect two
methods of doing this.
The
service company through which the services are provided should be set up so that
IR35 does not apply. For example, if the business engages 21 or more
consultants, the consultants could group together and provide their services
through one service company. Provided each consultant takes an equal
shareholding in the company, none of the consultants would own 5 per cent of
the shares in the company or be entitled to 5 per cent of the dividends of the
company.
As
long as the consultants do not receive a payment from the service company
(which is not taxable under Schedule E) that could reasonably be taken to
represent payment for services provided by the respective consultant to his
clients, IR35 will not apply. One way around this is for the consultants to
agree to take low basic salaries and pay out as much of the profit of the
company as possible by way of dividends to each consultant as a shareholder of
the service company.
This
proposal may not be attractive to consultants where there is a significant
difference in fee generation from consultant to consultant, as the only method
of reflecting the difference in fees generated by each consultant would be
through payments taxable under Schedule E, such as additional salary,
commission or bonuses.
Making
such balancing payments reduces the scope for maximising the tax benefits of
operating through a service company and therefore this type of scheme will only
work well where the fee generation of each consultant is similar.
The
alternative is to ensure, for each engagement-the consultant undertakes, that
the common law test of employment status would not point towards employment if
it were not for the consultant acting through the service company. In order to
minimise the chance that the test points towards employment, the business
should be willing to agree with the consultant, to the extent it deems is
commercially acceptable, that:
–
The contract between the service company and the business does not include any
mutuality of obligations requiring the service company (or, even worse, the
consultant) to perform any additional services that the business may require
and forcing the business to instruct the service company in relation to any
such additional services the business may require
–
The consultant is free to determine when to provide the services (subject to an
agreed delivery date for a project), where to undertake the services and how
the services should be approached to complete the project successfully
–
The engagement relates to the completion of a particular project, each project
can be completed in a relatively short period (ideally no more than three
months) and the consultant does not work for the business in relation to
several projects back to back which continue for a long period in total
–
The terms of payment are based on a fixed sum for completion of a project
(not on an hourly or daily rate) so
that the service company can maximise profitability through the efficient and
timely completion of projects
–
The service company does not have to provide a particular consultant to perform
the services and has the right to substitute any qualified person who is
employed or engaged by the service company
–
The service company has its own offices or place of work and provides
transport, tools and equipment for the consultant
-The
consultant provides his services (through the service company) to several
clients, being instructed by different clients either at the same time, before
or after the project undertaken for the business
–
The consultant does not receive any benefits (such as sick pay, pension,
private medical expenses insurance or life assurance) from the business and the
cost of providing such benefits is not expressly charged back to the business
by the service company
–
The consultant is not integrated into the workforce employed by the business
and does not undertake the same work as an employee of the business at a
neighbouring workstation
–
The contractual documentation clearly states that the parties regard the
relationship as one of self-employment and
–
If contracting through an agency, the terms of engagement between the agency
and the business and between the service company and the agency are consistent
with the above points.
Ideally,
a business should aim to build up a pool of consultants, any of whom they are
happy to engage. Consultants should then be engaged from the pool in relation
to short projects, noting the points above, and the business should vary the
consultant engaged on back-to-back projects.
Facing
reality
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The
Inland Revenue will apply the IR35 legislation wherever possible to maximise
the collection of taxes through the PAYE system and so many consultants
operating through service companies will be caught. If a business wishes to
continue to benefit from self-employed consultants, it should do all that is
commercially reasonable to engage consultants in a manner and on terms that
will permit them to operate outside the scope of the IR35 legislation.    Â
David
Andrews is an employment lawyer at Brobeck Hale and Dorr
