Recruitment agencies currently face a higher tax bill than they should if there are errors in determining the employment status of limited company contractors.

On 27 April 2023, HMRC issued a consultation about how to fix the problem.

The Problem

Employment status determination has been a key issue for recruitment businesses and end hirers since IR35 rules were changed in the public sector in 2017 and in the private sector in 2021*.

The decision about whether the work being done was inside or outside IR35 – or characterised as employment-like or not – moved to the end client, away from the contractor.

If HMRC finds that an ‘outside’ decision was wrong, and tax should have been deducted from payments made to a limited company for the work of a contractor, it aims to collect tax from the legal entity that paid the PSC, which is usually a recruitment agency. (It may move on to the rest of the supply chain in some circumstances.)

The problem with the rules in this area is that there is no consideration of the tax that would have been paid by the PSC when it received the income in its normal course of business. It would normally pay Corporation Tax and possibly the employer’s NIC, and the individual receiving income from the PSC would usually pay dividend tax.

We might expect that the agency, faced with a tax bill, would be able to ‘offset’ the taxes already paid on the same income by the PSC and contractor – otherwise, tax is being collected twice on the same cash. But, the rules do not allow for this. The result is that agencies are liable in full for employment taxes on the payments made – income tax, and employee’s and employer’s NIC. This position is clearly unfair and places agencies and the rest of the supply chain at disproportionate risk.

The Challenge

One of the difficulties HMRC had centred around the fact that PSCs are structured in different ways (e.g. they may have more than one shareholder, or may not). They also have different levels of income, so the amounts of dividend tax paid on income would vary between PSCs. The calculation of an amount of tax suffered by the PSC and contractor would not be the same for everyone. But it was felt that this wasn’t a reasonable excuse for not solving the overall problem.

The Proposed Solution

As a result, HMRC has been working with stakeholder groups and tax experts for some time on a possible solution, but this has not been straightforward. We now have a proposal which aims to allow HMRC to use qualified estimates of the tax likely to have been paid to reduce the amount requested from the agency (or other deemed employer). In addition, they propose that these rules will apply back to April 2017, unless settlements have already been agreed.

In my view, although no solution would be perfect, the proposal in the consultation is a good and necessary compromise. Where mistakes are made, the solution will normally reduce the amounts of tax claimed from agencies by more than half, which is good news for agency valuations and risk assessments. Historic tax risk is always a relevant factor in M&A work, so this development will be welcomed by those thinking about growing their businesses.

What happens next?

The consultation is open until 22 June 2023. HMRC say they would like to hear opinions from all the entities in contingent labour supply chains, including end clients, agencies and their advisors. You can find out how to respond to the consultation via this link. We expect the consultation to lead to a change in the law from April 2024, but with retrospective effect as noted above.

If you’d like to discuss the consultation or any other aspect of supply chain compliance, please speak to a member of our expert team – 01923 257 257 or email [email protected]

*The off-payroll working rules (known as ‘Chapter 10’ or ‘OPW’), introduced in 2017 in the public sector, and 2021 in the private sector, broadly replaced IR35 (‘Chapter 8’) in many cases for supply chains including limited company contractors (or PSCs).