Contractors, relabelling ‘labour’ as ‘services’ to appear ‘fully contracted out’ won’t dupe IR35 inspectors

Since the introduction of Chapter 10 of the Off-Payroll Working rules into the public sector on April 6th 2017, and its subsequent expansion to medium and large private sector companies from April 6th 2021, HMRC’s guidance has covered the issue of “contracted-out services” and how such arrangements are affected by the rules.

But you’d be forgiven for thinking that such guidance doesn’t even exist based on some of the set-ups we’re seeing from agencies and PSC contractors trying to branch out into ‘consultancy,’ writes Charlie Hemsworth, senior tax consultant at Bauer & Cottrell.

What HMRC says about contracted-out services

To recap for the already initiated, the (current) published guidance by HMRC states:

“A person who receives a fully contracted out service does not need to apply the off-payroll working legislation, as they will be above the client in the contractual chain and will have no obligations under Chapter 10, Part 2 ITEPA 2003 in relation to that contract.

“The service provider providing the fully contracted out service must consider if it is a public authority or medium or large-sized entity to see if it is within scope of the off-payroll working rules.”

Why ‘services’ and not ‘labour’ is all the rage

In simple terms, if a public sector organisation, or a medium or large private sector organisation, is engaging “services” as opposed to “labour”, then there is no obligation on that engager to determine the IR35 status of any PSC contractors involved. 

Instead, the service provider itself becomes the contractor’s “client” for IR35 purposes, shifting the responsibility down the chain – and how far, here, depends upon the service provider’s size.  

This exception to the rules has often been perceived as a ‘loophole,’ resulting in the emergence today of lots of new “consultancies” and these consultancies are engaging in “Statement of Work”, “Managed Service” or similarly worded contracts, as a route for placing PSC contractors with engagers who would otherwise fall within scope of the rules. 

Taxman says ‘relabelling’ won’t wash

The HMRC guidance was updated in summer 2021 shortly after the private sector rules’ roll-out, and placed further emphasis on contrived arrangements, by stating:

“Whether a contract is for a fully contracted out service is a question of fact, based upon the commercial reality of the arrangements. Care should be taken to ensure that a labour supply contract has not simply been re-labelled as a managed service.”

Despite this quite clear statement by HMRC in 2021, today, two years on, we’re seeing many organisations getting their ‘consultancy’ set-up very wrong, and erroneously assuming that a services-based written contract alone is a golden ticket. 

In our experience, a lot of the newer consultancies operating today are entities that have historically traded as employment businesses, and we frequently see cases where written contracts have been drastically restructured but with seemingly little to no change to the underlying business models in tandem. 

What does a genuine contracted-out service look like?

So, let’s take a look at some of the typical hallmarks of a genuine contracted-out service:

• The engagement/tender process

Usually there would be some kind of tender process, or at least written proposals setting out the services the consultancy proposes to provide to fulfil the client’s requirements. 

This tender process would include matters such as fees, resource levels and timeframes, with the consultancy defining the full scope of the work.  If the client simply approaches the consultancy with a day-rate job spec, needing one person, it falls at the very first hurdle and becomes near-on impossible to apply a ‘contracted-out’ service model in practice. 

• Identification of the workers involved

The matter of who is going to undertake the work on behalf of the consultancy should be under the consultancy’s complete control. It’s acceptable to include ‘skills profiles’ and the like as part of a tender or proposal, but there should be no workers named in the actual contractual documentation (aside from key personnel such as those who have overall responsibility for the service delivery). And there should be no picking and choosing or interviewing of individuals by the client. 

The consultancy should be in control of the number of personnel needed and for ensuring the suitability of all workers. In conventional consultancy situations, the consultancy would be using whole teams (usually a mix of their own staff and contractors). The consultancy should have the contractual right to change who is doing the work for any reason, providing it does not impact the delivery and they can continue to meet their contractual obligations. 

• Management of the project and workers

The consultancy should be responsible for managing the whole project. If the work only involves a small part of an overall bigger project and the client is co-ordinating everything and deciding what the workers need to be doing from one day to the next, this points to the provision of labour. 

The consultancy should have full responsibility and control over what is being done and when / where / how it is being done. The consultancy should be fully aware of what is hppening at all times, with the workers reporting to and liaising with the consultancy (not the client) in all aspects. 

There should be no integration of the workers into existing client teams and ideally the work is undertaken either remotely or at the consultancy’s premises.  The matter of control in these situations can be complex depending on the identity of the client and the nature of the work, and it is necessary to consider things on a case-by-case basis.

• Financial risk for the successful delivery of the services

The consultancy would be responsible for ensuring the quality of service and financially liable if things go wrong or it is not able to deliver. 

There should be mechanisms in the contract covering service levels, dependencies, acceptance criteria and disputes which are implemented in practice. 

• Basis of payment

A genuine contracted-out service is usually (at least in part) fixed price deliverable-based. The consultancy would agree their fees with the client at the outset and then be responsible for deciding how much it will pay any contractors it is using. 

Time and materials-based contracts bear little financial risk in most situations and unless everything else is firmly in their favour, where a consultancy is simply retaining a margin and paying contractors at individual day rates set by the client, they may as well be holding a sign over their head saying, “We are acting as an Agency!”.

Implications of your contract being deemed a sham (includes SDSs for all)

As even the most casual reader can see, there’s a lot to consider! And if it is found in reality that a consultancy is in fact simply providing people under the guise of sham contract, they and their public sector or medium/large private sector clients will be sitting firmly within scope of the Off-Payroll Working rules.

This means the client should be issuing Status Determination Statements for all PSC contractors, and the consultancy has its own obligations if it is the ‘fee-payer,’ as well as the requirement to comply with all legislation applicable to agencies (including the Conduct Regulations, and Agency Worker Regulations).

Our messages to ‘consultancies’…

If you feel comfortable that you are doing things correctly, that means you are ensuring that all parties are in agreement as to the nature of the arrangements. 

If the client agrees you are providing genuine outsourced services, get that agreement in writing, including confirmation that it will not be issuing IR35 determinations for any of your PSC contractors. 

Ensure you are meeting your own obligations, such as carrying out and communicating your own IR35 determinations with “reasonable care” if you are a medium or large organisation yourself, or confirming any “small company” exemptions to all relevant parties.  In the case of the latter and where the contractor is responsible for their own IR35 position under the old Chapter 8 rules, make this known to them – again in writing. 

If there are potentially gaps in your service models, and actually, in any case; you should prepare yourself for a situation where the client could issue SDSs at any time (at worst, ‘inside IR35 SDSs). You should consider what this unwanted determination would mean for the contractors you’ve engaged and the project you are committed to. 

Lastly be in no doubt, HMRC is scrutinising ‘consultancy’ arrangements

Finally, check your contracts for indemnities which attempt to pass down tax risk, or clauses which allow for termination for breach if any workers are found to be inside IR35. If you are in doubt, have your supply chain and practices thoroughly reviewed by an IR35 expert who can establish yours and your client’s risks -- and provide clear recommendations. We know that HMRC is ramping up its compliance activity and scrutiny into these arrangements. As the hefty tax bills and penalties we have seen to date show, it is better to get things right sooner rather than later.