Update No.20 - Initial Analysis of Ruling

PCG Director Kevin Miller has produced a first analysis of the full ruling, summarising the implications for contractors.

Introduction
Mr Justice Burton delivered his judgement in the PCG Judicial Review of the IR 35 legislation today. He found against the PCG on the three technical issues of EC Law. However, in his long written judgement and in his comments during the Court hearing, he has set out a number of significant issues where he believes that the Government and the Revenue have misled taxpayers.

The technicalities of his judgement, as it relates to the three issues of EC law, are of limited interest and relevance to contractors. As the PCG have noted in their press release the judge has found that on 8 key matters of fact he agreed with the case that PCG had always argued. Most critically he agreed that:

• Small firms of knowledge based contractors are in competition with larger consulting companies and body shops. Despite the Revenue having devoted a substantial part of their evidence to trying to dispute this issue Mr Justice Burton states "in relation to some contracts at least, or even some parts of some contracts, in practice the service contractor, through his service company, is in competition with large companies,"
• He also finds that the larger companies that are unaffected by IR35 will have greater flexibility to arrange their tax affairs.
• Many contractors will be adversely affected by IR 35. As a result he accepts that some service contractors may not continue to operate in the United Kingdom and some, who have intended to come to the United Kingdom to set up or work as service contractors, may not now come to the United Kingdom.

While it is helpful that PCG has been vindicated on these major issues the real benefit from the judgement lies in the judge's comments about the Revenue's guidance concerning the application under IR 35 of the existing case law on employment status.

Revenue Guidance
In his consideration of whether IR 35 breaches Human Rights legislation he examines the issue of the uncertainty of the legislation. While he accepts that the approach adopted under IR 35 - of applying the same status tests that sole traders have to pass when the provide personal services to clients - is not unreasonable he is strongly critical of the guidance and approach adopted by the Revenue.

For example he says that "it is essential that there is a sensitive and co-operative approach taken by ..(tax) inspectors, and that the Revenue guidance is clear and helpful ??.but the Revenue documentation?? has not always been either:"

He also cites the example, discussed in Court, of the contractor whose contract was inadvertly assessed by two different inspectors who produced entirely inconsistent answers, one saying that IR 35 applied, the other saying that it did not. In the judge's view the one who gave the answer that IR35 would apply "relied upon an entirely erroneous construction of the contract in question."

In a humiliating turn of events the Revenue had to apologise in Court for the error and in a telling comment their Counsel stated that the error did not reflect upon the uncertainty inherent in IR 35 but merely the difficulty of applying case law in this area! The very point that PCG have been making for over 18 months.

Status tests
The Judges has gone on to clarify a number of the traditional status criteria and tests where he considers the Revenue's guidance is misleading or incorrect. These comments will prove very helpful for contractors when they assess their own IR 35 status. Key issues are as follows:

In business on your own account.

In the case of Market Investigations Limited versus Minister of Social Security, Justice Cooke held that "the fundamental test to be applied is this: is the person performing them (these services) as a person in business on his own account? If the answer is yes, then the contract is a contract for services."

Mr Justice Burton, in his judgement comments says that "It is essential to any consideration of the common law test as to whether an individual is trading as an employee or as an independent contractor, that consideration should be given to whether he is in business on his own account" and, faced in Court by this view, the Revenue's Counsel Dr Plender has gone on record as accepting it.

However, throughout the legislation and the Revenue's guidance there are references to the rules being applied on a case by case basis. The judge made it clear that:

"the question of whether the service contractor himself has, prior to that engagement, performed or is, simultaneously with that engagement, performing ?? or will subsequently, after the termination of that engagement, perform, services for others, and is to be construed as carrying on business on his own account, is and must be a central consideration." During the Court hearing the Judge also added that the test of being in business on your own account should be "put up on every tax inspector's wall".

What does this mean for contractors? It means that where contractors have had contracts assessed and failed by the Revenue in isolation without having had their overall business history evaluated then they have good grounds for demanding a reassessment.

Where contractors are planning to have their contract reviewed - by the Revenue or by one of the many contract review experts - then they need to make sure that they supply comprehensive details of their business and contract history and business set up. Unfortunately this is not a test that will be much help to those who work through composite umbrella companies. It will be harder for them to argue that they are in business on their own account in a company where they may not even have control over the bank accounts.

But contractors who:

• work through their own intermediary,
• are registered to VAT
• handles the day to day running of the company's affairs and control company assets,
• file accounts,
• are actively engaged in seeking other work both before during and after their current contract
• have employer's liability and professional indemnity insuranceand generally demonstrate that theirs is a proper business will have gone a long way to placing themselves outside of IR 35.

Length of contract
One area of caution however relates to length of contract. The judge seems to accept that "There will be some who, even though normally in business on their own account, are deemed, in respect of a particularly long engagement, or one particularly subject to a client's instructions, or one where he is working alongside, or on exactly the same basis as, the clients' own employees, to be subject to IR35."

Hence contractors need to ensure that as far as is practicable contracts are shorter rather than longer. There is no set length but the judge did comment during the hearing that he might consider that where a contract was as long as a year then it might be indicative of disguised employment.

It will also help if contracts are broken down into discrete segments with each segment coming to a clear end and a new contract negotiated for any extension or continuation. This aspect will also be of relevance for the second area of concern for the judge, mutuality of obligation (see below).It also raises the issue of whether contractors are mixed in with employees doing very similar work or are clearly there as experts doing their own self contained roles.

Mutuality of obligation ("MOO")
Again the judge was strongly critical of the Revenue. He said "it cannot be right for the Revenue simply to conclude, as it does in ??.. ESM 0514, that "mutuality of obligation" is not a relevant issue: "Do not consider this factor when reviewing a work status, unless the engager or worker raises it".

He goes on to add:

"It has now recently been emphasised, by the House of Lords, in Carmichael v National Power plc [1999] 1 WLR 2042, that the test adopted in Nethermere (St Neots) Ltd v Gardner [1984] ICR 612 CA by Stephenson LJ, of an "irreducible minimum of mutual obligation" is another central piece of guidance in the analysis of whether there is employment or self-employment. Of course there is in fact no contract between the client and the service contractor, and thus no obligation on either party owed to each other, but it must be significant, when applying the common law test, to consider whether, looking at the actual relationship, and a notional contract, between the client and the service contractor, any obligation would be owed by the client."

No mutuality is likely to exist where a person is free to decline to carry out work and the engager does not have to offer available work to the individual. It is more difficult to apply the concept in the case of a hypothetical contract between a contractor and the end client but it is quite possible that such contracts may lack the "necessary elements of continuity and care" which are characteristic of MOO.

Mutuality may well exist if a contractor enters into a 12 month contract as an IT support worker. But it is less likely to exist where the contract is for a specific project with a finite and clearly defined life such as writing a piece of software.

Substitution
Another key criteria is the right of substitution. On this the judge has again been critical of the Revenue's approach. He commented:

"One of the questions that is addressed in relation to the ordinary issue of employee or not is whether there is a right of substitution in the contract with the client, or whether the services can only be supplied by the one individual. Again so far as computer services are concerned, the Claimants are concerned that, in practice, at any rate once a service contractor has commenced work at the client's premises on his equipment, his expertise will become such that no one else in fact would be able to replace him. Given that the issue is not determinative, but only one of the factors, that may indeed be right and may in a particular engagement be a strong counter-indicator against employment."

Essentially the message is that not having a right of substitution can never of itself be regarded as the only reason for failing IR 35. In addition the judge goes on to say that:

"it would not be right to make an absolute statement, as the Revenue appears to do in another of its guidance documents, that the need to obtain the client's permission necessarily negates the existence of a right to substitution, and/or points to employment."

Using the client's equipment
Another of the standard factors that the Revenue frequently cites when failing a contract is the fact that the contractor does not use their own equipment. Once again the judge has supported the PCG's contention that this test is hardly a determinative one in the context of the knowledge-based economy.

The judge says:

"The Claimants are inevitably concerned that, with regard to an assignment by a software specialist at a client's premises, it would be unlikely that he would bring with him any tools or equipment, which might be one of the more obvious indicia of self-employment if, for example, he were a jobbing builder or a plumber. *That must be right.*" (my emphasis)

Again where a contract is assessed as being caught by IR 35 and this is cited as one of the factors then the opinion should be challenged.

Contract issues
The judge was made aware of two particular issues concerning contracts. Firstly he criticised the Revenue's stance regarding those working on standard agency contracts. However he went to add that "Clearly some uncertainty could be resolved by the drafting, agreement and approval of a series of acceptable new standard forms." During the Court hearing he also remarked that it seemed logical and obvious that clients, agents and contractors would work together to ensure that the standard contracts in use would take the contractor outside IR 35. While it seems that many of the larger clients have not yet recognised the advantages this approach has for all concerned they may be spurred by the judge's other comment that:

"There is no binding conclusion that he is an employee simply because he is to be treated as if he were one for tax purposes, but if so advised he could seek to raise arguments to that effect.". I.e. contractors caught by IR 35 may well have reasonable grounds for claiming employment rights.

The judge also noted that contractors frequently do not have access to the client agent contract. However, he observes that "Equally, insofar as the inspector has access to something not available to the service contractor, such as the contract between the agency, which recruited him, and the client, which is or may be relevant, then it should clearly be supplied by the agency or the client or by the inspector."

Any contractor faced with a verdict on his contract based upon information he has not been given access to should cite this comment as grounds for insisting on being given such access.

Finally, the judge seems to be indicating that contractors who are relying upon their contract with the agent to the exclusion of any factors outside that contract that might cast their status in a different light may be disappointed.

The judge has stated that: "In those circumstances, of course the terms of the contract between the agency and the client as a result of which the service contractor will be present at the site are important, as would be the terms of any contract between the service contractor and the agency. But, particularly given the fact that, at any rate at present, a contract on standard terms may or may not be imposed by an agency, or may be applicable not by reference to a particular assignment, but on an ongoing basis, and may actually bear no relationship to the (non-contractual) interface between the client and the service contractor, such documents can only form a part, albeit obviously an important part, of the picture."

Conclusions
This judgement goes a long way toward clarifying the issues that the Revenue must consider when applying IR 35. While it does not change the tests it makes it clear that the Revenue's slant on case law is not the slant that the Courts will follow or apply.

Contractors who:

• run their affairs in a business-like fashion as businesses and
• take steps to make sure that their contracts have reasonable provisions for matters like supervision direction and control and substitution and
• avoid long open ended contracts which imply the creation of a degree of mutuality of obligation should approach IR 35 with greater confidence than they would have a month ago.

The Revenue have tried to coerce contractors into sheepish adherence to their interpretation of status case law. This decision sees the start of the process of calling the bully's bluff. The Revenue are not equipped to fight a large number of status appeals. Contractors who marshall their case and evidence and are backed by the collective strength of an organisation like the PCG will find that the Revenue will opt for softer targets.

Kevin Miller. FCA