· 2 min read · Features

Getting employment status right

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How do you tell if someone is self-employed or an employee? For HR departments this has been an eternal conundrum. Employment status has ramifications for how hirers treat each person for tax, National Insurance, employment law, and pensions, so getting it wrong can be costly.

The surge in the number of people working as freelancers and contractors since the recession has been welcomed by hirers, who have benefitted from the additional flexibility. Parliament has taken a different view, suspicious that many of the workers who now operate in this way are in fact disguised employees. Revelations of 25,000 off-payroll contracts at the BBC alone have added to the rising clamour for reform.

As a result, parliament tasked HM Revenue & Customs (HMRC) with opening at least 230 tax evasion inquiries per year into freelancers and contractors. It took only two years for HMRC to miss the target and put the future of employment status tests (known as IR35) in doubt. HMRC opened 192 IR35 inquiries into contractors in the most recent tax year (2013/14), 25% less than in 2012/13 and 81% less than in 2003/04, when it opened more than 1,000 investigations.

More worrying still, the tax yield has slumped to the lowest level in five years. HMRC netted just £2,240 per inquiry in the most recent tax year, down from a peak yield of £20,339 per IR35 inquiry in 2011/12. Employment status inquiries can take months to conclude, so at just over £2,000 extra tax per intervention it is quite possible that enforcement teams are now operating at a loss. HMRC created a number of specialist teams and vowed to strengthen its risk assessment criteria so that resources would be targeted at the highest yielding cases – a strategy that appears to have been unsuccessful.

The problem for HMRC is that IR35 inquiries involve the accumulation of evidence, such as contracts, both from personal service companies and the organisations they work for. HMRC also has to look at whether the day-to-day working reality reflects the contract. Employment status inquiries are complex and often hinge on eyewitness testimony, making it very difficult to decisively prove whether someone is an employee or not.

The Office of Tax Simplification recently issued a discussion document called Employment status report where it outlined reforms. One of these would be to make HMRC’s online Employment Status Indicator tool a mandatory requirement for organisations using freelancers or contractors. If the tool said a worker was an employee that would be the end of it.

The paper also proposes a statutory employment test. The concern here is that the rules set out in statute might deem a significant proportion of existing contractors and freelancers as employees, meaning higher costs for hirers. The so-called 80% test could be one such rule. It says that if a contractor or freelancer derives 80% or more of his/her income from a single source they should be counted as an employee of that organisation.

Another suggested rule is that an engagement lasting more than, for example, six months would automatically be deemed an employment relationship. Considering how many contractors and freelancers derive all of their income from a single source and are engaged for years by the same end user, the statutory test could have a profound impact on the UK’s flexible workforce and how HR departments engage flexible skills.

Darren Hayward is an employment lawyer at law firm Nockolds