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Thousands of IT contractors could be in line to receive a six-figure compensation payout caused by ongoing confusion over who pays employers’ national insurance contributions (NICs) on the work they do.
A series of group litigations are being prepared to secure compensation from employment agencies or umbrella companies that have unlawfully deducted employers’ NI from contractors’ gross pay since the roll-out of the IR35 tax-avoidance reforms to the public sector in April 2017.
The reforms introduced changes that mean limited company, or personal service company (PSC), contractors are no longer required to cover the cost of employers’ NI on assignments that are deemed in-scope of the IR35 rules – but there is mounting evidence to suggest that many have, and still are.
Litigators estimate that thousands of contractors from various sectors have erroneously had employers’ NI deducted from their pay since the public sector IR35 reforms came into play, with IT contractors among those left most out of pocket by the practice.
Umbrella companies, employment agencies and even potentially end-clients could be targeted by litigators intent on reimbursing contractors who have seen their take-home pay unlawfully reduced in this way.
The financial fallout from these legal actions could be massive, with experts predicting that some of the firms targeted will have no choice but to declare themselves insolvent – particularly if, as predicted, news of these legal actions emboldens other contractors to join group litigations or pursue separate claims of their own.
And with the government on course to extend the reforms to the private sector from 6 April 2021, there are concerns that thousands more contractors could soon fall victim to unlawful deductions.
“The whole employers’ NI issue has been the elephant in the room ever since the legislation took effect in the public sector back in April 2017,” said industry watcher Dave Chaplin, CEO of contractor tax compliance software provider IR35 Shield. “Firms got it wrong then and will do so again when the new tax rules hit the private sector in a matter of weeks.”
Where the law stands on employers’ NI
Once the IR35 reforms take effect, responsibility for covering the cost of employers’ NI at 13.8% is shifted onto the employment agency that pays the contractor’s PSC for the work they have done. Or, if the agency outsources its payroll responsibilities to a PAYE umbrella company, that company pays it.
“Any [private sector] contract that overlaps and continues after 6 April 2021, for which the client hands an inside-IR35 assessment to the agency, will generate a considerable extra unplanned cost for the agency,” said Chaplin.
“The agency will incur 13.8% employers’ NI on top of the contract rate, which they will have to fund because it cannot be lawfully deducted from the contract rate. For contractors who are outside IR35, the issue does not arise.”
HMRC’s off-payroll working guidance states that contractor day rates can be negotiated up or down to accommodate the added cost of employers’ NI. However, it is not lawful for employers’ NI to be deducted by the umbrella or agency from a fee that has already been agreed.
Therefore, if an uplift or reduction in the contractor’s day rate to cover the cost of employers’ NI has not been agreed, and the umbrella or employment agency deducts 13.8% from their gross pay, that would be classified as an unlawful deduction.
“Under the old regime, it is correct that employers’ NI was a deduction from the contractor’s fees, but under the new regime, the employers’ NI is paid on top of the contractor’s fees, by the fee payer – so this needs to be factored into agency margins to avoid unlawful deductions,” said Chaplin.
“However, if the agency dictates that the contractor will be paid less to account for employers’ NI, that could be challenged as an indirect recovery and an unlawful deduction.”
For this reason, said Chaplin, it is critically important that all private sector contractors that receive an inside-IR35 determination in the run-up to 6 April 2021 are paid in accordance with the new rules.
“This is the time bomb waiting for agencies that have contractors on their books as things transition in April 2021,” he said. “If the client passes the agency a status determination statement that says ‘inside IR35’, then the agency [or umbrella] is the fee-payer and has to magically find the 13.8% on top of the rate to pay, and pay it to HMRC to avoid evading tax.
“This is the reason all contract rates for inside-IR35 contractors need to be renegotiated prior to April 2021 [to accommodate the 13.8%]. This also presents danger, because if the negotiation starts with ‘we need to deduct employers’ NI’, then once again it is indirect recovery.”
Recouping the money unlawfully deducted from contractors’ pay in this way is what litigators are in the process of pursuing through group actions and legal challenges against the agencies and umbrella companies responsible.
“This is a multimillion-pound nuclear tax bomb waiting to go off that could force many agencies or umbrellas into bankruptcy, simply because the amount of tax at stake is more than the margins they charge,” said Chaplin.
To this point, the average umbrella company will charge an admin fee of between £20 and £30 and operate on margins of around 2%, making it impossible for them to cover the cost of employers’ NI without operating at a loss.
“If half of the 180,000 contractors [HMRC is targeting with the private sector IR35 reforms] ended up with a valid claim for unlawful deductions, of say £5,000 each, that’s a £450m claim,” said Chaplin.
“And that’s just the new contractors entering the umbrella market [because of the reforms]. The total market for umbrella workers is more like five times that number. We could be talking about litigation cases being brought to a total value of over £1bn, so it’s no wonder the litigators are circling.”
Group litigations under way
One of these litigators is City of London-based law firm McFaddens, which debuted its Umbrella Reclaim offshoot in October 2020 to help contractors claw back money they have lost through unlawful deductions. It plans to do this by launching group actions against the umbrella companies responsible.
Speaking to Computer Weekly, Umbrella Reclaim legal executive Robert Thompson said more than 1,200 contractors have joined its group litigations since launch from a variety of sectors, including construction, healthcare and IT.
“We always thought it was going to be acorns growing into oak trees and the floodgates wouldn’t open overnight, but it’s actually exceeded all our expectations,” said Thompson. “People join up, they go to work and they speak to their colleagues, and it all grows from word of mouth.”
Some of the sums being sought by Umbrella Reclaim on behalf of its clients are sizeable, particularly those involving IT contractors, he added.
“We have clients who have been with an umbrella company for six years,” said Thompson. “Under the law of tort, they can go back six years. Some of these claims against the umbrella companies, seeking reimbursement of employers’ NI and other costs, are substantial – especially for IT workers, because they are large earners.”
For example, Thompson cited a six-figure claim for unlawful deductions that the company is currently pursuing through its group actions on behalf of an IT contractor.
“That claim is for £150,000,” he said. “One could – and we will attempt to – add statutory interest on top of that. The courts say you can get 8%, plus the Bank of England base rate on top. With the interest and everything else factored in, that claim could reach a value of up to £200,000.”
Given the notoriously thin margins that umbrella companies are renowned for operating on, Thompson conceded there was a high chance that any of the firms targeted by Umbrella Reclaim’s group litigation efforts would declare themselves bankrupt as a result.
“There are no two ways about that,” he said. “The average fee an umbrella company charges is £25 a week, so how are they going to suddenly bear the cost of a group claim for employers’ NI? They won’t – they’ll go into liquidation.”
When that happens, the employment agency that arranged the placement for the contractor in the first place could end up being the group claim’s target. “There is a legal precedent for that,” said Thompson.
As proof of that, he cited a 2018 Unite union employment appeal tribunal victory that saw a contractor receive a £2,500 settlement for unlawful deductions from the agency that employed him after the umbrella company through which he provided his services went bust.
“This shows it can go up the labour supply chain,” he said. “Potentially even to the end-client because they have, in the main, forced contractors to use the umbrella companies.
“Think of all the instances where companies have responded to the IR35 reforms and unilaterally stated, ‘We’re not going to allow our agencies to engage with personal service companies – we will only allow them to engage through an umbrella company’.”
Robert Thompson, Umbrella Reclaim
Computer Weekly has reported on numerous cases where IT contractors working in the financial services, pharmaceutical, communications, utilities and technology sectors have been told their end-clients will cease engaging PSCs from April 2021 as part of their IR35 compliance strategies.
In almost all of these cases, the firms in question have told contractors they can either apply for a permanent role with the firm or provide their services through an umbrella company.
The number of contractors working through umbrella companies is predicted to soar on the back of the private sector IR35 reforms coming into play, which is what happened when the same changes were introduced in the public sector in April 2017. This, in turn, is likely to result in many more contractors suffering unlawful deductions, said Thompson.
“We have had a substantial number of workers working in the NHS who were forced to use an umbrella company, and that coincided with the public sector [IR35] changes in 2017,” he said.
“More recently, we are getting numerous calls from people affected by the changes currently where they are being forced, against their choice, to utilise an umbrella company. This area is growing every day from disgruntled contractors.”
The scenario set out by Thompson, whereby an umbrella company goes bust and the legal action ends up targeting the end-client or employment agency, is entirely possible, said Alexander Wilson, barrister and chartered tax adviser at Altrincham-based consultancy ETC Tax.
“If a significant class action developed, the advisers for that action will see that the umbrella company doesn’t have the resources to meet the claim because the margins for an umbrella company are tiny,” he said. “You don’t pursue someone in the civil courts if they don’t have the money. It’s a waste of time and effort. You go after someone who does have the money – and that’s the end-client.”
That might require some “legal contortions” with respect to establishing that the employment contract between the contractor and the umbrella company is really – as Wilson termed it – “a vicarious contract with the end-client” which makes them the employer.
“That is entirely achievable,” he said. “I suspect a lot of end-clients think they are insulated against claims because the umbrella employer is the employer on paper, but I think they will have a sharp awakening at some point.”
Clearing up the payment chain
Ahead of the private sector reforms coming into play, Computer Weekly has received sample copies from inside-IR35 contractors of the pay breakdowns given to them by the umbrella companies that their end-clients are insisting they work through from April 2021.
In many of the examples Computer Weekly has seen, a day rate has been agreed between the contractor and the agency. This often comes with assurances that employers’ NI will be paid on top of the agreed fee by either the agency or the umbrella company. But when the contractor’s payslip comes through, employers’ NI is listed among the deductions.
One IT contractor, who spoke to Computer Weekly on condition of anonymity, said: “I was told by my agency contact that employers’ NI should be added to my day rate, which is compliant with the incoming changes under the IR35 reforms, but if it wasn’t added to the day rate by the agency, then it would be my responsibility.”
When presented with an illustrative breakdown of their take-home pay, the contractor noted that employers’ NI was listed among the deductions.
When asked if they had challenged the deduction on the grounds that it is unlawful, the contractor referred Computer Weekly back to the agency’s original response that if employers’ NI is not added to the day rate, then it becomes the contractor’s responsibility, which is not the case at all.
Many IT contractors who have experienced unlawful deductions admitted to Computer Weekly that they were reluctant to query the matter out of concern that the agency or end-client might pull their contract.
Wilson said he understood their reluctance to speak up. “Workers aren’t going to rock the boat while they’ve got the latest project on the go – they’re going to wait until they’ve finished it, especially where this has been done by some large umbrellas [or agencies] with tens of thousands of contractors on their books,” he said.
At the same time, there are likely to be other contractors out there who are unaware that picking up the tab for employers’ NI is not their responsibility, so don’t think to query it, said Wilson. “The level of awareness about this is very high among contractors generally, but where you see less awareness is at the lower-paid end of the market,” he added.
“For example, where people take a role through an agency, and they’re given a rate, and they receive their pay packet but maybe do not look at it too closely.”
Improving the chain payment transparency
The government made it a legal requirement in April 2020 that employment agencies must provide contractors with a key information document that sets out how they will be paid, including details of any deductions that will be made. This is supposed to prevent scenarios like the one Wilson describes above playing out – but few agencies appear to be doing this.
According to research published in January 2021 by IR35 Shield, which featured responses from more than 3,000 contractors, 86% said their agency had never provided them with such a document – and 67% said they did not even know what a key information document was.
Whether or not that is because the agencies themselves are unaware of their obligations is unclear, but – either way – there is no getting away from the fact that the problem of unlawful deductions is endemic, said Wilson.
“The practice [of unlawful deductions] is widespread – extremely widespread,” he said, “to the extent that the umbrella companies and agencies that are operating completely properly seem to be the exception rather than the norm.”
As for why that is, Wilson said it could be a case of “ignorance” about where liability for employers’ NI is supposed to lie. “There is a level of ignorance,” he said. “Whether that is feigned ignorance, a ‘don’t mention the war’ kind of ignorance or genuine ignorance, I don’t know. I suspect it’s probably a blend.”
Essentially, though, employers’ NI is a hot potato that no one in the extended labour supply chain wants to end up holding, and end-clients, agencies and umbrella companies seem to hope that ignoring the issue will make it the contractors’ problem.
As an example of this, Wilson referred to a case he was involved in where an end-client had accepted the contractor’s agreed rate before telling them they would need to provide their services through an umbrella, which then went on to deduct employers’ NI from the agreed rate.
“The contractor complained to the agency and to the employer,” said Wilson. “The agency referred him back to the client, and the client referred him back to the agency, and it felt very much like both parties were burying their head in the sand.
“The agency didn’t want to lose the contract and didn’t want to tell the end-client that – strictly speaking – they would have to stump up the extra cash for employers’ NI. The end-client didn’t want to increase the cost of the project’s budget, and it is the contractor that usually gets stuck in the middle of all that.”
In such situations, contractors have the option to pursue legal action, said Wilson. They could file a claim for breach of contract that – depending on its value – could play out in either the county or high court.
“There you would be arguing in basic terms that there is an implied term for the contract that the worker bear the cost of the employers’ NI, which cannot be a lawful term,” he said. “So the court is bound to strike that term out and then apply a contract as though that term hadn’t existed.
“It’s slightly tortuous, but it seems to be quite valid. When I have represented in the past, it has been in the county court on that basis, effectively. No cases have gone to conclusion. It’s all been settled out of court, and the workers involved have received payments to recompense them for unlawful deductions.”
Contractors could take their case to an employment tribunal and make a “straightforward claim” for the unlawful deduction of wages, added Wilson.
Prevention better than cure
Although there is legal recourse for contractors that have lost money through unlawful employers’ NI deductions, is there any corrective action that can be taken now to prevent more people falling victim to this practice in future?
Wilson is of the view that HMRC’s guidance on the matter could do with tightening up, because its current wording could be open to misinterpretation.
“The guidance that’s out there on this is that it’s unlawful to deduct employers’ NI, so you may wish to renegotiate the rate, but this could lead to instances of indirect recovery,” he said.
On that point, HMRC published a comprehensive update to its Employment status manual in early March 2021 that sought to flesh out its guidance on where liability for employers’ NI should fall within the context of the incoming IR35 reforms.
The previous month, however, HMRC apologised to attendees of a recent educational webinar for any confusion it may have caused after it neglected to include employers’ NI in an example shared during the session, setting out how chain payments work within the labour supply chain when the IR35 rules apply.
This serves to highlight just how complex this issue is, said IR35 Shield’s Chaplin, if the government agency overseeing the reforms is also struggling to grasp how employers’ NI should work.
“HMRC has not educated the market very well on the employers’ NI issue and needs to act very quickly to improve its guidance in this area,” he added.
Computer Weekly put these claims to an HMRC spokesperson, who said the government department was “continuously enhancing” its “comprehensive education, support and outreach programme for the off-payroll working changes, based on stakeholder feedback”.
However, HMRC did concede that more could be done to make it clear how pay negotiations around employers’ NI should be handled, and said it would address this in due course.
“Our guidance explicitly states that employer national insurance contributions cannot be deducted from the payment made by the deemed employer to the worker and we have highlighted this in recent messages to employers,” said the spokesperson.
“We acknowledge that this point could also be clearer on our simple off-payroll working explainer pages on Gov.uk We keep all our guidance under review and will make further amendments to ensure our pages are explicit on how employer NICs are paid.”
Another problem is that HMRC’s messaging about how things will change under the IR35 reforms focuses mainly on how firms in scope of the new rules will assume responsibility for how the contractors they engage with should be taxed. The shift in responsibility for who picks up the tab for employers’ NI is less talked about, said Chaplin.
Computer Weekly put this claim to HMRC, but it did not directly address it in its response.
“HMRC positioned the new legislation as nothing more than the client conducting the status assessment instead of the contractor,” said Chaplin. “But this is only part of the picture.”
The situation also serves to highlight why the umbrella company market needs to be more tightly regulated, he said, which is something the government has been under pressure to do for several years.
For instance, the 2017 “gig economy” review by former Tony Blair adviser Matthew Taylor called for umbrella companies to be regulated more strictly, in response to complaints by contractors about the difficulties they faced when trying to resolve disputes with these firms about their pay and benefits.
Chaplin added: “[Contracting] stakeholders have been spelling out the problem [of employers’ NI] to HM Treasury for years, and pressing for the urgency to regulate the umbrella market, but our pleas have fallen on deaf ears.”
The Department for Business, Energy and Industrial Strategy (BEIS) ran a three-month consultation in 2019 about its plans to create a new single labour market enforcement body that would oversee the regulation of umbrella companies. The outcome of that consultation is yet to be made public, and a BEIS spokesperson confirmed to Computer Weekly that the results of the exercise are still being analysed.
Any regulation resulting from this consultation should focus on improving the transparency and communication between entities within the extended end-client-to-contractor supply chain, said Crawford Temple, CEO of Professional Passport, whose firm assesses payment intermediaries for compliance purposes.
“It is vital that umbrellas work to ensure that contractors are provided with clear information about their payment terms and what they can expect,” he said.
This is why the legal requirement for employment agencies to provide contractors with a key information document was introduced in April 2020, said Temple – but there is still work to be done to ensure contractors are educated properly about how they should be taxed.
“Under the new tax rules, there will be many contractors working through umbrellas for the first time and I would urge them to familiarise themselves with the key terms of umbrella working,” he said. “Contractual terms offered by umbrella companies do vary, so it is important to read and understand those terms.
“One of the main issues is lack of clarity on rates offered. Agencies often present the rate without any form of explanation and it is essential that the umbrella, in its communication with the contractor, makes it clear that this is the rate paid to the umbrella and not what the worker receives.”
With the IR35 reforms now just weeks away from taking effect in the private sector, and the threat of legal action looming large over agencies and umbrella companies, the best thing for all concerned to do right now is make sure they know who is liable for employers’ NI and that those deductions are taken correctly, said Chaplin.
“Either the client pays more, and some will, or the contractor agrees to take a pay cut,” he added. “However, if the agency dictates that the contractor will be paid less to account for employers’ NI, that could be challenged as an indirect recovery and an unlawful deduction.”