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Has your company a self-employed contractor time-bomb ticking away?

Meredith Hurst Friday, June 15, 2012

It can be a very beneficial arrangement for an organisation to hire a contractor rather than an employee. The company may benefit from an increase in flexibility from the contractor, who is likely to work longer hours at shorter notice than an employee. The company will save on national insurance contributions, holiday and redundancy pay and not have the worry of claims for unfair dismissal when the assignment or project comes to an end.

From the contractor's perspective, it can also be more financially lucrative to be self employed as they are likely to pay less tax and national insurance contributions than an employee.

For many companies, this arrangement works perfectly well. However, it does have its pitfalls. If the contractor works purely for the same company over a period of time they may gain 'worker' or even 'employee' status in the eyes of an employment tribunal. Claims are often made by contractors who have missed out on a redundancy payment or who feel they are entitled to holiday pay. If a claim is submitted for a redundancy payment it is more likely to be accompanied by a claim for unfair dismissal. When successful claims of this nature are made in the employment tribunals, a company may face large compensation claims because it is likely that other contractors engaged by the company will piggy back the first claim. There is surprisingly little financial risk to the contractor in making a claim in the employment tribunals.

Another worry, more so to the company, is the view taken of the arrangement by HMRC. There has been a big crackdown in recent years in IR35 claims where the taxman takes a different perspective of the arrangement than the employment tribunals. Whereas an employment tribunal will apply various tests to satisfy itself about the relationship and look at the situation in the round, HMRC apply a narrower range of tests. The result is that HMRC could find an employment relationship where an employment tribunal may not and vice versa. In the unfortunate event of a successful claim for unfair dismissal, in addition to any compensation awarded by an employment tribunal, a company may be required to pay back tax to HMRC.

Having an uncertain legal relationship makes it confusing and worrying for companies and contractors alike who fear an investigation by HMRC and the consequences of paying back tax over many years.


What steps can companies take to avoid these risks?

The first step is to identify the tests used by employment tribunals and HMRC to determine whether existing contractors are likely to be found to have either 'employee' or 'worker' status. The company should then carry out a risk analysis to identify any areas of concern. In addition to this, companies should always ensure they have a written contract for service in place and signed by both parties. Companies can also log into HMRC's website ( to determine whether existing arrangements fall foul of the taxman's test to determine whether the relationship is a contract for services rather than a contract of service.

On 9 May 2012, HMRC published useful guidance to assist companies and individuals to check whether the relationship is likely to fall within or outside the  IR35 rules. If the contractor can prove they are in the low risk category, HMRC are unlikely take any further steps for a few years before any further review.

The guidance sets out 12 business entity tests and allocates points for each test. The higher the point score, the lower the risk (more than 20 points equals low risk). The tests deal with:

  • Owning or renting business premises separate from the taxpayer's home          and clients. (10 points.)
  • Having professional indemnity insurance. (2 points.)
  • Ability to increase income by working more efficiently. (10 points.)
  • Annual advertising spend (More than £1,200 equals 2 points.)
  • Engaging workers who bring in at least 25% of turnover. (35 points.)
  • Previous employment relationships with the end client. (Minus 15 points.)
  • Having a business plan with cash flow forecasts and business bank       account. (1 point.)
  • Writing off irrecoverable debts. (10 points.)
  • Bearing the costs of putting right mistakes. (4 points.)
  • Negotiating payment terms and invoicing for work. (2 points.)
  • The right of substitution and substitution in practice. (2 points and 20   points respectively.)

The guidance includes example scenarios that seek to illustrate cases that are in or outside the IR35 rules.

The tests and the points allocated to them will, inevitably, be controversial, as will the omission of certain factors (for example, provision of own equipment). However, the publication of the guidance is helpful in that companies and contractors will have a better understanding of HMRC's approach and of HMRC's view of the relative importance of the factors.

Also, just to prove that IR35 is a hot topic for HMRC, on 23 May 2012, HM Treasury and HMRC published a joint consultation paper, which sets out the government's proposal for a new legislative measure that would require engaging organisations to deduct tax and NICs from, and account for employer NICs on, payments made to certain "controlling persons". This measure was brought about by the somewhat embarrassing disclosure that Ed Lester, the Chief Executive of the Student Loans Company, was being paid via his personal service company. Subsequent investigations revealed that large numbers of senior individuals within the public sector are being engaged through personal service companies for the purpose of avoiding paying employee income tax and national insurance contributions.

The proposal will inevitably be controversial as it will increase complexity, uncertainty and costs.


For further information and advice please contact Neill Thomas or 020 8681 8140.