The question as to whether someone is employed or self-employed is not as straightforward as it might at first appear. Many people assume they are free to choose, but HMRC emphasises that this is not the case.
How do you decide?
Although there is no clear-cut answer to this question, HMRC has published two factsheets (ES/FSI employed or self employed for tax and national insurance contributions and ES/FS2 which is for use by employers and contractors), which set out a series of questions to test the particular circumstances of any working relationship. These cover areas such as:
- Ultimate control of the work
- Right of substitution
- Profit element, and risk of loss
- Provision of materials and equipment
- Integration with the employer's business
- The intention between the parties
- Usual conditions in the industry
Note, however, these are matters of general employment law, and not specific tax legislation.
It may be tempting to cut payroll costs by engaging former employees as self-employed contractors. There are risks attendant with this strategy but if done correctly this can be a tax efficient approach.
For HMRC to accept the self-employed status it should be evidenced that:
- The worker operates a business assuming risks such as rectifying work, invoicing and waiting for payment
- The worker is not required to work for a particular engager
- The engager is not obliged to use that worker's services; and
- The engager does not have the right to control what the worker does.
HMRC has also developed a series of points based entity tests. A business will be scored on a number of key criteria which can enable them to review if they are a low, medium or high risk of being caught by the IR35 legislation and how he does it.
Where a contractor is engaged through his own limited company, the engaging business does not carry a risk that he will be recategorised as an employee. Instead special tax rules known as the intermediaries legislation or IR35 may apply. These use a similar test to establish the tax treatment of the contractor, but it is the contractor who bears the PAYE and NIC if the rules apply.
What are the practical differences?
Employees are taxed under the PAYE system and are liable to Class 1 national insurance (NI) contributions. If the worker is an employee, the employer also has to pay Class 1 NI on earnings over a limit set each year. Above this rate (£827 p.w. for 2016/17), the employee's NI rate then reduces to 2%, but for employers, NI continues at the full rate, with no upper limit.
Most businesses, all charities and CASC’s are entitled to an annual ‘employment allowance' of £3,000 (£2,000 to 5 April 2016) to reduce their liability for class 1 secondary national insurance contributions. Where a company has a single paid employee who is a director the allowance is not available after 5 April 2016.
The employer also assumes responsibility for paying statutory payments such as statutory sick pay and statutory maternity pay. Continued during 2016 until 1 April 2017 small employers will also come within the ‘auto-enrolment' regime, meaning that employees have to be enrolled in a pension scheme to which the employer is required to make contributions. Where a company has a single paid employee who is a director the allowance is not available after 5 April 2016.
Employees have rights under health and safety and employment laws, such as the rights to redundancy payments and not to be unfairly dismissed. Moreover, the range of social security benefits is greater for employees than for the self employed.
Self employed workers are taxed under self assessment, and are allowed more scope in claiming expenses. They also pay Class 2 and Class 4 NI contributions, the combined burden of which is lower than Class 1 NI. Their 'employers' are not subject to NI.
It is not surprising, therefore, that many businesses show a marked preference for self employment status for their workers!
What if you are wrong?
It is usually the responsibility of the person making the payment to get it right. If you treat a worker as self employed and he or she is subsequently ruled to be an employee, you could find that all the payments you have made will be treated as net payments, and you will have to pay the corresponding tax and employees' NI, as well as the employer's NI.
You may also have to pay interest and penalties.
Can you create conditions to favour self employment?
If you want to substantiate a classification of a worker as self employed, we strongly recommend that you have drawn up and enforce a suitable contract defining the services provided. In line with the tests referred to above, you will need to give particular consideration to the following points:
One of the main requirements is that self employed workers bear some element of risk in the arrangement, which means you will have to avoid the 'hourly rate', in favour of a 'price for the job'. The main principle is that the price, scope, and timing of the work should be agreed, and evidenced in writing, before the job commences.
Within reason, the more freedom the worker has in the detail of the way the work is carried out the better. You must also make it clear that the worker will have to put right any faulty work at his or her own expense.
One of the strongest tests of self employment is the right to substitute a worker who is equally capable of carrying out the work.
All self employed workers should hold public liability insurance.
Provision of equipment
Where practical, the worker should supply at least some of the important equipment or tools. Of course, the extent to which equipment is required depends upon the nature of the work.
What about the construction industry?
The construction industry is subject to exactly the same rules as any other type of industry. However, there are some special considerations.
Where the work entails use of heavy equipment or expensive plant, it is sometimes recommended that contractors hire the equipment to their subcontractors, who then include the cost within their 'price for the job'. Such arrangements may seem artificial, and there is the danger that with substantial hire costs being included in the pricing, the subcontractor's turnover may breach the VAT threshold and therefore require him or her to register for VAT. However, this is not necessarily a bad thing because VAT registration is often cited as further evidence of self employment.
With regard to pricing work, a competitive tender is best, but in practice it should not really matter who makes the first suggestion of an appropriate price.
Although there is a special scheme for taxing construction industry workers, registration as a subcontractor under the scheme in itself does not necessarily prove self employment status.
What about personal service companies?
These guidelines apply equally to the so called 'IR35' rules to test whether a worker would be treated as an employee of the client, if it were not for the existence of an intermediate service company. Generally, however, in this circumstance it is the responsibility of the personal service company to decide if the contract is one of employment and any liability for treating it incorrectly is also that of the personal service company. The personal service company is responsible for operating PAYE and NIC's on the receipt of payments from any contract that does not satisfy the ‘IR35' rules.
Visit the HMRC site for their view on employment and self employment.
Do contact us if you would like further help or advice on this subject.
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