It is perhaps not surprising that there has been relatively little legislative activity in the UK tax world over the past couple of months. The governments entire attention has been focused on the financial markets. Unlike the US, the UK government has not, to date, used fiscal policy as a weapon to fight the turmoil in the financial markets (in contrast, the US has announced some very generous tax concessions to make the takeover of financial institutions more attractive).
This enforced pause in legislative activity has given us the chance to focus our entire update on recent developments in employment-related taxation. We highlight below issues that will affect most large employers and those that rely, to a substantial extent, on the work of independent contractors.
Dragonfly Consultancy Ltd v HMRC Commissioners [2008]
IR35 legislation
There are several disadvantages to being taxed as an employee, rather than as a consultant. These include being subject to immediate taxation under PAYE and the restriction on claiming expenses as a deduction from taxable income. Self-employed workers will also generally pay less National Insurance contributions (NICs) and the employer will not be liable to employers NICs at 12.8%.
If the consultant operates through a service company in which they are the controlling shareholder, the fees received by the company would also be subject to corporation tax (which will generally be lower than the rate of income tax) and the shareholder would be able to receive the profits of the business by dividend, free of NICs.
As a result, it became extremely common in the late 1990s for consultants to operate through service companies. In response, the government published IR35 on Budget day 1999 to counter this perceived avoidance and to ensure that everyone pays their fair share. As described in R (Professional Contractors Group) v IRC [2001], the purpose of the legislation enacting IR35 was:
to ensure that individuals who ought to pay tax and NICs as employees cannot, by the assumption of a corporate structure, reduce and defer the liabilities imposed on employees by the United Kingdoms system of personal taxation.
The conditions for the application of the IR35 regime are set out in Schedule 12 to the Finance Act 2000 and Regulation 6 of the Social Security Contributions (Intermediaries) Regulations 2000. Although the income tax and NICs tests are not identical, in most cases both the income tax and NICs parts of the IR35 legislation will apply where the circumstances are such that, if the services were provided under a contract directly between the client and the worker, the worker would be regarded for tax purposes as an employee of the client.
To apply the IR35 legislation you must therefore consider whether the individual concerned would be treated as an employee if the services were provided directly to the client. If the IR35 legislation applies, the service company is obliged to operate PAYE and NICs and is only entitled to limited deductions for expenses.
Facts in Dragonfly
In Dragonfly an IT consultant, Mr Bessell, provided his services to the AA Group (AA) through the company Dragonfly Consultancy Ltd (Dragonfly), in which he was the controlling shareholder and the only consultant. Dragonfly provided the services of Mr Bessell to AA through an agency company, DPP International Ltd (DPP).
DPPs contract with AA was to provide temporary staff to AA. DPP would provide CVs of candidates and AA would select which of them it required.
The details of the appointment would then be completed in a schedule to the agreement between the two companies.
The relationship between Dragonfly and DPP was governed by a series of contracts under which Dragonfly provided services to DPPs clients. Again, the schedule to the agreement would set out the specific terms of the appointment, in which Mr Bessell was named.
Mr Bessells status for tax purposes
The starting place for determining whether an individual is an employee is the guidance provided in Ready Mixed Concrete (South East) Ltd v Minister of Pensions and National Insurance [1968]. A contract of services exists if:
When considering the terms of the hypothetical contract between Mr Bessell and AA, the Special Commissioners found that:
In considering the overall terms of the hypothetical contract, the Special Commissioners concluded that Mr Bessell would not have been in business on his own account, and that he would have been an employee had he been directly engaged by AA.
Dragonfly appealed on the basis that:
Henderson J considered each point in turn.
i) SubstitutionIt was established in Ready Mixed Concrete that the freedom of a contractor to complete their tasks by their own hand or those of another is inconsistent with the relationship of employment.
In Dragonfly the terms of the contract between Dragonfly and DPP and the evidence given by AA meant that Dragonfly would not have been able to supply a substitute for Mr Bessell without the consent of DPP and, more importantly, AA.
Henderson J concluded that the hypothetical contract between Mr Bessell and AA would have contained only a very limited right of substitution. It was clear that AA wanted to contract the services of Mr Bessell rather than those of any qualified IT consultant. Further, substitution would only be determinative of an individuals employment status if the notional contract between a contractor and client contained an unqualified right of substitution.
The conclusion is unattractive to any individual who supplies their services through a company, as it will be difficult to demonstrate that the client did not intend to specifically employ the services of the consultant behind the company, the notional contract therefore only containing a limited right of substitution.
ii) ControlIn spite of the fact that Mr Bessell carried out tasks with little direction or supervision by AA, the Special Commissioners found that AA had sufficient control of Mr Bessell in order to imply an employment relationship. Henderson J agreed on the basis that the notional contract between Mr Bessell and AA would have included terms relating to the direct supervision and control by AA (rather than Dragonfly). This conclusion was reached on the basis that AA allocated tasks to Mr Bessell that were managed and reviewed by AA on a project basis.
Again, the conclusions in Dragonfly will make it difficult for a taxpayer to argue that a client would not have sufficient control under a hypothetical contract to imply an employment relationship. In practice, it is likely that a client would insist on a similar level of control as AA in Dragonfly for any consultant working on its premises. Even with a consultancy company that supplies many consultants, the reality of the engagement will be that the client directs and monitors each consultant in a similar fashion to that in Dragonfly. Save in unusual circumstances, the hypothetical contract imposed by the IR35 legislation will therefore normally include sufficient control to imply an employment relationship.
iii) Intention of the partiesThe difficulty in assessing this criterion is that the intention of the parties to the actual contractual relationships will not be the same as those of the parties to the hypothetical contract. However, Henderson J concluded that the intentions surrounding the actual contractual relationships can be taken into account in determining the intention of the parties to the hypothetical contract. The intention of the parties will only be important in borderline cases, and in the case of Dragonfly the intention of the parties under the actual contractual relationships was inconclusive in determining what the intentions would have been under the hypothetical contract.
Henderson J appears to have agreed with the Special Commissioners on this point, regardless of the fact that the actual contractual provisions were designed to avoid any employment relationship between Mr Bessell and AA.
iv) Worker statusHenderson J concluded that IR35 is only concerned with whether the notional contract would be a contract of services or not and therefore it was not necessary to consider the intermediate category of worker.
Conclusions from Dragonfly
The difficulty with the decision in Dragonfly is that the statutory fiction created by the IR35 legislation makes it extremely difficult for a consultant to avoid employment treatment when placed in a direct relationship with a client. This conclusion seems distant from the initial view provided in the Professional Contractors Group case that the legislation should only apply to borderline cases. It would appear that, following the decision in Dragonfly, it will be much harder to fall outside the scope of the legislation than it is to fall within it.
Sempra Metals Ltd v HMRC Commissioners [2008]
Until recently, it was possible for companies to obtain a tax deduction for contributions made to an employee benefit trust (EBT) at the time of payment, and for income tax and NICs to be avoided on the benefits provided by the EBT. If the EBT was resident offshore, it could also avoid capital gains tax on assets held in the trust.
The potential tax advantages of using an EBT have attracted increasing attention from HM Revenue & Customs (HMRC). Most notably, the ability of a company to obtain a deduction for contributions to an EBT was successfully challenged in MacDonald (Inspector of Taxes) v Dextra Associates Ltd [2005] and limited by s43 of the Finance Act 1989 and later by Schedule 24 to the Finance Act 2003.
Schedule 24 was introduced to restrict the availability of a corporation tax deduction to circumstances where the contribution to the EBT was used to provide benefits that were taxable in the hands of employees (or would have been had the employees been resident in the UK).
The facts in Sempra Metals gave HMRC the opportunity to reaffirm its position regarding the availability of a deduction on contributions and to revisit the argument raised in MacDonald that payments to an EBT should be treated as earnings.
The facts
Sempra Metals Ltd (Sempra) trades metals in the City of London and until the establishment of an EBT in 1995 incentivised its employees through a cash bonus scheme.
Sempra was attracted by the idea of an offshore EBT as it would allow the company corporation tax deductions on contributions to the trust and could increase the amount of the bonuses through the saving of NICs. The proposal was that employees could elect for their bonuses to be paid to the EBT, which could then make loans to the employee. Unless the employee was a bad leaver, there was no expectation that the trustee would call for the loans to be repaid.
Due to the introduction of Schedule 24, Sempra established a family benefit trust (FBT) by which the employees could nominate a beneficiary and the FBT would make a loan to the relevant family member. The purpose of this trust was to avoid the restriction on the availability of a corporation tax deduction under Schedule 24 on the basis that the FBT was not a trust established for the benefit of employees.
The issues
The Special Commissioners considered several specific issues in Sempra Metals, each of which is worth considering in turn.
i) Whether payments made by Sempra to the EBT and FBT were wholly and exclusively expended for the purposes of its trade Sempra argued that the contributions were for the benefit of its trade as the employees who benefited from the contributions were crucial to the success of the business. The contributions to the EBT were therefore essential in enabling Sempra to retain key employees. HMRC argued, however, that the payments were made for the benefit of the employees themselves and not that of Sempras trade.
The Special Commissioners agreed with Sempra that the payments to both trusts were made to preserve and maintain the competitiveness of Sempra in the market place. Accordingly, the Special Commissioners found that contributions to the trusts were made wholly and exclusively for the benefit of Sempras trade.
ii) Whether payments to the EBT were deductible having regard to s43Section 43 was an anti-avoidance provision. It applied where amounts contributed to a trust constituted potential emoluments and prevented the employer from obtaining a deduction until the amounts contributed to the trust were used to pay bonuses or benefits to the beneficiaries.
Sempra argued that there was no realistic possibility that the amounts paid to the EBT would be potential emoluments as it was understood that the trustee of the EBT would loan amounts to the employees and would not make formal appointments of cash. However, the Special Commissioners held that the issue should be determined by reference to the terms of the trust deed.
The EBT trust deed was drafted widely and allowed the trustees to make appointments of income and capital. In one case, the trustees made a payment of income to an employee, rather than entering into a loan. This led the Special Commissioners to find that there was a realistic possibility that the payments to the trust would become emoluments and therefore that the contributions to the EBT were not deductible until the relevant emoluments were paid to the employees.
iii) Whether payments to the FBT were deductible having regard to Schedule 24Sempra argued that although the payments to the FBT indirectly benefited the employees and therefore were wholly and exclusively incurred for the benefit of its trade, they did not fall within Schedule 24 on the basis that they were not payments to an employment benefit scheme for the purposes of that schedule.
The Special Commissioners disagreed and held that the payments to the FBT fell within the scope of Schedule 24 as the term employee benefit scheme included a trust, scheme, or other arrangement for the benefit of employees. The indirect benefit to employees afforded by the FBT was therefore sufficient to bring the payments within the scope of Schedule 24, and as such they were not deductible until the amounts were taxable in the hands of the employees.
iv) Whether the payments made by Sempra were emoluments or earnings that gave rise to income tax and NICsSempra argued that the payments to the EBT and FBT were not earnings, on the basis that the trustees did not exercise their powers of appointment when allocating funds to beneficiaries. The relevant beneficiaries were therefore not absolutely entitled to any amounts allocated to them and should not be considered as receiving earnings. Further, as the loans made by the EBT and FBT were genuine, the amounts advanced should not be treated as earnings.
HMRC argued that the payments should be treated as earnings as the employees were entitled to the bonuses but chose to have them paid to the EBT and FBT. At that point the employees could either choose to have the cash loaned to them or invested in other property, such as land. The amounts paid to the trusts were placed unreservedly at the disposal of the employees, which was consistent with the factual evidence that demonstrated that the employees referred to and considered the amounts held by the trust as their respective pots.
If the Special Commissioners found for HMRC then, although the payments to the EBT and FBT would be subject to income tax and NICs, Sempra would be entitled to claim a deduction for the contributions under Schedule 24 and s43.
Despite the evidence that the employees would not have directed their bonuses to the EBT and FBT if they believed there was a possibility that they would not receive the benefit of the funds, and that the trustees of the FBT and EBT almost always followed the requests of the employees, the Special Commissioners found in favour of Sempra. They were not prepared to ignore the existence of the EBT and FBT and the continuing obligations of the trustees. They stated:
We agree that the trustee was likely to comply with reasonable requests but that does not mean that the trustee was a cipher who did what it was told.
The future of EBTs
As in MacDonald, HMRC lost the argument that payments to a trust should be treated as earnings in the hands of the employees. However, there are inconsistencies in the decision reached by the Special Commissioners that may lead HMRC to appeal the decision.
On the one hand, the Special Commissioners agreed, when considering the accounting treatment of the payments, that the amount of each employees bonus had been unconditionally vested in him at the time the directors resolved to make recommendations to the trustee, but held that the amounts were not placed unreservedly at the disposal of the employees when considering the earnings issue. The distinction drawn is somewhat unclear and it may provide HMRC the opportunity to appeal the decision on the earnings argument.
The decision may also be challenged on the basis that the uncertainty over the allocation and use of the funds by the trustees was not a real commercial risk for the employees when deciding whether to pay their bonuses to the trusts. As far as the employees were concerned, the funds held by the EBT and FBT were at their disposal. Without this expectation, they would not have directed the funds to the trusts.
A higher court may be reluctant to ignore the existence of the trusts, as this may undermine the status of discretionary trusts in many other areas of law. However, whether Sempra Metals is appealed or specific legislation is considered, it would appear that HMRC is closing in on the issue that certain payments to EBTs should be treated as earnings in the hands of employees. If HMRC were to win this argument, many EBT schemes would be placed in serious danger, as taxing contributions to a trust as earnings would completely remove the benefits provided by the EBT.
VAT and the removal of the Staff Hire Concession: Potential increased costs for exempt and partially exempt businesses
The VAT treatment of the supply of temporary staff turns on whether the employment bureau supplying the staff is acting as principal or agent in the supply. The advantage of the employment bureau acting as agent is that VAT is only charged on the margin made on supplying the staff, rather than the total sales value of the supply (being the total cost per hour of the temporary worker).
The agency treatment was therefore advantageous for either exempt or partially exempt businesses that would not be able to fully recover the increased VAT cost were the employment business to act as principal.
Development of the VAT Staff Hire Concession
The introduction of the EU Working Time Directive and the enactment of the Conduct of Employment Agencies and Employment Businesses Regulations 2003 (the Conduct Regulations) meant that employment bureaux would act as principals when supplying their own employees as temporary staff.
The changes potentially had the effect of increasing the cost of hiring temporary workers for businesses that were either exempt or partially exempt, as employment bureaux would be acting as principals and not agents when supplying their own staff.
In order to compensate for the additional VAT cost, HMRC introduced the VAT Staff Hire Concession (VAT Notice 700/34), which essentially preserved the agency treatment of employment bureaux even when supplying their own staff, provided that the client business is responsible for paying the employee and deducting relevant taxes. The effect of the concession was that, although under employment law the bureau may be acting as principal, for VAT purposes it could choose to be treated as an agent.
Removal of the Staff Hire Concession
HMRC has announced that from 1 April 2009 the VAT Staff Hire Concession will no longer apply. This will result in an increase in the cost of hiring temporary staff for any exempt or partially exempt businesses in circumstances where the employment bureaux supply their own employees to the client.
Any businesses that rely on the provision of temporary staff should therefore discuss with their employment providers and advisers how their contractual relationships should be restructured to mitigate the potential impact of the removal of the concession. Possible alternatives include the employment bureaux acting only as agents (and therefore not supplying their own staff) or structuring the payment of workers around the restrictions contained in the Conduct Regulations.
BY Blaise Marin-Curtoud, partner, and Anthony Whall, associate, Jones Day. E-mail: bmarin@jonesday.com; awhall@jonesday.com.