Firms and recruiters misusing "Inside IR35" risk exposure from rogue umbrella companies

The off-payroll working legislation ("OPW"), or "IR35 reforms", rolled out to the private sector in April 2021, having already been embedded into the public sector since April 2017. We all know the common phrase: If a limited company contractor is "Inside IR35", then payments made to their limited company must be treated as employment income, just like a salary.

But, wrongly used, the words "Inside IR35" can open the door to a legislative loophole leading to huge agency balance sheet exposure and risk of criminal sanctions. The vulnerability occurs when rogue umbrellas seek to adopt what is euphemistically called the "Gross Payment Model".

Misplaced words

Since April 2017, recruiters have used two words, "Inside IR35", as a shortcut phrase instead of saying, "Sorry, the client has banned limited company contractors and will only use contractors if they are on PAYE."

The practical reality is that the parties negotiate "Inside IR35" engagements on that basis, and the contractor either ends up on an agency payroll or works via an umbrella. Umbrellas can be an attractive option for agencies because they eliminate the payroll cost, outsource the hassle, and generate a small income for the agency through an ongoing commission per timesheet.

Let's assume the contractor has been told "Inside IR35" via email or in a recruiter advert, and the monies for the contractor pass to an umbrella company for processing. All appears fine. But, is it?

Beware of the opportunistic umbrella

If the umbrella company does put the contractor on an employment contract and correctly pays all taxes, there are no issues. But what if the umbrella decides to pay the contractor gross monies to the contractor's limited company, sometimes referred to as a personal service company or PSC?

In the latter scenario, the off-payroll legislation ("OPW") comes into play, and the umbrella company becomes what's referred to as the "fee-payer", essentially the entity above the PSC. The party responsible for deducting and paying the taxes to HMRC is the "deemed employer." But, the umbrella isn't the deemed employer because the client has not given a Status Determination Statement to the worker, thereby failing to trigger the tax liability transition mechanism in section 61N(5).

In non-technical terms, the tax liability now sits with the client, who, if investigated by HMRC and hit with a tax bill, will likely exercise the tax indemnity clauses the recruitment agency typically signs. The client may even sue the agency for gross negligence.

If HMRC speaks to the umbrella company, the umbrella will state the engagement was "Inside IR35" and that the client did not give a Status Determination Statement ("SDS") to them or the worker. Therefore, the statute dictates they must pay the limited company gross monies.

The Status Determination Statement (SDS) is crucial, but what is one of these SDSs?

What is a Status Determination Statement (SDS)?

Let's start by saying what an SDS isn't. It isn't the words "Inside IR35". That isn't enough.

The updated rules in April 2021 introduced specific changes, including the Status Determination Statement ("SDS") and debt transfer provisions. The SDS was intended to make sure in cases where the status was "Inside IR35", the onus for paying those taxes passed down the supply chain to the party paying the PSC.

But, there are rules for a statement to qualify as an actual SDS, requiring the following legislative requirements to be met:

1. The SDS must contain the conclusion on the deemed status of the worker.
2. The client must have taken 'reasonable care' in concluding the status in the SDS.
3. The SDS must explain the reasons for the conclusion.

If all three requirements are met, and if the SDS is passed from the client to the worker, then the 61N(5) trigger is invoked, and the fee-payer (the party paying the PSC) assumes liability for the tax and not the client.

Three routes to tax risk: No SDS, void SDS, or weak SDS

There are three routes rogue umbrellas can follow to implement a "Gross Payment Model":

• No SDS: With no SDS, the rogue umbrella pays the money gross to the PSC and claims they were told it was "Inside IR35", but no SDS was given to the worker.
• Void SDS: The words "Inside IR35" do not qualify as an SDS. Neither does an SDS without reasons in it. Nor one where reasonable care was not taken.
• Weak SDS: A weak SDS could be considered by the umbrella and then just dismissed and replaced with their determination that says "Outside IR35". There is no statutory obligation on the fee-payer to follow what the client has concluded on IR35 status – another hole in the legislation.

The client is now unknowingly building up tax risk under the OPW rules in the abovementioned cases. The agency may also have committed an offence under the Criminal Finances Act 2017 for looking the other way and failing to prevent tax evasion.

Will CEST provide cover?

HMRC's Check Employment Status for Tax (CEST) tool is a free online guidance-only service designed to help organisations determine whether a worker should be classified as an employee or self-employed for tax purposes. The status result can be downloaded to a PDF file. But is the CEST output PDF a valid SDS?

A statement is only an actual SDS if reasonable care is taken to reach its status conclusion. HMRC's off-payroll guidance on reasonable care lists behaviours that HMRC consider do not constitute reasonable care, which includes "failing to take account of all relevant evidence." We know from a comprehensive analysis published in a recent CEST report by IR35 Shield that CEST rarely conducts a full multi-factorial assessment when issuing an "Outside IR35" determination, which is contrary to binding law from the Court of Appeal in Atholl House, published on 26^th April 2022. Or in layperson's terms, CEST has not taken account of all the relevant evidence.

In addition, a statement is only an actual SDS if it contains reasons for the conclusion. The CEST output often includes a one-liner like, "Your answers told us you have accepted or would accept a substitute. This suggests the worker is working on a business-to-business basis." The one-liner is unlikely to meet the statutory requirement of explaining the reasons for the conclusion. Neither will "the answers you have given suggest you are providing personal service to your client", which is the single line that appears in an "Inside IR35" decision.

A CEST output is arguably wholly unsafe to be used as a robust and valid SDS, and a rogue umbrella seeking to pay gross can leverage its weakness.

How clients and agencies can secure their supply chains

With this risky tax loophole now understood, what should clients and agencies do?

There are four options:

1. The client or agency could remain the "deemed employer, " deduct the taxes, and pay the PSC the net amount directly.
2. The agency could run the payroll and provide the client with an audit trail.
3. The client and agency could insist on an entire audit trail for every payment using an umbrella, proving the correct money flows have occurred.
4. Do nothing.

The first option is messy, leaving the client open to future employment tribunal claims. Option two removes the benefits of using umbrellas, so option three is arguably better. Option four is, at best, negligent and could lead to criminal sanctions.

Never say "Inside IR35" again

In all engagements, the words "Inside IR35" should never be used unless accompanied by a robust IR35 assessment that meets the statutory requirement for being a valid Status Determination Statement.

Also, using "Inside IR35" as a placeholder for "payroll-only" opens the door to non-compliance.

Finally – if there are umbrellas in the supply chain, an exhaustive audit trail is the only way to guarantee compliance and combat the risk that the rogues leave you with a nasty future surprise.