IR35: the small company exemption - everything off-payroll contractors need to know

It’s worth restating because as far as HMRC exemptions go, it’s pretty stark. The reformed Intermediaries legislation from April 2021 exempts small companies from making IR35 status decisions, with the effect that contractors who supply them will be making the IR35 status decision themselves, as they have done since 2000, writes David Harmer, associate director of contractor solutions at Markel UK.

What is a small company under the off-payroll rules?

Small companies are defined by s382(2) of CA2006, as meeting at least two of the three following criteria:

• Turnover of no more than £10.2 million
• Balance sheet total of no more than £5.1 million
• No more than 50 employees

HMRC provides guidance on what each of these criteria mean but for the sake of clarity, broadly-speaking each of these can be defined as:

Turnover -- income generated from the trade of the business

Balance sheet -- total amount of assets of the business before any deductions

50 employees -- 50 individuals engaged under contracts of service; i.e. and contractors/subcontractors/deemed employees are not to be included in this total.

Nevertheless, HMRC clarifies that all employees count (whether temporary or part time) and a company can calculate the average number of employees across a financial year by adding up the monthly total of those engaged under contracts of service and dividing by the number of months in a financial year.

It is important to remember that this “exemption” applies to the end-client business – being the party in the chain in receipt of the services of the Personal Services Company (PSC). 

Who is the ‘end-client business’?

To many contractors, this might seem like an odd question – it is obvious who the end client business is, surely, and for many contracting chains it will seem obvious too! However, in our experience, contracting chains are more complex than the legislation anticipates and answering this question has to be the starting point.

For a typical contracting chain –i.e. PSC-to-agency-to-client, it is easy to identify that the ‘client’ is the ‘end-client’ for the purposes of the legislation, and the party which must assess whether they are a ‘small company.’

But in a contracting chain where the end-client has outsourced the services to a third party, then that third party is the ‘end-client’ under the legislation.

In subcontract arrangements (perhaps most typified in the construction industry), the end-client at the top of the services chain is unlikely to be the ‘end-client’ for the purposes of the legislation. The end-client responsibility will pass down the contracting chain as the overall project is broken down into bespoke services undertaken by different contractors/subcontractors.

To state it plainly, the ‘end-client’ under the new IR35 legislation is the party in receipt of the PSC’s services. In all cases contracts are key, and the semantics of contract wording can be critical.

Where are labels identifying who the end-client is no good?

In very broad, simple, terms the end-client under the legislation is the contracting party at which the PSC stops being passed up the chain – but the contracts have to confirm that; simply calling it an “outsourced” or “subcontract” contract, does not make it so, if within the terms and conditions it is evident that the services of the PSC are being passed on. In a true commercial outsourced or subcontracted relationship, there should be no mention of individual PSCs -- it should simply be a contract for ‘packaged services’ and ‘deliverables.’

We have seen cases where organisations have been complying with their responsibilities as ‘decision-maker’ under the off-payroll legislation, but upon analysis of the contracts, we have determined that they are not the ‘end-client’ for the purposes of the legislation. 

We have also seen multiple cases of contractors banding together to form a new corporate outsourced entity to try to remove the responsibility from the end-client! However, based on an analysis of the contracts, we have then established that the terms still flow through as a provision of an individual’s service rather than a genuine outsourced packed service (meaning the whole purpose of setting up in this fashion is lost, as it doesn’t break the end-client’s obligations to assess the status).

So while ‘who is the end-client business’ may seem like a stupid question, as with many areas of tax, the ‘stupid’ question often yields the most informative answers!

What if the end-client is NOT a small company?

If the end-client is not a small business, then they will have to assess the IR35 position Properly considered decisions should include a full critical analysis of all contracts and a working practices questionnaire completed in conjunction with the contractor, in person. Yet ultimately the end-client shoulders the burden, and while they must take “reasonable care,” they are free to consider what information they deem relevant in assessing the IR35 position.

In our experience, while we have seen end-client organisations take note of contract review reports from contractors (and we think these will be crucial to the client-led disagreement process), the same cannot necessarily be said of a contractor-completed Check of Employment Status for Tax (CEST) check. We suspect the bad publicity for HMRC’s tool may have dissuaded many end-clients from placing reliance on this. And for both complete transparency and the avoidance of doubt, we too have stated on many occasions that we believe that CEST is woefully inadequate in determining the status of real-world engagements.

Much has already been written on the issue of end-client obligations and the decision-making process, and I have included this here for completeness. But this is not the main focus of this article – so back to the small company exemption.

What happens if the end-client is a small company, and what about agencies?

If the end client is a small business, then effectively for contractors it is ‘business as usual’ – they, the contractor, retain the obligation to self-assess and make their own decision.

We have heard from many contractors that they are actively seeking engagements from “small” end-client businesses, and we can see the appeal in this; especially considering the highly publicised knee-jerk reactions of some larger organisations (particularly in the banking sector), when the rules for off-payroll working in the private sector were first announced.

At the time of writing (on the cusp of 2021), it does seem to still be a struggle for some agencies to confirm to contractors whether or not an end-client is a ‘small’ business.  While in some cases it may be a reluctance, we suspect that often the agency simply doesn’t know the situation at the point of trying to secure the position. 

For contractors under contract, you do have the ability to ask the end-client directly. Furthermore, under the legislation, you (and the party closest in the chain to the end-client) have the right to request that the end-client confirm whether they are a small business or not.  Unfortunately, however, while you have the right to ask (and the end-client must respond) there must be an “engagement” to enact this right. This means that a contractor can ask before the first payment is made, but there is no obligation for a client to respond before a contract has been entered into!

Where should language about IR35 change, and what should it change to?

Where the end-client is a small business, while it is true that decision-makers and fee-payers are done away with, it is not true to say that IR35 is done away with.  Rather than talking about “IR35” as a global term in the future, it might very well be better to use the labels “Chapter 10” and “Chapter 8.”

The new private sector IR35 legislation (Chapter 10) effectively says that an end-client needs to determine if it is a ‘small’ business of not.  If not, Chapter 10 applies and we are in ‘decision-maker’ and ‘fee-payer’ territory.  If it is a small business, then we revert to Chapter 8 (which is the IR35 legislation of 2000 which we have come to know and love!)

Where does Chapter 10 slip away and Chapter 8 (your old friend) remain in play?

In reality what the introduction of Chapter 10 does is:

1. If the end-client is a medium or large business, then Chapter 10 applies. This means the end-client has responsibilities to determine whether IR35 applies and the fee-payer has responsibility to make the correct payment to the PSC. 

It doesn’t automatically impose ‘liability’ -- the law on deciding IR35 hasn’t changed so there would still need to be an HMRC enquiry, case law considerations etc, before HMRC can issue determinations (and then standard appeals processes are still available).

2. If the end-client is a ‘small’ business, this means it does not have the responsibility to make the decision and there is no fee-payer responsible for making the correct payments.  

It means that Chapter 10 slips away, and Chapter 8 is considered.  This is our ‘old friend’ which says that the PSC; i.e. the contractor, is responsible for deciding IR35 and making the correct payments.

What is the taxman doing on compliance and enforcement?

It does seem to be the case that HMRC has already made a concerted effort to target compliance on end-client businesses for Chapter 10. It is also true that HMRC have stated they would not actively seek retrospective action on contractors if it deems them caught under Chapter 10, but this is where the word of warning about the global term of “IR35” must be cautioned. While the PSC itself will likely not be the target for compliance under Chapter 10, Chapter 8 still exists. HMRC have not stated they will stop all action under Chapter 8, they have not said they won’t target the contractor under Chapter 8 – the contractor is the only target under Chapter 8, but it still a target.

So contractors must fully understand that contracting with a small end-client may seem easier in the short-term to avoid the hassle of end-client decision-making. In the long-term, there is only one place potential liability can accrue -- on the contractor themself.  Personally and professionally, I am by no means discouraging contracting with small business end-clients, but for those contractors who are actively seeking out ‘small company’ end-clients, this may not provide the ‘escape’ from the legislation they are looking for.

As far as policing the legislation is concerned, HMRC has made a concerted effort on publishing information on Chapter 10 and it certainly seems they are geared up to police it. But I must reiterate that Chapter 8 has not gone anywhere and should not be ignored.

What’s the IR35 outlook for contractor limited companies?

HMRC seemingly undergo restructuring on a regular basis, and within HMRC there are mid-size/wealthy units, and small/individual units. We can foresee that it is likely the mid-size/wealthy teams will focus on Chapter 10 compliance and the small/individual teams will focus on Chapter 8. 

Arguably the introduction of Chapter 10 has effectively meant that IR35 can be policed on two fronts, from two teams within HMRC; meaning there are now more resources available to target compliance on both Chapter 10 and Chapter 8. Although, we did see a lull in HMRC activity during coronavirus lockdown, we are certainly not experiencing that lull now and we are seeing no signs of HMRC closing off their cases quickly prior to the introduction of Chapter 10.

Finally then, in our opinion, Chapter 8 activity is likely to increase rather than decrease, and we would encourage contractors engaged by small businesses not to wane in their ‘due diligence.’ Contractors -- it is vital that you have your contracts and working practices reviewed and are fully prepared before HMRC come knocking.