IR35, Agency Worker Rules or MSC? Choosing the right regime for agency-contractor relationships
For the incoming and existing IR35 tax rules to apply, there are certain key components that need to exist. For example, for either legislation to be relevant the individual contractor must personally perform a service for an end user/client through an intermediary.
The intermediary can be a PSC/limited company, partnership, another individual or some other entity in which the contractor has a beneficial interest. Typically, a contractor does not have any ownership interest in an agency, so the agency itself is unlikely to be an ‘intermediary.’
The simplest form of the labour supply chain to which IR35 applies is a three-party relationship (i.e., the contractor, an intermediary, and an end-user).
Where an employment agency is involved to broker the contractor's services to clients, there can be four or more parties involved, which makes the situation more complicated.
How will the new IR35 operate?
Let’s look now only at the incoming IR35 regime (from next April). Subject to some limited exceptions (including where a contracting entity is located overseas), while the end user/client is responsible for making the tax status determination for the contractor in all cases, if an agency sits between the client and the PSC, the client's IR35 obligations are limited to making the determination and communicating it down the chain to the contractor, via the agency.
Agencies will often be the entity closest to the PSC in the labour supply chain, meaning that responsibility for operating PAYE and NICs will rest with them, if the contractor is decided to be an employee for tax purposes.
If they fail to operate that system, HMRC may pursue the agency for taxes owed and they could also face fines or other penalties.
Then, if the monies are not recovered from the agency, this could revert back up the contractual chain to the end-user in certain circumstances.
However also from next April, there is a small company exemption applying to end-user companies with a turnover of less than £10.2 million, a balance sheet of less than £5.1 million or 50 employees or less. (N.B. Two of these must apply for the end-user to be considered ‘small,’ and therefore exempt from the 2020 framework). In addition though, it is important to appreciate that this exemption is not based on the turnover, headcount or staff volume of the agency, but of the end-user.
When do the existing Agency Worker Rules apply?
The Agency Worker Rules (set out in Chapter 7 of the Income Tax (Earnings and Pensions) Act [ITEPA] 2003) were introduced in April 2014.
The Agency Worker Rules cover a typical three-party scenario: (1) the contractor, (2) the agency and (3) the end user.
In certain circumstances, the Agency Worker Rules will also capture 'umbrella companies' (i.e. companies that employ agency contractors on temporary assignments).
Specifically, the Agency Worker Rules apply where:
- A contractor personally provides services to an end-user. The contractor must be subject to the right of supervision, direction, or control by the end-user, or another person in the contractual chain.
- There is a contract between the end-user (or a person connected with the end-user) and a person who is not the contractor, typically the agency, through which the contractor's services are provided.
If the Agency Worker Rules apply, the contractor must be paid subject to PAYE deductions for income tax and NICs.
When do the existing MSC rules apply?
The MSC legislation (set out in Chapter 9 of the Income Tax (Earnings and Pensions) Act [ITEPA] 2003) was introduced in April 2007.
Its aim was to adapt the tax system to accommodate situations where several contractor shareholders worked through a single company, operated by a scheme provider.
The scheme provider would take care of all invoicing and accounting, and might even control the contractor's bank accounts!
Prior to the MSC rules coming into force, participants would benefit from favourable tax treatment of their income by being part of such a scheme, despite effectively working as employees.
If a contractor operates via a limited company to provide personal services, but the running of the company is controlled by a third-party provider, then the MSC rules may apply.
The reach of the MSC rules is extremely wide and again, in certain circumstances, the MSC rules will capture 'umbrella companies'. Similarly, in a recent case before the Tax Tribunal, the MSC rules caught an accountancy firm that was providing support to a PSC.
If the MSC rules are deemed to apply, then the contractor's income will be re-classified as standard employment income, subject to income tax and NICs.
It should be noted that, while the obligation to operate PAYE sits with the managed service company, HMRC has power to recover any unpaid PAYE and NICs from certain third parties, including:
"A person who (directly or indirectly) has encouraged, facilitated or otherwise been actively involved in the provision by the MSC of the individual's services"
This can include employment agencies.
Which rules apply?
With effect since 2000 (and with effect from April 2021), IR35 must be considered first and, if it applies, the MSC legislation will not apply.
The Agency Worker Rules rank below both the MSC and IR35 rules in terms of priority.
This is a complicated area and one that employment agencies should take advice on.
What can agencies do to prepare for IR35 reform in 2021?
Although the deferral of the new IR35 tax rules has given 12 months of extra space, we would advise against complacency and get preparing now to avoid some of the panic that ensued in recent months when the commencement date was April 6th 2020.
For agencies facing next year’s commencement, an initial step is to audit their labour supply chains and establish where they sit in those chains. This will help determine what if any obligations they have under reformed IR35.
If they haven’t already, contractors’ recruitment agencies should also talk to their end-user clients and PSC contractors themselves, to make sure all parties know the change is still incoming. Closer to the time, but even now for best-practice, agencies should and set up clear communication channels for passing information up and down the labour supply chain.
Contractors’ agencies should also put policies and procedures in place for dealing with the various aspects of IR35 reform, especially those aspects which don’t feature under the existing IR35 rules (of 2000). For example, agencies should take implementation steps towards how to handle status assessments made by clients and how to manage any subsequent challenges by contractors to those assessments.
The latter area is particularly important for agencies, as they are not going to be responsible for making the assessment, but could end up caught in the crossfire between a contractor and the end-client if there is a disagreement over the outcome of the assessment.
How did we get here, and where are we going?
As our experience at the recruitment expo underlined, contractor jobs agencies need to understand which set of rules applies to them and whether they will have to adjust their working practices, now or in the future. How contractors, clients and agencies’ other contractual partners, such as umbrella companies, are impacted, this year and next year, should also be assessed.
From HMRC’s point of view, all three frameworks outlined in this article are designed to ensure individuals and businesses pay the correct amount of tax, while of course making it easier for the department to pursue those who have underpaid. Arguably, next year’s IR35 reform achieves that goal for the Revenue more than ever before, but the forerunners to that framework – in force right now -- can’t be overlooked either.