Wednesday, September 17, 2008

Contractors continue to lose out - Dragonfly case is just a symptom not a problem

The press have given plenty of space to the High Court decision last week in the case of Dragonfly Consultancy Ltd v HM Revenue & Customs. The case concerned a contractor, who had provided his services through both his own intermediary company and an agency to the AA. I will use this case to highlight some key points relevant to anyone who supplies their services to an 'employer' (or a company that would be their employer were it not for some special arrangements).

Raw facts
Mr Bessell, the contractor in question, had been working on the assumption that his company was not caught by IR35. HMRC believed otherwise and succeeded in their claim both before the special commissioner and the High Court. HMRC's argument was that Mr Bessell would have been an employee of the AA but for the imposition of his company (Dragonfly Consulting Ltd). HMRC's success means that the company is liable to account for tax in accordance with what we know as the IR35 rules.

What does all this mean? Well, even if you're familiar with IR35 and the various indicators of an employment relationship, you would be forgiven for finding some of the reports a little confusing. (The case is complicated also be the fact that an agency was supplying the services of Dragonfly/Mr Bessell to the AA).

It is by no means clear why the taxpayer was encouraged to take his appeal to the High Court. As is generally well known, such appeals have to be on points of law. No new facts can be introduced. This is one of the reasons why it is SO critical to present the best possible case before the Commissioners. You get no second chances. Many taxpayers have come unstuck when considering an appeal only to find that their case was poorly presented and argued before the Commissioners.

The detailed facts in this case are too complex to set out in this blog. Suffice it to say that, as reported in the press, the Judge placed particular emphasis on the lack of a 'right of substitution'. This was in the context of the contract between the agency and the AA - even though there was a right of substitution in the contract between Dragonfly and the agency. The Judge held that this right was ineffective in practice for a number of reasons. (eg: it wasn't replicated in the other contract, it never happened and was never likely to happen as the AA wanted the services of Mr Bessell personally).

What this all seems to mean is that anyone involved in cases where the IR35 rules could be in prospect needs to be more confident than ever that:
- ALL of the contracts in the chain are watertight - ie they avoid any deemed employment status between the contractor and the end-user 'employer';
- The FACTS accord with the contractual terms;
- The end user 'employer' is also clear and consistent as regards the contractual terms and the facts. Thus, for example managers responsible for the contractor would need to treat him/her as an independent contractor.

As ever the most frustrating aspect of all such cases is the lack of joined up thinking as between employment law and tax law.

End user 'employers' are keen to avoid engaging contractors as employees. This is invariably due to a combination of:
a) the onerous legal obligations imposed on employers by employment laws; and
b) the obligations to pay employers' NIC at 12.8% of all staff pay. This is, in effect, seen as a payroll tax and best avoided by NOT taking on staff.
However it is the onerous obligations imposed by employment law that really drives the 'employer'. It must be as the daily rates received by independent contractors are often much, MUCH higher than the same people would earn if on 'staff'.

Underlying problem
Employers suffer few disadvantages if they refuse to engage workers as employees. That is as long as the 'employer' doesn't pay the independent contractors direct. If they do and HMRC successfully challenge the arrangements, then it is the 'employer' who is penalised.

This is what drove the rise of personal service companies. 'Employers' avoid the prospect of being liable for payroll taxes by refusing to engage independent contractors direct. In effect the 'employers' insist that the contractor forms their own company. This means that if there is a problem with the taxman it is down to the contractor and his personal service company to resolve.

For some years the tax system relevant to contractors who ran their business through such a company was very attractive. It favoured the extraction of income from such companies by way of dividends and this reduced the tax payable by the contractors on their earnings. And this led to the introduction of the IR35 rules (so called because they were initially set out in the 35th press release issued by the Inland Revenue on Budget Day 1999) . The aim of the legislation foreshadowed by that press release is to ensure that if someone is, in reality, an employee of the end user 'employer' the personal service (intermediary) company must effectively tax their income as earnings. This limits the possibilities to reduce taxes by drawing money out of the company by way of dividends.

In effect the only person who can lose is the contractor.

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