Those dealing with businesses affected by the construction industry tax deduction scheme (CIS) are probably well aware by now that employment status is an increasingly important and difficult area for contractors engaging the labour of subcontractors; AccountingWEB writer Rebecca Benneyworth reports.

However, recent developments mean that those engaging freelance workers in any business should be particularly aware of this issue and the potential ramifications for their business of an enquiry into the employment status of those presently treated as self employed.

Two developments in this field bring particular problems for employers. The first is the Demibourne case, heard before the Special Commissioners (SpC486). The outcome of the status tests in the case are not of any particular significance – in essence the Commissioners ruled that to transfer an individual from employment to self employment there needed to be significant changes in practice and working arrangements – but there are other aspects of the case which give significant cause for concern.

The company was required to pay a settlement under contract at the termination of the enquiry which resulted in the reclassification of the individual as an employee.

Practice over many years has been to accept that the individual has paid self employed tax for some or all of the period concerned, and therefore to treat this amount as the tax due on the earnings, and to collect only amounts of NIC due by the employer.

This would include both the normal employer (secondary) contributions, and the amounts normally paid by the employee (primary contributions), bringing a significant liability to employers – up to 23.8% of the amounts paid to the employee. No deduction is available for Class 4 contributions paid by the individual on the earnings.

In Demibourne, HMRC sought a full settlement of the tax in addition to the normal procedure regarding National Insurance Contributions, which was upheld by the Commissioners. It would seem that this practice is now the standard approach, for the following reasons :

• The amount of tax paid by a self employed individual on income may be lower than the amount due by an employee on the same income, as tax rules for self employment allow expenses to be claimed against the income for tax purposes, which would not be allowed for employment income. Accepting the self employed tax as covering the tax due under Pay as You Earn would therefore lead to a loss of tax to the Exchequer.
• Where an individual has been reclassified as an employee, it is open to that individual to revisit his self assessment returns and amend any which are still open for amendment, and make error or mistake claims in respect of earlier returns. This of course would result in repayment of the tax to the individual concerned. Only where the returns are not open for error or mistake claims is the tax guaranteed to remain in the hands of HMRC.

Current practice is therefore to seek settlement of the tax in addition to the NIC, but it is possible to gain an offset for the amount of tax paid by the individual concerned, only where the employer can obtain a mandate from the individual. The mandate is an irrevocable written undertaking that the individual will not seek a refund of the tax and requests HMRC to apply the tax paid against the PAYE liabilities of the employer.

In many cases, the employer will not be able to trace the individuals concerned, as they may have left the engagement some time before. Under these circumstances, employers have no option but to settle the tax in full, as current HMRC guidance is that tax can only be offset where a mandate is in place, otherwise there is a risk of significant loss of tax to the state.

When a status reclassification goes back beyond the time allowed for error or mistake claims by the individual concerned (5 years and 10 months after the end of the fiscal year) technically the tax cannot be repaid to the individual, so HMRC should make full allowance for this in the settlement. Affected employers should ensure that this is the case; where no allowance is made for the tax in earlier years, it is clear that HMRC could receive the tax twice.

Find out how the Employment Status Indicator (ESI) Tool can help, plus its limitations.