When contracts conflict – the implications under IR35

Even in these still challenging times, instances remain where IT contractors should refuse to sign with an agency, thereby declining the lower-tier contract, if they want to minimise their chances of being caught by IR35, writes Ben Evans of Lawdit Solicitors.

And when it comes to the upper-tier contract – between agency and client – IT contractor company Primary Path recently demonstrated the value of having consistency between it and the lower-tier contract, in the event HM Revenue & Customs investigates under the contentious legislation. There are plenty of other IR35 cases – such as Dragonfly, where the contractor was helped towards an outside IR35 position because the terms of the contract between contractor and agency were accurately reflected in the upper level contract between agency and client. As I will explain, this is not as straightforward as it might sound, but the diligent contractor will do their utmost to ensure that the upper and lower contracts do not conflict with each other. This means getting both sets of terms right first time, from the outset, or ironing out any discrepancies before the assignment commences.

When contracts conflict - consequences of contracts not correlating

The main danger of the upper tier and lower tier contracts not correlating is that the contractor may be liable to pay income tax and National Insurance Contributions (NICs) on their earnings, in addition to interest and penalties on any sums owed to HMRC under IR35.  It is irrelevant that the contractor is not a party to the upper-tier contract and has no automatic right to inspect its terms. 

Right to see and amend the upper contract

Of the two contracts, the contract between the agency and the client will be subject to closer scrutiny from HMRC. HMRC inspectors have seized upon the decision in Usetech v Young (Inspector of Taxes) (2004) All ER (D) 106, where it was held that the upper level contract (i.e. the agency/client contract) should determine status as an employee or a contractor.

The problem with this is that the contractor is not a party to this contract and has no automatic right to see the contract.  Essentially, the contractor is being bound by terms he or she has not necessarily agreed to.  HMRC will have a right to inspect this contract and will usually bring it to the attention of the contractor, although the contractor will not have recourse to any defence having become aware of the contract after it has been entered into.

The agency will therefore need to be aware of IR35 consequences and to consider these when entering into both upper-tier and lower-tier contracts.  This area of the law is currently subject to review and reform has been mooted for a number of years.

Reducing the risk

The problems associated with the contractor/agency and the agency/client contract not correlating usually arise because the two contracts are designed to regulate different interests of the agency. However, a number of practical considerations may reduce, or diminish altogether, the problems associated with non-correlation of the two contracts.

1.     The upper-tier contract should include a right of substitution and avoid an obligation for the provision and acceptance of work.  The contract should be specific to a project rather than a time period.

2.     The lower-tier contract regulates the relationship between the agency and the contractor and should not, therefore, refer to one client, as this will mean IR35 is applicable. 

3.     The payment of a reasonable salary will also reduce the likelihood of HMRC looking too deeply into the arrangement, whereas the payment of dividends; a hallmark of tax avoidance procedures, will no doubt encourage HMRC to investigate. 

4.     The lower-tier contract should also state that the contractor is subject to the control of the agency and not the client being provided with services.

What can you do?

As a contractor you are in a delicate position - you have no right to see the upper tier contract despite its importance to you. Accordingly the only contract that you have any real influence on is the lower tier contract. You need to ensure that the four points listed above are adhered to; if they are not then do not sign with that agency.

Thursday 4th August 2011