In this article, we consider the importance of considering hypothetical contracts in the context of employment tax status determinations following the recent case of Little Piece of Paradise Ltd v HMRC.
When engaging a contractor to perform services, the hiring party will usually need to consider the employment status of the contractor for both employment law and tax purposes. However, whilst there is some overlap, the tests for employment status, approach and consequences are quite different.
Unlike employment status for employment law purposes (such as required for certain claims in the Employment Tribunal), there are only two employment statuses for tax purposes: being (1) employed; and (2) self-employed. However, determining the correct employment status for tax when the individual provides the services through an intermediary is notoriously complex, and consequently, there is a wealth of case law in this area and more coming through all the time.
For the purpose of this article, we are considering here only those intermediaries which do not deduct PAYE directly from the earnings of the individual performing the services.
How the Hypothetical Contract is Applied in Practice
In order to determine employment tax status where there is an intermediary, the First and Upper Tier Tax Tribunals and the Courts will look at what is known as the “hypothetical contract” between the parties. In other words, if there is a contract between the hiring party and an intermediary (usually a personal service company), they will consider what the relationship would be between the individual providing the services to the hiring party if they were to remove the intermediary and infer a contract based on the conduct of the parties and any relevant documents.
The case of Little Piece of Paradise v HMRC, is specifically on this point. In that case, a sports presenter provided live darts and boxing coverage to the hiring party through his personal services company (the intermediary). Applying the hypothetical contract rule, the First Tier Tribunal disregarded the intermediary and considered whether there was mutuality of obligation between the presenter himself and the hiring party under the terms of a “hypothetical contract”. The Tribunal decided that there was sufficient mutuality of obligation between the individual presenter and the hiring party because the same monthly fee was paid throughout the relationship regardless of whether or not the work was carried out. There were also restrictions on the services that the presenter could provide to other/third parties. In addition, the drafting of the termination clause in the actual contract between the intermediary and the hiring party suggested there existed a mutuality of obligation between the presenter and the hiring party.
The Tribunal also decided that the hiring party had a sufficient degree of control over the presenter by deciding which events it wanted the presenter to cover, and so – to some extent – it therefore controlled when and where the services were performed. In addition, the presenter could only appoint a substitute with the hirer’s permission. Further, if a substitute was approved, they were paid directly by the hirer, rather than through the intermediary.
For the above reasons, it was held that when removing the intermediary from the equation, the conduct of the parties and the terms of the actual contract were sufficient to infer a hypothetical employment contract between the hiring party and the presenter which gave rise to PAYE liabilities.
Avoiding A Hypothetical Employment Contract
The most important thing to note is that there is no single determinative factor when assessing tax status and the relationship needs to be considered “in the round”.
However, it is likely that the risk of falling foul of the IR35 and Off-Payroll Working rules can be mitigated by taking the following steps:
- Consider each contractor relationship on its own facts and do not adopt a blanket approach.
- Look carefully at whether there is a right to control the work carried out. Please note that the Tribunal may consider there is sufficient control to infer a hypothetical employment contract even if the right to control is not actually exercised and/or the individual providing the services has some autonomy.
- Avoid limiting rights of substitution. This is a complex issue in itself and substitution clauses in contracts should be very carefully drafted and applied in practice.
- Consider who provides the equipment to perform the services and how integrated the contractor is in the business.
- Check the fee arrangements and avoid regular fixed payments which may appear to be akin to salary payments.
- Consider whether the contractor works on an ad-hoc or regular basis.
- Look at whether the contractor takes on financial risk and whether they are able to profit from their work.
- Use HMRC’s online tool, Check Employment Status for Tax (CEST). However, be aware that CEST is not always reliable and is often inconclusive.
- Ensure that status is determined by looking at the reality of the de facto relationship and not just the written contract between the parties.
The case law in this area is still evolving and we expect there to be further developments within the next 12 months at least, as cases make their way through the court system. However, it is important that all of those involved in determining employment status understand the IR35/Off-Payroll Working rules and the concept of the hypothetical contract, and how it could be applied to them and that they, accordingly, seek professional advice when in doubt.
If any of these issues impact you or your business, or you have any questions, please get in touch with the authors below, or any member of the Employment Team.