Taxation of Personal Service Companies and the UK Construction Sector: what is changing and who will be affected?
2020 is looking to be a year in which the tax burden of companies operating in the UK construction sector is likely to increase. This is due, firstly, to the delayed implementation of the VAT reverse charge (now 1 October 2020) and also to major changes in the UK tax treatment of off-payroll workers. We discussed the impact of the VAT reverse charges in our Infra.law, Spring 2019 edition, Making (construction) customers pay. In this article we discuss the implications of the changes to the off-payroll working rules (commonly known as “IR35”) and steps companies affected by these changes can start to make.
What is IR35?
In summary, after a lengthy period of consultation, the UK government is proposing to amend IR35, the existing off-payroll working rules. These rules are (very broadly) designed to catch disguised employment relationships through the use of personal service companies (PSCs). The effect is that payments made to the PSC are subject to employment taxes, i.e. PAYE and NICs.
Historically, the tax and compliance burden fell on the individual / PSC – so construction companies and other businesses did not need to concern themselves with their application. In 2017, the rules were reformed to shift the tax and compliance burden to the end user / client in a public sector context. These reforms are now being rolled out (with additional changes) to the private sector.
This article focusses on the position where work is done in the UK for UK construction businesses. Where there are international elements, the rules may still apply, but there are additional layers of complexity.
When does IR35 apply?
The IR35 rules apply where an individual provides their services through a PSC in circumstances where, if they were engaged directly, they would be regarded as an employee for tax purposes. For example, where an individual is working under a PSC full time on a single construction project for a single employer over a number of years, the starting assumption is likely to be that they should be treated as an employee (although the facts require close examination in each case). The IR35 rules could potentially apply to anyone involved in a construction project, from members of the project management team, to designers, to on-site labour, to security guards (and many more besides).
To determine whether an individual is an employee for tax purposes requires a detailed examination of both the relevant contractual arrangements and their actual day-to-day working practices. HMRC has an online tool for this purpose (Check Employment Status for Tax or CEST) that it has recently updated to “make CEST clearer, reduce user error and consider more detailed information” following criticism that it was too complicated and ambiguous. HMRC has also added new CEST-related guidance to its Employment Status Manual. HMRC has stated that, provided the tool is used correctly, with accurate information, and there are no tax planning arrangements, it will stand by the answer produced by the CEST.
The employment status question has been the subject of a number of tax tribunal decisions over the last few years. A recent case involved an individual who provided construction management services (including night shift management) to construction companies – albeit he successfully argued that IR35 did not apply.
When do the changes come into force and who is affected?
The new legislation is currently in draft form. Although it is subject to consultation and, inevitably, some uncertainty over its exact status given the upcoming UK General Election, as drafted it will apply for the tax year 2020-21 onwards, regardless of whether the relationship with the PSC / worker originally started before that date. There has been no express indication of any material change or delay, so affected businesses should continue to plan on the basis of an April 2020 start date. Detailed HMRC guidance is also expected in due course.
In terms of any retrospective impact, HMRC have recently stated that they will only use information resulting from these changes to open a new enquiry into earlier years if there is reason to suspect fraud or criminal behaviour.
The changes will only apply to businesses that are not “small”. This means broadly where two or more of the following conditions are satisfied:
- the business’ annual turnover is not more than £10.2million;
- the balance sheet total is not more than £5.1million; and
- the number of employees is not more than 50.
How will these changes work?
The new rules align the treatment for off-payroll workers in the UK public and private sector. Broadly, they will operate at every level of the construction supply chain, where payments are made by the “employer” or the “end-user” to the PSC for an individual worker’s services.
The consultation materials indicate that the rules do not operate to impose an obligation on a contractor to enquire into or investigate the status of any PSCs which are engaged by any of its supply chain. The contractor will only need to concern itself if it “employs” PSCs directly or through one or more labour or recruitment agencies.
In short, the onus is on the “end-user” of the PSC to determine the employment status of their contract workers and whether the IR35 rules apply. They do this by giving a status determination statement (or SDS) (broadly a decision on whether the “employment” test is met) to both the party they have directly engaged (either the PSC or any labour supply / recruitment agent supplying the PSC) and the individual worker. The intention is for the SDS to be passed down so that all parties involved are aware of whether the rules apply or not. There are provisions entitling the PSC to challenge an SDS and requiring the “end-user” to respond to any such challenge, but we are awaiting HMRC guidance on how this might be implemented in practice.
Where the IR35 rules apply, the actual tax liability falls on the “fee-payer”, i.e. the person who ultimately pays the PSC. The “fee-payer” is treated as making a payment of “earnings” and is required to operate PAYE and NICs on payments made to the PSC.
There are penal consequences if businesses do not comply with their obligations. For example if a contractor fails to provide an SDS, the tax liability will transfer from the employment agent paying the PSC to the contractor directly. The stated intention is to promote compliance and incentivise all businesses to do the relevant due diligence on their supply chains.
What should affected businesses be doing to prepare for the changes?
The new rules place a potentially significant compliance burden (and financial risk) on affected construction companies. They will now be required to consider the employment status of individuals and the details of their labour supply chains in a way they never have previously.
Affected business should start preparing as soon as possible for the upcoming changes. HMRC have been clear that they expect preparations to begin well in advance of the April 2020 start date. HMRC are likely to focus on reviewing compliance once the new rules take effect (and may have little sympathy if work has not been done in time).
Steps that may be taken by construction companies include:
- Undertake a full audit of the status of their existing contractor workforce.
- Consider how to deal with those contractors who are caught by IR35 and look at potential solutions such as bringing them onto payroll.
- Undertake financial assessments of the impact of the IR35 rules and budget accordingly. For example a review of contract rates might be applicable, especially when negotiating future service agreements with temporary agencies.
- Initiate conversations with affected contractors as soon as possible.
- Consider and review the procedures in place with any agencies or other intermediaries that form part of the labour supply chain.
- Review systems and processes going forward, in particular to build in an IR35 assessment to the onboarding of new contractors.
A version of this article was published as a blog by Practical Law Construction on 10 December 2019.
This article was written by Senior Associate Hugh Gunson and Trainee Solicitor Meenakkhi Bhattacharyya. For more information please get in touch with Hugh via firstname.lastname@example.org or on +44 (0)20 7438 2252 or Meenakkhi via email@example.com or on +44 (0)20 7427 6741.