IR35 Reform

New Public Sector IR35 rules explained

After many months of conjecture and uncertainty we now finally have the draft legislation setting out the changes proposed to IR35 for public sector workers from April 2017.

We look at some of the standout features of the draft legislation in more detail below, but in simple terms the proposed new scheme will work as follows.

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The basics

From April 2017, the ‘traditional’ IR35 rules will be disapplied where services are supplied to a public sector end client – the new rules will take over instead.

The underlying test remains exactly the same as for the traditional IR35 rules: would the worker be an employee if they worked directly for the end-client? But the changes mean that the rules place responsibility on the person who is paying the PSC to operate PAYE if the new IR35 does apply, and, to some extent at least, the public sector end-client will always bear some responsibility for making the IR35 decision.

We’ll use below the typical scenario of a PSC providing services via an agency to a public sector client to illustrate how the new rules will work.

From April, where a public authority end client enters into a contract (some of these contracts may have already been entered into) for an individual to perform services personally and the new IR35 legislation is in point, the end client must tell the agency that it has concluded either that IR35 applies or does not apply. This can be in the contract or otherwise (it appears that it could even be verbal).

If for any reason this does not happen, the agency can ask the end client for written confirmation and this must be given to the agency within 31 days. The agency can also ask for the reasons why the end client has reached its conclusion – again a written response must be provided to the agency within 31 days.

If IR35 does apply, the agency then becomes “the deemed employer” of the individual. This means that for all tax/NIC purposes (including the Apprenticeship Levy calculation) the individual becomes an employee of the agency: a P45 or new starter checklist must be obtained, PAYE must be operated using the appropriate tax code, the individual must be included on RTI returns and when the contract ends a P45 must be issued.

However, as the agency will not actually be paying the individual directly (the agency will still be invoiced by the PSC in the normal business to business way) the PAYE calculation is based on the PSC’s invoice for the services, less VAT, any materials used to carry out the work and any allowable expenses incurred by the individual. This figure is called the “deemed direct payment”. Most importantly, the agency will become the party liable to pay employer’s NIC on the deemed direct payment.

Unlike traditional IR35, this will not be payable by the PSC out of its receipts, it will become a direct liability of the agency. There are some worked examples in the guidance issued by HMRC earlier this week which illustrate the step by step transactions further, and show how the PSC achieves a set-off of the PAYE deduction.

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Analysis of the new legislation

Whilst simple in overall concept, as ever there are many difficult aspects of the detailed draft.

One of the burning questions over the past few months has been how wide the net would be cast when defining the scope of public sector work.

It appeared at least possible from reading the consultations that many outsourced contracts (e.g. construction projects) could fall within the ambit of the new rules. However, it does not now seem that this is the case and the provision is narrower than it might have been.

It is clear from various provisions that the legislation applies only where an individual is providing personal services (or is obliged to provide personal services) to a public authority end client, in circumstances whereby the end client will be in a position to say whether IR35 applies or not to that specific individual. This would not be feasible in the case of outsourced public sector contracts unless the provision of the personal services of an individual is what is being contracted for.

Furthermore, because of the route the draftsman has chosen in disapplying the traditional IR35 rules where there is a public sector client in favour of a whole new set of rules, HMRC will need to be careful not to try to extend the scope of this legislation. If they were to do so, they could find that they lose out completely by picking the wrong ‘end client’.

To illustrate, if an individual undertakes work on a public sector contract and is clearly a “disguised employee” then it will become a statutory defence from April 2017 for the PSC to argue that the client is a public authority. If the PSC succeeds, the traditional IR35 rules under which the PSC would be liable do not apply – the new public sector rules apply instead and the PSC will not be liable.

Whilst this may seem an odd scenario, there is in fact a perfect example in one of the very early IR35 cases – Synaptek v Young. In that case the director, Gordon Stutchbury, was held to be a disguised employee of EDS who were an IT supplier; however Mr Stutchbury was actually working at the Benefits Agency at the time (who had outsourced its IT workers, including many ex-employees, to EDS). At the time, many thought that there were political reasons for not naming the government as the “disguised employer” in one of the first IR35 cases. If that case were heard from April 2017 onwards Mr Stutchbury’s clear and obvious defence would be that IR35 could not apply to his company as the end client was a public authority.

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Who makes the IR35 decision?

There have already been widespread reports that the public sector end client will always ‘decide’ whether the new IR35 rules apply, and indeed there is some responsibility on the end client in the draft legislation. However, we feel that most commentators have overstated the position here.

Under the draft rules a public sector end client will need to inform the party that it contracts with (typically an agency) of its conclusion about whether IR35 applies or not. However, this section of the legislation is headed “information to be provided by clients” and appears to be nothing more than a non-binding view of matters that is provided by the end-client.

There is nothing within the legislation to say that an agency must follow this conclusion, and no direct sanction for ignoring it. This is to be contrasted with the position whereby a public sector end client does not respond to a direct request from an agency for an IR35 conclusion within 31 days: if that happens the public sector end client becomes “the deemed employer”.

See also HMRC’s ‘Digital Tool’ Test Driven

It is true to say that an end-client will be in a good position – probably a better position than the agency – to make a judgment; however the end client may not have access to the terms of business between the agency and the PSC, nor know of the wider business circumstances of the PSC (factors very much relevant to IR35) and therefore there is clearly scope for the agency to make up its own mind. This is reinforced by the ability for the agency to ask for written reasons: what would be the point of that provision if the decision is taken out of the agency’s hands in any case?

Ultimately, the party paying the PSC has to make up its own mind and is responsible for arriving at its own decision on the new rules. No doubt if an end client tells an agency that it thinks IR35 does apply and the agency fails to operate the new rules, penalties for non-compliance will be higher. Cynics might conclude that HMRC expect indifferent end clients to include blanket provisions that IR35 does apply, agencies to capitulate as they do not know better and are fearful of penalties, and PSCs to have no say in the matter.

With regard to this final point, notable by its absence is any specific mechanism for the PSC to challenge the decision that IR35 applies. In fact, the only way in which the PSC takes back control over the IR35 decision is under a debt-transfer rule that states the PSC itself becomes “the deemed employer” if it provides a fraudulent document as evidence that IR35 does not apply.

There is a general right under the NIC legislation to request a decision in relation to IR35, however this is not a quick procedure and usually results in an investigation. It is inevitable that wresting the IR35 decision away from PSCs may resolve HMRC’s perception of non-compliance, but is likely to result in over-compliance and excessive deductions of tax, with no effective method of resolution.

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Other technical issues

At our recent seminars we discussed the employment law ramifications of including freelance contractors on the PAYE payroll, and how this might muddy the waters of an arm’s length relationship. The rule within the draft legislation that the entire Income Tax Acts apply “as if the worker were employed by the person…making the deemed direct payment” exacerbates this: it will become even more important that contractual relationships are very clearly defined to avoid confusion.

There remain many logistical questions as to how agencies will cope with these new rules and whether systems will be adapted in time; let alone that there will be a major financial impact on ‘caught’ public sector contracts that extend beyond April 2017.

Underpinning the IR35 decision is HMRC’s much vaunted Digital Tool for deciding employment status. Few details have been released so far, let alone the promised beta version of the tool. The guidance accompanying the legislation now simply says it will be available ‘before 6 April 2017’. We will be commenting further on the Digital Tool in due course.

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The legislation is of course still in draft form and is subject to amendment. Interested parties may comment on the clauses between now and 1 February 2017.

In the meantime, our advice to agency and intermediary clients is to review whether they have any arrangements whereby a PSC worker is providing services to a public authority, for example schools or the NHS. For a full list of bodies included within this definition, details are contained in the original consultation document which can be found here. The scope includes wholly owned subsidiaries of the bodies listed.

If you do have any such arrangements, contact us for further advice.

Published: 01.04.17 - Posted In: Uncategorized