The Off-Payroll tax rules introduce compliance requirements on all parties in the contractor supply chain. For recruitment agencies, and some clients, this means calculating and processing tax and National Insurance Contributions (NICs) due on fees paid to contractors deemed within the scope of the rules.
The sum to be treated an employment income is referred to in Chapter 10, Part 2 of the Income Tax (Earnings and Pensions) Act 2003 as the ‘deemed direct payment’. To comply with their legal responsibilities, it is essential that agencies and clients familiarise themselves with this calculation.
This isn’t to be confused with the ‘deemed payment’ referenced in the original IR35 legislation – Chapter 8, Part 2 of the ITEPA. Unfortunately, conflation of the two terms is believed to have contributed to the excessive taxation of many public sector contractors as a result of non-compliance with the Off-Payroll rules amongst agencies after April 2017.
How tax treatment has changed from IR35 to Off-Payroll
Under the original IR35 legislation, contractors working ‘inside IR35’ subjected their affected income to a tax calculation centred around the ‘deemed payment’.
The contractor could set aside 5% for expenses and the rest was considered the gross cost of hire to the ‘deemed employer’, which meant that the payment had to be considered as including the employer’s NICs. This has long been a source of contention amongst contractors, who were effectively picking up the taxes which realistically should have been borne by the client.
This arrangement subjected ‘inside IR35’ contractors to considerably higher effective tax rates than those of permanent employees. This unfairness was the catalyst for many taxpayers to consider tax avoidance schemes, which ultimately led to the controversial Loan Charge.
However, this anomaly was corrected under the new legislation, which involves a much simpler tax calculation, where the payment to the contractor is treated like a regular salary.
What is the Off-Payroll ‘deemed direct payment’?
Chapter 10 requires that, where the Off-Payroll rules are deemed to apply, the fee-payer – i.e. the party in the supply chain closest to the contractor’s limited company - makes to the worker ‘a payment which is to be treated as earnings from an employment’.
This is otherwise referred to as ‘the deemed direct payment’, the calculation of which is explained in Section 61Q, and summarised below:
- Identify the value of payment made by the fee-payer to the worker, excluding VAT
- Deduct costs incurred by the intermediary for materials used
- Deduct expenses incurred by the limited company that would be claimable if the worker was employed
The resulting sum is the deemed direct payment. This is a far simpler calculation, especially given that most contractors won’t have any applicable costs for materials or expenses, meaning in most cases the deemed direct payment is the contract rate agreed with the worker.
According to the legislation, this sum is to be treated as salary, and subject to income tax and employee’s NICs deductions via Pay As You Earn (PAYE). VAT is then added back onto the post-tax sum and paid over to the contractor’s limited company.
Off-Payroll tax rules: Who is liable for employment taxes?
‘Employment taxes’ is the legal term meaning the taxes that an employer pays, which includes employer’s NICs (13.8%) and the Apprenticeship Levy (0.5%). The crucial difference with the deemed direct payment is that the ‘inside IR35’ contractor is no longer liable for employer’s NICs, which amounts to 13.8% of the contract rate.
Unfortunately for agencies, the fee-payer is ultimately liable for employment taxes, to be paid on top of the fees paid out. This works out at a combined rate of 14.3% of the pre-tax contract rate agreed with the contractor.
Though statute requires that this sum is ultimately paid by the fee-payer, this is an unrealistic prospect in some cases. Many recruiters would be forced to fold if required to fund this cost for each ‘inside IR35’ contractor engaged. In practice, it is expected that the sum will need to be sourced from the end client, which agencies will have to accommodate for by negotiating higher margins for affected engagements.
Alternative arrangements and umbrellas
Should the client be unwilling or reluctant to fund the employment taxes in full, the agency is placed in a tricky position where it becomes almost impossible to appease all parties. Whereas the client will likely seek to decrease the contract rate, the contractor will be unlikely to budge, having already suffered a tax hike as a result of being deemed ‘employed for tax purposes’.
In such a scenario, the only viable option would be to terminate the contract and attempt to find a replacement who is prepared to work for a lower contract rate. This tug-of-war on rates reinforces the importance of compliance and cooperation between all parties in determining IR35 status.
In the public sector, some agencies have encouraged contractors deemed within scope of the rules to work under umbrella companies, which operate a payroll. This negates the administration associated with running a company for the contractor, while relieving the agency of their fee-payer responsibilities.
The Off-Payroll tax rules don’t apply to contractors engaged via umbrellas, who are treated as employees in any instance, but this does mean that employment taxes are still due.
Employer’s NICs deductions from contract rates are illegal
One option agencies can’t take is to deduct the employment taxes from contractor fees. This practice is prohibited by the Social Security Contributions and Benefits Act 1992, Schedule 1, Section 3(2)(a), which states:
‘No secondary contributor shall be entitled to make, from earnings paid by him, any deduction in respect of his own or any other person’s secondary Class 1 contributions.’
Though this approach is unlawful, there have been reports of its adoption amongst agencies and umbrella companies in the public sector. This is believed to be partly a result of HMRC’s failure to clearly explain the differences between IR35 and the Off-Payroll tax rules when educating the public sector.
Advertising contract rates for ‘inside IR35’ engagements
Agencies are also advised not to deceptively advertise contracts at gross rates, if contractors are ultimately deemed ‘inside IR35’. Historically, contract rates have been advertised as gross as contractors have been responsible for compliance. Many have accepted these rates in the knowledge that they would be able to operate outside of IR35.
Contractors will rightly expect to receive the quoted rate for engagements deemed ‘inside IR35’, and won’t expect there to be a substantial discrepancy between the agreed rate and that received. However, this is exactly what is happening in many cases.
This is worse where the rate paid by the agency to the umbrella is quoted, because employment taxes must also be funded out of that amount. The simple way to understand this is that permanent salaries are not quoted with employment taxes included, and therefore neither should ‘deemed employment’ engagements.
Experts have warned that this could be construed as legal misrepresentation, rendering the consequent deduction of employment taxes unlawful. This is understood to have occurred in practice, despite legislative provisions which should prevent it. Chapter 10, Section 61T(1)(a) requires that the client inform the contractor, in the contract or otherwise, of the IR35 status upfront.
The key for all parties therefore is clarity. For agencies, this means accompanying any advertised contract rates with a disclaimer regarding IR35 status and any other deductions that may be made.
Why agencies must police ‘inside IR35’ payments
Another non-compliant practice that clients and agencies need to be aware of is the proliferation of tax avoidance schemes in response to the Off-Payroll tax rules. These schemes typically operate under the guise of 'umbrella companies' when they are far from being a vanilla payroll service. This is an issue for clients and agencies, particularly those in lengthy supply chains, due to the liability transfer provisions proposed by HMRC for Off-Payroll in the private sector.
The taxman has proposed that tax liability be passed up the supply chain in instances where a party has failed to fulfil its compliance obligations and HMRC has failed to collect the outstanding liability from the offending party. Meanwhile, Section 15(1) of the draft legislation introduced in the Finance Bill 2019-20 states:
‘PAYE Regulations may make provision authorising the recovery from a relevant person of any amount that an officer of Revenue and Customs considers another person should have paid under PAYE Regulations in respect of a deemed direct payment.’
To secure the supply chain and ensure that they don’t expose themselves to any unnecessary risk, clients and agencies must take measures to ensure that monies passed to payroll companies, including the employment taxes, are processed correctly.
Clients may decide to ensure that contracts with agencies strictly define the calculation to determine the deemed direct payment, and insert a clause indemnifying themselves in the event that the fee-payer fails to comply. Similarly, both clients and agencies would be advised to insist on copies of payslips from the fee-payer, demonstrating that the correct tax has been paid.