IR35 – Alarming Substitution Ruling

An IT specialist was only able to record a part win at a recent First Tier Tax Tribunal hearing.

John Spencer, whose company, JLJ Services Ltd (JLJS), had appealed against tax and NIC assessments totalling nearly £153,000 plus interest of just over £48,000 covering the years 2000/01 – 2007/08, was found to be a self-employed contractor but only up to 31^st December 2003. After that date, the Tribunal Judge considered IR35 to be applicable.

At the time of the hearing, Mr Spencer, now 66 years of age, had been retired since 2007. He had a very long career in Information Technology and would probably have been one of the early computer specialists.

In 1993 and 1994 Mr Spencer was contracted to supply services to Highams, an agency, who made his services available to Texas Instruments in Bedford for 14 months, and then to BAE systems for 2 months. Following a period of 4 months unemployment, John Spencer formed his company. Although the precise motive for forming the limited company was not established it was reasoned by the Tribunal that Highams would have probably wished to protect their risk of exposure to PAYE and NIC and persuaded the contractor to incorporate. Indeed, many similar work procurement agencies, like Highams, insisted that all their “casual” workers form a company.

From 1994 – 2000 Highams found work for the contractor. In May 2000, the agency obtained a 6 month engagement with Allianz, the German insurer that had taken over Cornhill, at their Guildford offices. Allianz were particularly keen to engage someone hastily to undertake a project geared to installing and writing programmes for Unix systems. Following a telephone interview JLJS was offered the contract.

Although written contracts were produced, none seemed to exist for the initial engagement. The initial contracts were however very similar to the later contracts.

The wording of the contracts between JLJS/Highams and Highams/Allianz were virtually identical. In particular, they gave the contractor a qualified right of substitution and set out the terms in relation to control, hours of work and termination.

Following the initial 6 month contract there were various contract extensions and projects within each extension period up until 31^st December 2003. With the sole exception of one 10 month extension, all of the later extensions were for short periods; one for 1 month, two for 2 months, three for 3 months and two for 4 months. From 1^st January 2004, however, the position changed and contract extensions were for 12 month periods and there was an absence of project descriptions. This was because Allianz wanted to retain the services of Mr Spencer indefinitely.

The Tribunal set out what it considered to be a realistic contract worker situation, viz:

• an individual has a particular area of expertise;
• that area of expertise is one that he has found has not enabled him to gain full time employment;
• the explanation for not gaining full time employment is that the area of expertise is likely to be one that various companies might need but not on an indefinite basis, but rather simply to complete a particular project;
• the type of work for which the worker is engaged is likely to be work outside the core work of the business;
• the individual has only been able to gain work through rendering his specialist expertise available through placement agencies;
• the past pattern of work has confirmed all the above points of short engagements with different companies and many unwanted gaps between engagements;
• the area of expertise is likely to be one where the client would indicate the project to be done and the hoped-for time frame for completion of the project, but would not expect to be able to supervise or control the worker in any way, simply because the expert would be engaged to do something outside the expertise or competence of the company; and
• the company hiring the individual, engaging him for a project, would consider it quite inappropriate to provide holiday pay, pension benefit and the other normal incidents of employment because they would all be inappropriate for such contract workers.

Substitution

JLJS’s contract with the agency provided the following substitution clause:

“ The services shall be performed by the Contractor. However, the Company may send a substitute of equal experience and ability to perform the Services as set out in the Schedule. In the event of a change, the Company and/or the Contractor shall submit to Highams the names of suitably qualified substitutes and shall permit the Client an opportunity to interview such proposed substitutes.”

Mr Spencer attached some importance to this clause, arguing that if he was ill or unable to carry out the work for a period of time, the ability to offer a replacement worker would protect his company’s continuing ability to retain its contract. Although JLJS did not have any other employee’s, Mr Spencer knew of two people who possessed the requisite experience.

Two Allianz employees, appearing as witnesses for HMRC, indicated that they would have discretion in the interview process as to whether to accept any proposed substitute. Furthermore, they also said that they would look to Allianz’s normal supplier, Omni, to provide a replacement worker and that it would take any substitute three weeks to be of any use, since the substitute would have to learn much about Allianz’s existing procedures and systems. One of the witnesses also said that he was unaware of the existence of the substitution clauses which contradicted his view that he had expressed in earlier interviews with HMRC. The Tribunal, however, did not consider this to be an indication of dishonesty but rather an exhibition of a realistic businessman’s contempt for a clause that he probably found irrelevant.

The Tribunal considered that the contractual substitution clause was unrealistic as a replacement worker could not be offered short term as it would take a replacement three weeks to be of any use. This meant that a substitute could only be realistically used where absence was for a long period but even this appeared implausible to the Tribunal. Rather alarmingly, the judge concluded that even though Mr Spencer knew of two suitable candidates they would probably have existing engagements or be working or living some distance away. Even if one of them had been available they may not been able or even have wished to provide their services.

In seven years no substitute was ever offered.

Right of substitution was considered irrelevant “window dressing” and therefore bore no influence in the Tribunal’s decision. 

Control

Two clauses appeared in the JLJS/Higham contract relating to “rights of control” but their emphasis was principally on regulations and health and safety.

As Mr Spencer was an expert in his field, there was little intervention with the day-to-day work that John Spencer was doing. Allianz would naturally enquire about progress, particularly if a project was overrunning.

If some emergency arose, Allianz testified that they could require the contractor to pause work on a particular project if some other matter needed to be attended to first.

Although Mr Spencer did not believe there was any quality control at Allianz or at least the type he had been used to in his career, the Tribunal believed there would have been sufficient quality control for the management to derive confidence that Mr Spencer was capable to accomplish the project work.  Nobody within the company would have possessed the detailed knowledge of Mr Spencer’s field of expertise to be able to critically assess his methodology.

The contracts were silent about working hours, although the reality was that this was a flexible arrangement. Up until mid 2004, Mr Spencer worked five days a week for generally 37 ½ hours. He then moved home from Harlow to Somerset and reduced his working week to three days but was expected to work 22 ½ hours per week.

During his time at Allianz, the end client introduced a time sheet system which their employees were required to complete and allocate their time to particular matters and projects for the purposes of cost control. Although Mr Spencer was also required to participate in this system, JLJS was still paid in accordance with the invoices they submitted to the agency.

Mr Spencer almost always worked at Allianz’s offices at Guildford and did virtually no work at home.

The Tribunal accepted that in the early period of the contract when Mr Spencer was engaged for a single project and for defined projects thereafter, the contractor was using his expertise in a manner that could not be controlled in the sense of “how” he did his work. Control over his work was therefore limited.

At the end of 2003 however, Allianz wanted Mr Spencer’s services on a permanent basis. They no longer engaged him on projects but rather on an annual basis and as such he became one of Allianz’s key computer experts, available for work that was likely to be available indefinitely. As such, the control argument became stronger. 

Mutuality of obligations (MOO)

As far as Judge Howard Nowlan was concerned, the wealth of case law in surrounding this test progressively indicated that MOO is of diminished importance or nearly meaningless!

Judge Nowlan stated that a feature of being an employee is the hope and expectation that there will be some relationship of faithfulness between employer and employee. An employer will generally endeavour to keep staff employed even when work is short. Contractors will be dispensed with first. With short term engagements none of this is relevant to contractors and certainly in the earlier years Mr Spencer never knew whether various contracts would be renewed.

Integration

Mr Spencer paid for meals, even the Christmas lunch, whereas staff enjoyed certain benefits in this regard.

Business on own account, financial risk & provision of own equipment

Due to computer security reasons, John Spencer could not attach his own laptop to the company’s systems and it was accepted that he would work almost entirely with Allianz equipment.

If John Spencer ever used his own vehicle on Allianz business, he was not reimbursed for any costs.

As JLJS were paid by the hour there was no opportunity to make more or less profit regardless of company efficiencies.

The only business or financial risk referred to was that, in the event of the agency becoming insolvent, JLJS would not be paid for work done by Mr Spencer. The Tribunal rejected this argument.

Other factors

Allianz had extraneous reason for preferring to engage Mr Spencer as a contractor rather than an employee, which took on more relevance when John Spencer reduced his working time after 2003. This was because Allianz’s German parent company laid down internal rules for the numbers of strict staff numbers who could be engaged in certain areas of the business and when 1 ½ staff members were designated as permitted for a particular area in which Mr Spencer was working, it was highly convenient that, as a contractor, he could be excluded from the headcount.

JLJS, who were represented by Clearsky Accounting, had retained funds of only around £2,000 after it had paid for the costs of the appeal, highlighting the importance of fee protection and tax loss insurance.