IR35 and Employment Status
July 2000

When IR35 was revealed in the '99 Budget, initially it was thought that it would be an accountancy problem, obviously in part it is. The real issue, however, as to whether a particular individual is going to be found to be a 'disguised employee' or not will rest on law.

In establishing whether a individual, who works through a Personal Service Company or certain types of partnership, is taxable under the IR35 system depends initially on whether the Inland Revenue deems them to be employed or self-employed. The decision is based on several documents produced by the Inland Revenue. Firstly, IR56 which is a simple test to find out whether you are employed or self-employed. This test has been used for many years and has merely been extended to incorporate Ltd Co and the relevant partnership arrangements. Secondly, the Inland Revenue have recently produced a document called IR175 'Supplying Services through a Limited Company or Partnership. This document to be honest sheds no more light on the case than IR56.

Since the late 1800's the courts have attempted to come up with a decisive test for establishing whether a person works under a contract of service which is akin to an employment contract or under a contract for services which is akin to being an independent contractor or 'self-employed'. The first test to be used was a relic of the common law rights of master and servant. Nowadays, however, the courts have realised that the 'Control test' as it is known cannot be a decisive factor especially when the individual is a professional or skilled person.

The Control test then developed into the Integration Test. This looks at whether the individual has become 'part and parcel' of the organisation. If the individual has become involved in the everday life of the client company a certain amount of control comes with this situation. This also goes to the mutuality of obligation. The more involved you are the more there is an obligation to perform tasks within the client company.

Mutuality of obligation looks at not only the intention of the parties but also at whether an obligation has built up through a continuing relationship. In the vast majority of situations the parties intend that there is no obligation to accept or provide work outside of the contract they are under. If, however, there is a continuing relationship between the parties the intention can be rebutted. This may happen where, for example, an individual starts a contract on a short term basis but ends up staying with the same client for a considerable time. The courts may in this circumstance find that an employment relationship has been established.

Another test which the courts have used is the test of economic reality or "is the individual in business on their own account". The test is based on such things as whether there is any financial risk involved in the contract or whether the person can profit from sound management of their business. It is not appropriate to use this test in all circumstances but sometimes the test has been used when it shouldn't giving an inconsistent result.

There is one particular case that of Hall v. Lorimer (1994) where the mixed approach was taken. The court looked at the contracts, how the individual worked in practice and then took a step back and looked at the whole picture. This has been favoured in several cases since then but there is no consistency in which type of test the court will use.

One issue that has received a lot of attention, is the right of substitution. It must be pointed out that this is not a test in itself. This was first mentioned in the case of Australian Mutual Provident v. Chaplin (1978) where the judge stated that if there is an unfettered right to substitute yourself for another person thereby having no obligation to perform the services personally then there can be no contract of service. In two further cases, the Ready Mixed Concrete case in 1968 and Express and Echo v. Tanton in 1999, the court held that because there was a right of substitution which had been utilised on more than one occasion and the individual did not have to perform the services personally the contract could not be one of service.

What is interesting in the latter two cases is that the right of substitution clause was conditional not only on the substitute having the relevant skills and experience but also on the company agreeing to the substitution. The argument here is that in effect this does not convey a right at all.

In a very recent case between Glasgow City Council and two gymnastic instructors the appeal court distinguished Tanton on its facts. In the Glasgow case there were so many restrictions on the right of substitution that it was not in fact a right at all. So, where it was previously thought that having a right of substitution clause in a contract would mean that the contract could not be one of employment, it has been shown that this is not the case. A substitution clause will not protect the individual where the clause is not used or where it is seen to be a sham or where it is conditional on the client agreeing to the substitution.

At present, it would appear that many judges are following an important statement from the judgment of Stephenson LJ in Nethermere (St Neots) Ltd v. Gardinier [1984] which stated that "There must, in my judgment, be an irreducible minimum of obligation on each side to create a contract of service…" Stephenson LJ was following a quote in the Ready Mixed Concrete case [1968] where MacKenna J. considered that there were three conditions which must be fulfilled for a contract of service to exist. Firstly, mutuality of obligation; secondly, a sufficient degree of control ; and thirdly, consistency of the remaining terms of the contract. Although it is open to interpretation, more recent cases appear to be saying that the minimum requirement is of mutual obligation. That is, that the employer is obliged to provide work and remuneration for which the employee is obliged to provide their services personally. The obligation comes from the intention to create legal relations in the contract of employment.

The repercussions of IR35 are that the Industry has had to take a good look at the contractual provisions. In terms of practicality what needs to be done is for the contracts in the industry to be proper commercial contracts not some variant of an employment contract, which up until now they have been. In a commercial contract there is no notice period the contract either terminates on completion of the contract or on breach. In some industries, especially in the IT industry, the agents and the clients will not take out the notice clause which gives them the right to end the contract on 28 days notice. In addition to this, the contract should not state that the client has direction, supervision and control. This is not a device because in most cases the client may have control over 'what' is done but not 'how' it is done and that is the important point. Most contractors are brought in because of their knowledge and skill and so the client cannot tell them in practice how to do the job.

In advising a contractor on the way forward it is best for them to seek professional legal advice on the contract. A lawyer should be able to look at the contract and determine as far as possible whether it is a contract which reflects self-employment. Then, and this is very important, the working practices should be reviewed to establish whether they are a true reflection of the contract.

It will not be until the first few IR35 specific cases go through the courts that we will know how this situation is going to pan out. Unfortunately, there are unlikely to be any cases going through until after April 2001 when the first IR35 declarations are warranted. This means that the contractor industry is likely to be in limbo for at least another 12 to 18 months.