Tech contractor loses IR35 tribunal appeal: 'Right' to substitute didn't mean he could, say judges

Substitution's 'not a silver bullet' advisor says


An IT contractor has lost an appeal [PDF] which found he was an employee in the eyes of HMRC, with the judges agreeing he fell under the new IR35 off-payroll tax rules.

Robert Lee, working as a contractor under the company name Northern Light Solutions, had challenged an earlier First-tier Tribunal ruling which found his work for the Nationwide Building Society to be "employment" for tax purposes.

But his appeal in the Upper Tribunal on 6 and 7 May failed, partly because his legal team did not convince the judges that the clauses in his contract suggesting he and the agencies had the "right" to offer a substitute IT professional did in fact mean such a substitution could happen.

The ruling meant Lee would have to pay an additional £74,523 in income tax and National Insurance Contributions due to determinations made by HMRC for various tax periods between 2012 and 2015.

The tribunal found Lee, under the terms of the "hypothetical contract", was paid a "day rate in the region of £450 and required to work a professional week, which for the Clarity Contracts is specified to be 7.5 hours a day."

A contractor or agency's right to substitute their work to another person of equivalent skill has been held as a key signal that the contractor is self-employed, rather than a "disguised employee", and thus can be considered as falling outside of the IR35 rules.

Reforms to the IR35 off-payroll working rules, which critics argue classes contractors as paid employees without the employment benefits, were introduced in the private sector in April this year, after a year's delay due to COVID-19. The new rules put certain liabilities on employers and make it more difficult for contractors to place themselves outside the revamped tax laws. Some employers – including BAE systems – have introduced blanket bans on contractors working outside IR35.

Lee worked for Nationwide through his Northern Light agency, which contracted with another agency, AxPO, which in turn contracted with the building society itself between 2012 and 2014.

What is IR35?

IR35 is a tax reform that was unveiled in 1999 by the UK tax authorities. The latest regulation change will force medium and large private sector businesses in the UK to set the tax status of their contractors and freelancers. Previously this was set by the contractors themselves.

Those workers found to be within the scope of the legislation – i.e. inside IR35 – will have to pay more tax than they might expect, despite not receiving benefits enjoyed by full-time employees, such as holiday or sick pay, pension, or parental leave.

The reforms are part of the government's crackdown on so-called "disguised employment," where workers behave as employees but avoid paying regular income tax and national income contributions by billing for their services through personal service companies (PSCs), which are taxed at lower corporate rates.

Critics say that being inside IR35 is essentially "no-rights employment," meaning techies are paid and taxed similarly to regular employees but do not receive any of the security or protections that go along with permanent employment.

Contractors within IR35 can be hired and fired at will and without reason. The measure came into effect in the public sector in 2017. The British government hoped the reforms would recoup £440m by bringing 20,000 contractors in line.

The implementation in that area has been described as an "utter shambles." HMRC reckons that only one in 10 contractors in the private sector who should be paying tax under the current rules are doing so correctly. It estimates the reforms will recoup £1.2bn a year by 2023.

Barrister Michael Collins, acting for Lee, had earlier argued that the "right of substitution meant that the hypothetical contracts could not be a contract of employment."

Although the First-tier Tribunal had found that there was a right to provide a substitute in these contracts, this right was qualified. The tribunal found that Nationwide would have had to agree to a substitution, and that it was under "no obligation to accept such a replacement if in [its] reasonable opinion such replacement was not wholly suitable."

The ruling said that "in practice it would be impractical for [Nationwide] to accept substitutes due to the necessary restrictions on access to [Nationwide's] systems and restricted site access. Any substitute would need to go through vetting checks and an interview and get up to speed on the project."

The Justices found a hypothetical contract – one that would have described the agreement between Lee and Nationwide – showed that his relationship with the building society was one of employment and the tribunal dismissed the appeal.

Lessons from the case include the need to effectively describe and communicate working practices at an early stage in the relationship, according to Dave Chaplin, CEO of ContractorCalculator, a firm advising contractors on their IR35 status.

Chaplin also claimed HMRC's evidence from the notes of meetings, which underpinned several aspects of the ruling, appears to frame the facts relating to substitution in a manner that does not align with what really happens on the ground in IT projects. It was therefore important to keep a good, evidenced audit trail on projects to establish off-payroll working, he said.

"Lee's contract did include a legitimate unfettered right of substitution, but it was never exercised, and the client never gave witness evidence to back it up as a genuine right. The judges chose to disregard those substitution clauses. Substitution is no silver bullet to definitively proving a worker is not employed unless it has taken place," Chaplin said. ®

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