Employment Update: Employee Status

15 October 2008

A highly skilled consultant may be treated for tax purposes as an employee of his own service company and not self-employed.

In Dragonfly Consultancy v HMRC the High Court has restated the essential elements of an employment contract and confirmed that, where these elements exist, there will be a contract of employment, despite what the parties themselves may have intended or even written into the contract document itself.

The consultant in this case provided his services through a company of which he was sole director and 50% shareholder. That company in turn contracted with an agency which provided his services to an end user. He worked for the end user for over four years. Over that period, there was a series of short fixed-term contracts between his service company and the agency, and between the agency and the end-user.

The IR35 rules (so called after the Inland Revenue press release which spells them out) provide that such a consultant is to be taxed as an employee if ‘the circumstances are such that, if the services were provided under a contract directly between the client and the worker, the worker would be regarded for income tax purposes as an employee of the client’.

HMRC said that this was such a case.

This required the High Court to look at the conditions that must apply if a contract is to be treated as an employment contract.

In this case, the service company could deploy a substitute consultant but only with the prior approval of the end-user. The High Court said that such a limited right was not incompatible with an employment contract.

Although the consultant worked alone, the court thought it significant that he was treated as part of the end-user’s IT team and was subject to regular appraisals and monitoring by the end-user. This pointed towards the relationship being an employment contract. Also, the consultant worked for virtually no other client over the relevant period.

Importantly, the court said that the fact that, in their written agreements, all the parties to this arrangement stated that it was not their intention to create an employment contract and the end-user was irrelevant. Whether there was an employment contract or not depended on an assessment of all the circumstances of the case.

In this case, the court decided that the relationship between the consultant and the end-user would have been an employment contract if he had engaged with the end-user directly. This meant that, for tax purposes, he should be treated as an employee of his service company.

Points to note –

  • End-users may want to insist that consultants working for them under the IR35 rules have an employment contract with their own service company so that HMRC have an employer that they can look to for PAYE income tax without involving the end-user.
  • The court said that it should not consider an IR35 case without referring at all to what the parties had intended. Statements of intention in the contractual documentation might, in borderline cases be of real assistance.
  • As in all cases where employee status is at issue, documentation should be carefully drafted. In this case, it was fatal to the consultant’s claim that he was an independent contractor that the wording of the contract between the agency and the end-user did not allow the agency to provide a substitute contractor without the end-user’s consent.
  • This was a tax case. The consultant tried to argue that a person may be self-employed without necessarily being in business on his own account. The court disagreed. In the context of specific statutory codes, such as the Working Time Regulations, there can be ‘workers’ as well as employees and self-employed. However, in the context of the IR35 rules, the only distinction that matters is whether there is a contract of employment or not.