Implications for Contractors Financial

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The Problem
The Inland Revenue has decided, with one piece of legislation, to solve two or three “problems” that it perceives with personal service companies as they currently operate:

  • Some lower-paid workers are forced to operate (against their will, it is assumed by the IR) in this manner in order to reduce the cost of their employment (no NI etc) and to deny these workers statutory employment rights (holiday + sick pay, pension benefits, unfair dismissal etc).

  • Other people operate in this manner out of choice to avoid NI etc, although they are effectively “employees” to all intents and purposes, and the IR reckons that people who operate this way gain an unfair competitive advantage over companies employing people in the more traditional way, and

  • they could raise more in taxes.

Please don’t bombard me with emails and phone calls about what a folly this whole thing is, I’m afraid we’re stuck with it (well maybe not, but more of that later).

Inland Revenue Guidelines
The Inland Revenue’s guidelines, including examples, can be found at
This document contains the famous “Charlotte” example discussed below.

Implications for Contractors

Financial: Contractors who currently pay themselves mostly by dividends will see their post-tax income fall by about 20% to 25%, as they will now be expected to pay both employers and employees NI.
All income from relevant engagements must be paid out as salary and related employer’s NI, subject to deductions for:
expenses otherwise eligible for deduction under the normal Schedule E expenses rule

employer pension contributions to an approved fund within the normal limits, plus

a flat rate 5% of the gross relevant income to cover other expenses, and

employer’s NICs paid during the year, plus any due on the deemed payment.

Allowable pension contributions for the contractor can be based on the deemed salary

Contributions paid in respect of other employees will have to come out of the 5% allowance, or out of taxed income.

Employees’ contributions will still be taken into account for income tax.
Corporation Tax:
Corporation tax computations remain based on taxable profits calculated as before BUT:
Where deemed, salary and employer’s NI exceed the actual salaries and employer’s NI - the deemed figures used for corporation tax avoid double taxation.

If actual expenses are lower than the total of the IR35 allowable expenses and the 5% expenses allowance - there will be a profit for dividends or retained reserves.

If actual expenses > 5% allowance there will be loss before tax
Mixed income:
Where the company has some income which is outside of 1R35 then that income is not subject to the IR35 rules and dividends can still be paid out of any profits which arise.

Uncertainty: 50% of contractors surveyed by the PCG ( are classed as “borderline” using the Inland Revenue’s examples. A leading tax Counsel concluded that:

The fundamental problem with the IR35 proposals is the use of the case law test for employment/self employment. This will cause a great deal of uncertainty.”

Employment or Self-Employment? The Main Tests
The tests are based on case law. Individual cases quoted below are from the Inland Revenue’s guidelines. The main criteria used by the Courts are:
The right to get a substitute or helper to do the job.

Control (what, when, where and how)

Provision of equipment.

Financial risk and the opportunity to profit from sound management.

Basis of payment and benefits.

Exclusive services

Part and parcel of the organisation

Right of dismissal.

Intention of the parties (to the contract)

Factors personal to the worker.

Mutuality of obligation.
The key issues are:
Substitution: Potentially the most important issue for contractors is substitution. A recent Court of Appeal decision held that it was necessary for a contract of employment to contain an obligation on the part of the employee to provide services personally. A contract which allowed services to be carried out by a person other than the contractor was a contract for services and not a contract of service. [Express and Echo Publications Ltd v Tanton. March 11th 1999]
Financial Risk: The IR has stated that “we have made it clear that we would take account of a substantial investment in skills, where a skilled worker incurs significant expenditure on training to gain a skill which will be used in subsequent engagements. This kind of investment can be treated as a pointer to self-employment in the same way as investment in tools or equipment”
Additional important financial risk areas are matters such as the ability to profit from efficient performance or the risk of making a loss or having to correct faulty work at your own cost. Fixed price contracts will be advantageous.
Length of contract: While length is not conclusive the Revenue have made it clear that they regard longer contracts as indicative of employment. Whenever practicable use shorter contracts with separately negotiated extensions.
Personal factors: The ‘Charlotte’ example (Appendix A) shows the importance of personal factors.

Hall v Lorimer showed that it is inappropriate to look solely at the terms and conditions of the individual engagement. The decision may be affected by the way in which the worker generally carries on his occupation including:

  • The worker’s business activities as a whole including the worker’s exposure to bad debts and the amount spent on organising, obtaining, or carrying out the work.

  • The length of the particular engagement and the number of other persons for whom similar work is performed.

Determining your status:
The IR uses a status checklist to establish the facts behind a worker’s relationship with the client/employer. This follows the main aspects of the tests noted above.

Implications for Employers/Clients
Unfortunately, most of our clients do not regard this as being their problem. It is, for a few reasons, and OTC will be trying to stress this to them over the coming months:

  • Rates, especially for contractors with rare skills, will rise to compensate. This is inevitable.

  • Many contractors will choose to go abroad – I’ve heard many figures for the amount of extra green cards the US is going to make available for IT workers – and this will have consequences for the availability and quality of staff (not just contractors), and

  • this is the big one – any contractor deemed an “employee” by the IR is likely to be able to take their “employer” (note, not the agency – the legislation specifically ignores any intermediaries) to an industrial tribunal to claim employees rights – pensions, paid holidays, sick pay etc. I don’t think this has sunk in with our clients yet, and could be the most costly consequence of the legislation in the long term.

What can be done?

  • Join the PCG ( This is a body that was set up in direct response to the IR35 proposals in order to represent contractors, and they have done a fine job so far, even pointing out flaws in the proposed legislation and winning some (admittedly small) reprieves. Also, funding permitted, the PCG is considering a legal challenge to the legislation on the basis that it will have an adverse effect on competition. Unfortunately, this may take some time, and may have to go all the way to the European courts. OTC is an Associate Member of this body.

  • Some changes can be made to our standard contracts. I say some, because as yet we have not persuaded any clients to change theirs (but I believe it will only be a matter of time). These changes are as follows:

Substitution. OTC can insert a substitution clause that would state that the contractor had a right to substitute another equally qualified person to do the job, if OTC agrees to it.
Exclusivity. OTC can remove any exclusivity clauses from their contracts, and replace it with a conflict of interest clause. This would state that the contractor may supply services to whomever they wish except where this would cause a conflict of interest (i.e. a direct competitor of the client).
Length of Contract. OTC will try to negotiate three-month extensions where possible, and issue new contracts for each new term (rather than letters as at present).
Right of Dismissal. The Inland Revenue guidelines regard the right to give notice on the contractor’s part as being a “strong pointer to employment rather than self-employment”. OTC proposes to remove this right (where it exists) from our contracts. Unfortunately, our clients would wish to retain the right to dismiss the contractor with the usual notice period. This will make any contract very one-sided, but would be a small price to pay if it meant it passed the IR35 tests.

  • Some changes can be made to our standard contracts with agreement from our clients (in the longer term). These include:

Control. It should be possible to persuade our clients to specify exactly the work to be done for each contract, instead of providing a general contract for unspecified “services”.
Financial Risk. Take a deep breath. Structuring payment so that instead of being paid an hourly rate, a reduced hourly rate is paid plus a bonus at the end of the contract. This, if agreeable to all parties, would probably make the contract pass the IR35 tests by some margin.

OTC cannot guarantee that these measures will lead to any contract passing the IR35 tests, for two reasons:

  • each tax office will follow the guidelines differently. It could very well turn out that two of our contractors, working on the same project, with the same contracts, but living in different parts of the country, are viewed differently by their tax offices. I’m afraid this is outside of our control.


Example 3 – Charlotte – an IT consultant working through her own service company


Job description/Control

Charlotte’s client for this engagement is a software company. She has been engaged for her programming skills to work on a specific project as part of a team developing a new piece of software. She works to the client’s project manager who allocates particular sub programs to Charlotte that she writes. The client expects the project to last for around three months.

The manager specifies the way in which the sub-program is to be structured and can require changes to be made to make the work fit in with other parts of the program as it is developed, to rectify overall design faults, etc.
Charlotte works a set number of hours but actual working times are flexible in line with the company’s flexi-time arrangements for its employees. She is required to work at the client’s premises.

Payment basis/risk/sick pay/holiday pay

Charlotte is paid £3600 every four weeks in return for working a 40-hour week. Extra payments are made at the equivalent hourly rate for any additional hours agreed.

Payment is made 14 days after the company has invoiced the client.
No sick pay or holiday pay is paid. Under the contract Charlotte has with her company she is paid an on-going, but much lower, salary which includes provision for holiday pay and sick pay.

Length of contract and personal factors

  1. The contract is for 12 weeks – but there is provision for an extension if the project over-runs and all parties agree to the extension.

  1. Charlotte does some work for another client at weekends and has worked for various clients in the past – always through her company and often through employment agencies. Her contracts have usually lasted for between one and three months. Most have been similar to this one but some have involved her in specific tasks for a fixed fee using her own equipment and working at home.

  1. Charlotte has an office at home and a computer and other office equipment that is used for some of her other work. These contribute to her company’s business organisation – which she uses to obtain work, keep records, prepare invoices, etc.

Other factors

  1. The company is contracted to supply Charlotte to do the work personally

  1. All equipment is supplied by the client

  1. The engagement cannot be terminated ‘early’ other than following a breach of contract

  1. There is no restriction imposed by the contract that prevents either Charlotte or her company providing services to others during the engagement.

  1. All parties intended that the company/client engagement would be self-employment.


There is an extensive right of control over Charlotte. The more important features are the client’s ability to shift Charlotte from task to task and to specify how the work should be done. In addition the client can control to some extent where and when the work is carried out. But control is not total. Charlotte is engaged to work on a specific project so cannot be told to work on something completely different – and she cannot be required to work elsewhere. Overall, this is a strong pointer to employment.

It is the arrangements between the service company and the client that are important here. The company is paid the equivalent of a salary - with overtime payments – but no sick pay or holiday pay. Although the invoicing arrangements result in a small financial risk this is minor. Overall there is no significant financial risk and no opportunity to profit from sound management of the task. This points to employment.

Charlotte and her company have a ‘business organisation’ – including an office and associated equipment based at Charlotte’s home. She has a variety of clients and all her contracts have been fairly short term.

This is a strong pointer to self-employment.


) Both point to employment


Neutral factor (no right to terminate is common in engagements of this length – whether employment or self-employment)

Pointer to self-employment.

Pointer to self employment, but will only be relevant if the other factors are neutral.

Overall picture

This is a borderline case. On balance, given all the facts, Charlotte would have been self-employed had she been engaged directly by the client. The new rules will not apply to the engagement.
The following point towards self-employment:

  1. existing business and a variety of different engagements, some of which would clearly count as self-employed if she had been engaged directly by her client.

  2. overall business organisation (office and equipment at home, business like approach to obtaining engagements and carrying them out, etc). Charlotte would clearly be regarded as being ‘in business on her own account’ for those engagements where she carried out of a specific task for a fixed fee using her own accommodation and equipment.

  3. risk from invoicing

  4. the lack of an exclusivity clause.

Other factors point to employment:

  1. There is fairly extensive control over Charlotte. The client can dictate ‘what’ work is carried out on the project and ‘how’ the work is done. But control is not total. Charlotte cannot be directed to work on another project or undertake some quite different work. Nor is there control in other areas (e.g. she subject to the clients normal staff rules/disciplinary procedures)

  2. There is virtually no financial risk in the engagement and no opportunity to profit from sound management of the task

  3. Charlotte must carry out the work herself

  4. all equipment and accommodation is provided by the client.

What can then have more significance is the extent to which the individual is dependant upon, or independent of, a particular paymaster for the financial exploitation of his or her talents (see Hall v Lorimer). The fact that Charlotte’s company is also engaged in contracts which involve carrying out a specific task for a fixed fee, using her own equipment, suggests that it is a genuine business and neither she nor her company rely on a single client for the exploitation of her talents. These factors balance the control and other employment factors that exist in this particular context and put the matter near the borderline where the mutual intention for self-employment becomes decisive.

However, the overall picture would have been rather different had the engagement been longer. For example, had the engagement been for twelve months the ‘personal factors’ would have been far less significant and the employment pointers would have predominated. Just because a person has an established business does not automatically make them self-employed for all engagements (see Fall v Hitchin (49TC433) – also referred to in Hall v Lorimer). Also, if she had not also had contracts of a type which would clearly have fallen within the definition of self-employment, employment pointers would have dominated and the contract at issue would have been one of employment. The same could apply to shorter contracts.

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