HMRC's IR35 change: an opportunity for consulting firms?
From April 2020, medium and large private sector businesses will be responsible for setting the tax status of any independent contractors they use. As the UK’s gig economy continues to thrive and freelancer numbers grow exponentially, this will present a significant risk for large organisations that are heavily reliant on third party contractors operating through Personal Service Companies (PSCs).
This will also inevitably put pressure on temporary and interim recruitment firms focused on placing freelancers into contractor roles within these organisations, as client companies will increasingly prefer to hire full time employees or engage consulting and managed service firms (where the status risk will sit with the third party service provider) that deliver a largely equivalent service under a formal Statement of Work (SOW) or similar arrangement.
What is IR35?
The IR35 legislation is in place to determine whether off-payroll workers are bona fide contractors or acting akin to a direct employee of the company they are providing services to (‘disguised’ employees). Working as a disguised employee through a PSC gives a marginal tax benefit to the contractors, whilst saving the organisations they are engaging with a material amount of employers’ NIC.
HMRC uses a series of different tests to determine whether contractors should be considered disguised employees, including the following:
- Control & Direction: Contractors need to demonstrate a certain amount of autonomy in the way they undertake a project;
- Substitution: Contractors need to demonstrate a right of substitution for their services as the client is engaging with a company as opposed to an individual;
- Mutuality of Obligation: Contractors should be engaging on an assignment with no expectation of further work being provided after it is completed; and
- Exclusivity: Contractors will typically work for several clients at the same time.
While these tests may appear simple at first glance, the legislation remains difficult to interpret in many cases, leaving many corporates and contractors struggling to accurately assess whether working arrangements fall inside or outside of IR35.
What’s changing?
In the 2018 Autumn Budget, the Chancellor announced that off-payroll working rules for the public sector would be extended to the private sector in April 2020. The new rules will apply to medium (greater than 50 employees) and large companies only. The implication is that the client organisation that a contractor is working for, as opposed to the contractors themselves, is responsible for determining whether the worker falls within IR35 or not.
Where a contractor is deemed to be ‘inside’ IR35, the client must deduct employees NICs and income tax from his or her pay, as well as paying employers’ NICs. This therefore presents a significant financial consequence for companies engaging meaningful volumes of contractors.
The opportunity (and risks) for consulting firms
The new rules are likely to cause a significant shake up across the private sector and many large corporates, including HSBC Bank in the UK, have recently announced they would reduce their use of contractors and look to hire many of these workers as employees to ensure complete compliance and avoid any risk of reputation harm as a result of falling foul of HMRC.
Alongside this recruitment drive, corporates are also likely to switch the procurement of project-related services away from contractors and towards consulting firms operating under a specific SOW. This is likely to present both considerable opportunities, as well as risks, to private sector consultancies. The main opportunities are as follows:
- Increased demand: Demand for projects delivered by a consulting firm under a SOW, as opposed to by independent contractors, could increase exponentially as volumes of work are displaced by the new regime. This reduces the IR35 risk for the end client and transfers it to the consulting firm meaning that, if the price is right, medium and large corporates will ultimately prefer to procure services in this way. In a recent survey, one quarter of clients said they would put freelancer projects on hold due to IR35. Engagements that are focused on ‘outcomes’ and delivered by substitutable teams as opposed to individuals are likely to fall outside of IR35.
- Availability of talent: A consequence of this heightened risk around hiring contractors is that the contractors themselves may feel they are better off in permanent employment. The UK ‘challenger’ consultancy market is growing rapidly, with small firms growing revenue at an average of 18% in 2018, compared to 7% across large firms as demand for a more forward-thinking, specialist breed of consultancy increases. The main challenge for many of these smaller firms is hiring sufficient consultants to meet demand, but they could well find an increased number of CVs coming across their desk as contractors look for permanent homes.
Nevertheless, many small to mid-sized consultancies still leverage an associate model to some degree, drawing upon a pool of independent contractors to support project delivery as they manage their own growth, seek to ameliorate fluctuations in demand, or draw upon specialist expertise on an ad hoc basis as projects necessitate. Importantly, this associate model exposes consultancies to IR35 risks if these contractors are deemed to be disguised employees.
“Corporates are likely to switch the procurement of project-related services away from contractors and towards consulting firms operating under a specific statement of work.”
– Will Evans, Livingstone
The principal consequence of IR35 for the consultancy community is likely to be the shift of risk from the ultimate clients (the larger ones of which are often much better equipped to manage these sorts of resourcing challenges) to the service providers (who will therefore have to shoulder the burden of employing consultants or substantially re-inventing their own talent supply chain). It is therefore critically important that consultancies utilising this associate model are having their client and contractor contracts scrutinised to ensure that these workers fall outside IR35.
Uncertain times
As HMRC’s interpretation of the IR35 legislation across the private sector remains unclear, it is likely to be some time before enough cases have been through the courts to provide sufficient clarity as to which employment arrangements fall within the legislation. Nevertheless, going forward the reforms materially shift the risk from individual contractors to clients and are likely to lead to a wave of changes across the market. Some possible reactions could include:
- Talent resourcing providers delivering more projects with a defined outcome, as opposed to a ‘body’ for a defined period;
- Insurance products emerging to protect firms using contractors against potential liabilities while the IR35 status is not clear. For example, we have already seen some open-ended indemnities given by contractors to end clients to protect against tax liabilities; and
- Contractors may opt to move around more between clients or shift their working patterns to fall outside IR35.
Despite this uncertainty, there is likely to be a meaningful opportunity for agile consulting firms that can effectively position themselves as a credible alternative to the contractor market, whilst ensuring their own exposure to these seismic reforms is minimised.
An article by Will Evans, an Associate Director at Livingstone, a global mid-market M&A and debt advisory firm. Evans focuses on the consultancy sector, recently providing advisory services to UK-based Catalyst Development during its merger with US-based Sionic Advisors.
