Employed, Self-employed and Kippered
TAX AND LEGAL status were the subjects of the July 2002 meeting and here Eric Longley discusses employment, self-employment and how to tell when you're what. A summary of this article appeared in the printed edition.
A LOW TAX economy requires strict tax compliance. The taxman is therefore keen to ensure obedience to the tax rules, and especially by those individuals who should be taxed under Pay As You Earn as employees instead of as self-employed.
A main attraction of being self-employed is that you can claim business expenses as costs against income. But there are downsides: chiefly that there is no holiday pay [this has since changed - see Your rights as a worker], nor sick leave unless you make your own insurance arrangements.
The Inland Revenue has spent much time ensuring that as many individuals as possible are within the PAYE net and not treated as self-employed. As well as journalists, the Revenue has sought to move actors, drivers, North Sea divers and independent computer consultants into the PAYE net.
There is a third category of "employment", called IR35. This applies to some people who "incorporate" their activities - that is, they form a limited company. Their income goes into a so-called "loan-out" company that hires out their services. The company deducts expenses from this income, and pays the balance out to its human as salary and/or dividends. IR35 applies to cases where, if it were not for the loan-out company coming between the worker and the contractor, the individual carrying out the work would be treated as an employee. It sets out special rules as to how the company and individual are to be taxed.
It is preferable for the Revenue and the Exchequer that people are taxed through the PAYE system. Firstly, under PAYE the tax collecting system is operated by the employer so the cost does not fall on the public purse. Secondly, under PAYE the scope for expenses against income is severely restricted, increasing the tax paid. Finally, employees usually pay tax monthly, which helps to ease cash flow for the government, whereas the self-employed usually pay twice-yearly.
If the person being engaged is unquestionably self-employed and it is clear that "employee" status does not arise, then the rules are quite simple for the person engaging the worker. Payment is made against an invoice, VAT is paid if and as required and expenses are claimed as appropriate in the contractor's accounts.
If the person being engaged is of indeterminate status, and the contractor is not sure whether they qualify as an "employee" to be dealt with under PAYE or as self-employed, then there is considerable risk. If the Revenue determines that a person treated as self-employed was actually employed, it can treat the fees paid as salary net of tax and demand tax on the grossed-up amount from the employer. So if you were paid £15,000 your client - now deemed to be an employer - would face a bill for an extra £4230, with employer's National Insurance contributions on top of that. Little wonder, then, that employers/contractors are nervous about getting the employee/self-employed status correct.
From the employee's point of view recategorisation from self-employed to employee can be a bonus, as they are not required to pay tax on the income received. Assuming tax has not been paid under the self-employed rules, then the individual has, in effect, received a payment free of tax! Of course they lose their self-employed status for that work and cannot claim expenses, but generally recategorisation is financially beneficial to the employee! Where the Revenue recategorises an individual as an employee, and tax has been paid under the self-employment rules, they should request repayment of the self-employed tax amount.
Some contractors prefer to engage loan-out and/or IR35 companies. The Revenue cannot recategorise a company as an employee and collect further tax from the contractor.
The difficulty lies in determining whether the individual is in fact an employee or self-employed. The same problem concerns the loan-out company, in determining whether or not it will be within the IR35 rules.
Deciding whether an individual is an employee under "Schedule E", or self-employed and hence assessable under "Schedule D", is a question that has exercised the Courts for many years.
Unfortunately the legislation is of little help in defining self-employment and employment. For "Schedule E" or employment it merely states that "tax shall be charged in respect of any office or employment on emoluments therefrom". What constitutes an office or employment has been left for the Courts to decide.
As it is the Inspector of Taxes who queries whether an individual is self-employed or an employee it is useful to consider how the Revenue looks at the problem. Each case is examined individually.
In the past the Revenue has largely relied on what is called "the master-servant relationship". A servant would of course be an employee. "A contract of service provides that in the performance of service a worker will be in the other's control to a sufficient degree to make the other master". All the other facts have to be consistent with it being a contract of service. An example of the distinction would be where your car needs work carried out on it. Mechanics who do the work without your having any right to control it in any way are self-employed. If, however, you control their mechanic's work hours, how they carry out the work and where then, arguably, you have a degree of control consistent with there being a master-servant relationship.
The difference between contract of service (employee) and contract for service (self-employed), has featured in many court cases. Another indicator is whether the person engaged to perform services is performing them as a person in business on their own account. If the answer is yes, then it is a contract for services; if not then it is a contract of service. Again, this has to be viewed in the context of all the other facts. Quite often one indicator will point one way and the next the opposite way.
Although control in a master-servant relationship is still important, the Courts have developed other tests of what constitutes self employment. Partly this has been forced by new technologies and work patterns. For example it is no longer necessary to go to an office to sub-edit copy, since it can be done in real time from home using the computer and email. Working from home does not necessarily indicate self-employment.
Quite often the facts will be balanced and/or neutral. Where this is the case, then the intentions of the parties concerned will be important. Here the presence of a written contract that clearly demonstrates the intentions of the parties may be the decisive factor.
The Courts consider other issues. For example, does the individual provide their own equipment? Do they hire their own helpers? What degree of financial risk is involved? What degree of responsibility is there for investment in the business and management? Is there opportunity to profit from sound management in the performance of the task (the profit/loss risk)?
Individuals, who buy their own tools, bear their own running costs, pay their own overheads and material are more likely to be self-employed. Generally employees do not and are not required to take such financial risks.
There are a number of exceptional cases that should not be taken out of context. A member of an orchestra is under strict control by the conductor, but they do not have their own business structure or risk their own capital. However the Courts held that contrary to these indicators pointing to the musicians being employees they were in fact self-employed. This was because they were individual instrumentalists with individual reputations even when playing in an orchestra. So remember to take care when trying to compare your circumstances to previous court cases to ascertain your status.
As long ago as 1967 the Courts held, in the case Ready Mixed Concrete (South East) Ltd v Minister of Pensions, that "a servant is obliged to provide his own work and skill and the freedom to carry out the work either by one's own hands or by another's is inconsistent with a contract of service". In effect the Court was saying that if you could send a substitute, this was not a contract of service or employment as an employee.
The importance of substitution (sending someone else to perform the work), has increased with two more cases. The first was Hall v Lorimer in 1994, which involved a television vision mixer. The individual had to be at the contractor's premises at specified times and the contractor provided all the equipment. Despite this, the Court found that Mr Lorimer was self-employed, not least because Mr Lorimer could send a substitute.
Another important case concerning substitution, Express and Echo Publications Ltd v Tanton, involved a newspaper delivery driver who was on a fixed run, in a vehicle provided by the engager and wearing a uniform provided by the engager. However, the Court found the driver self-employed because there was an unsigned contract that genuinely reflected the true agreement between the parties. This agreement stated "in the event that the contractor is unable or unwilling to perform the services personally he shall arrange at his own expense entirely for another suitable person to perform the services". In practice the worker did occasionally provide a substitute, including a six-month period when he was ill.
These two cases amongst others have made the Inland Revenue focus on substitution. The Inland Revenue's internal manual says that the right to substitution must be genuine. The manual goes on to note three provisos when considering the right of substitution:
- the right must be genuine
- the engager must not have an unreasonable right of veto over the choice of substitute
- the worker must engage and pay the substitute; merely recommending another worker is not substitution.
All this brings us back to where we started: each case has to be looked at on its own merits. If the Revenue still thinks you are an employee you must demonstrate that your unique circumstances support the argument that you are self employed. If you cannot, then in the arcane technical jargon of tax accountants, you"re kippered!
To establish and protect yourself as self-employed, as a minimum you should seek to:
- Provide your own equipment where possible and practical
- Work from your own premises where possible and practical
- Hire your own assistants and pay them (under PAYE)
- Have a written agreement that genuinely allows substitution
- Where appropriate try to ensure that substitution is practised
- Pay for your own overheads and expenses
- Where practical charge for a job rather than by the hour
- Do not agree
holiday and sick pay arrangements
- Where possible ensure the only requirement is that the work be carried out and that there is no ongoing control of how and when you perform the services
For further information, contact: Eric Longley, tax specialist at Smith & Williamson, the independent professional and financial services group. Tel 020 8446 4371