UK: A Question of Status

Are you genuinely self employed (?) is a question many are being asked by the Inland Revenue in its latest drive to increase the number of people paying income tax through the PAYE system and making National Insurance ("NI") Contributions. The drive is seen as a wider attack by the government on owner managed businesses, such as husband and wife companies, composite companies, and personal service companies which are criticised for the lack of contribution they make to the economy. In addition, the Revenue recently announced a major investigation into approximately ten percent of its database of construction companies regarding their categorisation of sub-contractors under its Construction Industry Scheme. The Revenue believes that many sub contractors classed as self employed are in fact employees to whom PAYE and NIC apply.

For individuals, the advantages of being self-employed are lower tax rates and a greater freedom to organise their work; the advantages for employers to engage them is that they qualify for much less statutory rights such as paid annual leave, the right to claim unfair dismissal and redundancy payments.

However, there is no uniform statutory definition of "an employee" and hence no easy formula for determining employment status. Various legislation relating to health and safety, social security, and employment contain various definitions and in some instances refer to "workers" and not "employees." An individual will be either (1) a worker or (2) an employee, where: (a) there is a contract (written or oral) between the business and the individual; (b) they do the work themselves and do not substitute other people to do it; and (c) they are not carrying out the work as part of their own business.

An employee is distinguished from a worker by the existence of mutuality of obligation, i.e. there is an expectation that the business will give a person work to do and an equivalent expectation that he must make himself available for work. Further, an employee is controlled or supervised by his employer in the way that he carries out his work (i.e. the number of hours, working pattern and resources used).

In contrast, a self employed individual is someone who is in business on his own account, who usually works for a variety of businesses and who takes on financial risk as part of carrying out his work. Such an individual works under a contract for services and not of service. Evidence of financial risk is the individual taking out insurance (e.g. personal indemnity insurance), having his own office, remedying defects in his work at his own expense and in his own time, supplying his own equipment, getting paid for his work upon issuing an invoice at a fixed rate based upon a quote for a discrete piece of work regardless of the number of hours actually spent completing the work, as well as penalties for late completion, or incentives for timely completion.

Many self employed individuals are termed "contractors" or "sub-contractors" and often work through their own limited liability services company, in which case the elements of financial risk detailed above must be taken by their own personal services company and not the individual himself. Setting up such a corporate structure is prevalent in certain industry sectors such as construction and IT, and enables the contractor to pay himself a salary out of the payments received from clients, at a lower rate falling within a lower tax band. The balance can then be retained by the company, expenses deducted from it and an additional salary paid to a spouse, with the remainder being paid out as a dividend with tax on it deferred until the time the dividend is actually declared. Any remaining balance can be retained by the company and taxed as corporate income.

The Inland Revenue views many of these limited liability companies as little more than sham structures to disguise the reality on the ground which is that the contractor is actually employed by the client of his limited liability company. Accordingly, the Finance Act 2000 and Social Security Contributions (Intermediaries) Regulations 2000 were introduced to combat such practices in the belief that £900 million in income tax and NI contributions would be gained. The so called IR35 rules are triggered when an individual provides his services through a limited liability company in which he has more than a five percent share and then receives a dividend that amounts partly or wholly to payments received from the company’s client for services. The services must also have been performed in what but for the personal services company, would be an employee capacity.

Aside from financial risk, other relevant factors for determining employee status are: the right of a contractor or company to substitute the individual carrying out the work, freedom to undertake work for other companies and the absence of exclusive engagement, and the absence of any hallmarks of an employment relationship (e.g. paid holidays).

Determining whether an individual is self employed, a worker, or an employee, requires a detailed examination of the facts of each case. It is also possible for an individual to move from being "self employed" or a "worker" to being an "employee" over time, as the nature of the relationship between the individual and the business engaging his services develops. In a case decided earlier this year, Dacas v Brook Street Bureau (UK) Ltd (2004)EWCA Civ 217, the Court of Appeal decided that the longer an individual works for a business and the more he is integrated into its workforce, the greater the likelihood that he will move to being an employee, and one year was stated as a general guideline of the time scale for the change in status to have taken place.

Mrs Dacas had worked exclusively through the Brook Street Bureau agency as a temporary cleaner for Wandsworth Council in one of their hostels for six years when she was summarily dismissed for swearing at a guest. There were two express contracts, one between the agency and Mrs Dacas, the other between the agency and the Council. The Court stated that "practicality and common sense" should mean that in all such tripartite relationships, the employer is always the client, who is the end user. The objective fact and degree of control over the worker is crucial. The Council controlled Mrs Dacas’s work, told her when to work and how, paid her wages through the agency, and ultimately, took the decision to dismiss her.

This analysis may apply under IR35 and regardless of whether the individual is providing services through a limited liability company which contracts in turn with an employment business ("agency") to supply the individual’s services to the agency’s clients. Usetech Limited –v- Young (HMIT) (2004) STC (SCD) 213 demonstrated the real risk to personal services companies. In this case an oil rig design engineer ("H") supplied his services through his own company ("U"). U contracted with an agency which in turn contracted with one of its clients ("B") to provide H’s services to B. B provided all the equipment, and set the number of required work hours in its contract with the agency. U took out employer’s liability and professional indemnity insurance. H needed permission to take time off work but performed work for other companies on week-ends and in the evenings.

The court decided that H was an employee of B because the degree of control he could exercise in practice could not materially be distinguished from that of a senior employee. Further, H was required to agree his work hours with a manager to whom he reported within B and B had contracted for H’s services and not simply the services of a person. Therefore, any right by the agency to substitute H was illusory. Nor, was there any financial risk as U was not risking its capital as part of supplying H, and the risk of B not paying or of the agency not passing on payment was the same risk run by any employee.

A personal services company will be covered by the Conduct of Employment Agencies and Employment Businesses Regulations 2003 ("the Regulations") if it chooses to find work through an employment business. The agency can then charge its clients a referral fee if the contractor supplied is engaged directly by the client as well as having to comply with onerous duties to provide information and contractual documentation. However, a contractor may contract out or "opt out" of the Regulations (in their entirety, the opt out cannot be selective) by written agreement with the personal services company, and then giving notice of this agreement to the agency. The opt out is not available to those working with children, the elderly and infirm or other vulnerable groups.

Husband and wife companies are family run businesses whereby a couple share tax liabilities by drawing income through dividend payments equally even if one spouse generates all or most of the business’s income. The couple thereby reduce their overall tax bill by making use of the non-working spouse’s personal tax free allowance and lower tax bands.

Such a practice was successfully challenged by the Revenue using 1930’s legislation, in Arctic Systems Limited –v- Inland Revenue Commissioners (unreported 2004) (Sp Comm) case concerning an information technology business run by Geoff and Diana Jones, resulting in the couple facing a tax bill for an entire year. The Revenue argued that dividend payments exceeding a person’s contribution to the company should be treated as if they were all the working spouse’s income and taxable under s.660A Income and Corporation Taxes Act 1988. The decision will affect all such companies where one spouse is either inactive or contributing much less income generation. The Court of Appeal is due to hear the Jones’ appeal of the decision on 29 and 30 November 2005.

In last year’s budget the Government introduced a much criticised nineteen percent rate on dividends (IR591). The Tax Faculty and Chartered Institute of Taxation argues that the IR35 Regulations should be replaced and that current taxation rules hinder growth, enterprise and productivity. Other government plans include increasing NI contributions payable by "life style" businesses and the dti is expected to make an announcement later this year regarding the extension of statutory rights to categories of workers not currently covered. The government is reported to have agreed to such an extension in principle with trade unions.