The Legal 500

Many organisations use atypical working arrangements to keep their ‘employee' headcount low and to avoid statutory employment obligations - giving them greater flexibility to hire and fire such casual staff at will. Employment status is significant not only in terms of what statutory employment protection may exist, but also from a number of other legal perspectives, including an employer's liability for making tax and social security deductions, and complying with immigration requirements, and health and safety legislation.

If a company engages the services of an individual who is mistakenly treated as self-employed, what are the employer's liabilities to HM Revenue & Customs (HMRC) should the individual subsequently be classified as an employee? The Special Commissioner recently considered this issue.

Demibourne Ltd v HM Revenue & Customs

B worked for a company (D) under a contract of employment for a number of years before he reached D's compulsory retirement age of 65. B then had a retirement party. After this he continued to work, performing his usual duties, but was treated by D as self-employed. Pay As You Earn (PAYE) was accordingly not operated. B worked in this fashion for nine years until an HMRC inspector visited the workplace and expressed the view that B was an employee. Shortly thereafter PAYE was operated on B's earnings. During the period in which B had been considered self-employed he had completed self-assessment tax returns and paid his tax accordingly.

The issues before the Special Commissioner were:

i) whether B was an employee, rendering his employer liable to income tax and national insurance; and

ii) whether HMRC had correctly assessed the employer's liability for back tax.

Was B an employee?

When considering the issue of B's employment status, the Special Commissioner acknowledged that it is possible for someone who was previously engaged as an employee to become an independent contractor working for the former employer. To achieve this, however, there has to be a clear distinction between the old employer/employee relationship and the new one, amounting to a contract between client and independent contractor.

Examining whether there was a sufficiently clear distinction between B's terms of engagement following his 65th birthday and those of the previous employment, the Special Commissioner did not consider that there were sufficient changes to recategorise the relationship. The only changes of consequence were the fact that PAYE was no longer administered and B was no longer entitled to paid holiday. Apart from those changes, B's engagement was virtually identical: he worked at the same place for similar hours, still provided his own tools and was subject to the same degree of supervision. Although he submitted invoices to the company, the Special Commissioner found that he could not really be said to have been in business on his own account - the amount of work that he carried out for other persons was relatively small and was not organised on a commercial basis. For these reasons it considered that B was an employee.

Liability for PAYE

Having regard to the issue of liability for PAYE, D argued that as B had already paid tax as part of his self-assessment returns during the years that the parties believed him to be self-employed, HMRC should take that tax into account. Once the HMRC inspector had come into the workplace and identified that B was an employee, she had advised D of the decision in writing. The letter included the statement: ‘Please note that it is not Revenue practice to charge tax twice and only tax already paid on Mr Bone's earnings will be taken into consideration.' However, no voluntary agreement was reached between the Revenue and D, so HMRC subsequently sought to recover the unpaid tax directly from D as the employer on the grounds that it was in breach of its obligation to deduct income tax at source.

The Special Commissioner found that it did not have jurisdiction to order HMRC to choose whether to collect tax from either Company D or B. It did, however, express concern that this could result in tax being accounted for twice - once through B's self-assessment and again through the determinations made against D based on the estimated amounts of B's earnings. The Special Commissioner suggested it would be preferable if HMRC and the employer reached an agreement to adjust the tax determinations to be paid by D.

NEW HMRC APPROACH

It should be noted that HMRC may, in limited circumstances, seek to recover tax from the individual employee, instead of the employer, in circumstances where the employee knows of the employer's wilful failure to deduct PAYE from their earnings (s72 of the Income Tax (PAYE) Regulations 2003). That exception was not found to apply on the facts.

Before this decision, HMRC's practice was to credit the individual's tax contributions against any PAYE settlement due from the employer. HMRC's approach now appears to be to recover the tax twice without giving the employer any credit for tax already paid by the individual. The employee then needs to reclaim tax previously paid under the self-assessment regime. This stance seems to be motivated by the concern that if HMRC reaches a settlement with the employer giving credit for tax paid by the employee under self-assessment, the employee could subsequently seek a refund of the tax they paid on the basis that only PAYE tax was due and not the tax they paid under the self-assessment. At present HMRC officers have indicated that exceptions may be made if the employee has given a written undertaking that the tax already paid can be offset and that they will not seek a refund.

Practice points

HMRC is reported to be in discussions with tax professionals to resolve the problems caused by its new approach. In the meantime employers should consider their contractual arrangements with individuals who have been retained on a self-employed basis, and include provisions requiring the individual to repay to the employing entity any tax refund obtained from HMRC if they are classified as an employee, and/or requiring them to give a written undertaking to HMRC that the tax they have already paid can be offset against the employer's PAYE assessment and that they will not subsequently seek a refund from HMRC. Particular care should be taken where a former employee is retained as a consultant (for example after a redundancy exercise or retirement) where there is no discernible difference in the nature and delivery of the services they provide.

Demibourne Ltd v HM Revenue & Customs [2005] UKSPC SPC00486