Key Differences between Self-Employed and Employees
From 6 April 2021, changes will be introduced to the IR35 rules. These changes will make private companies responsible for assessing the status of the individuals they engage as contractors for the purpose of calculating income tax and national insurance contributions.
In our previous article, which can be found here, we discussed these changes in more detail and considered the impact the changes may have on private companies and what affected companies can do to address the changes.
With so much discussion and in some cases, concern around the implementation of the IR35 changes, we thought it would be helpful to summarise more broadly the key differences between being an employee vs being self-employed for the purpose of calculating tax liability.
Employment status – Why does it matter?
Employment status is important both in respect of working out what statutory rights an individual is entitled to for the purposes of employment law and in respect assessing an individual for tax purposes.
For an individual, only those who are classified as “employees” for the purpose of employment law benefit from rights to claim unfair dismissal, maternity leave and redundancy rights. If they are assessed from a tax perspective as being self-employed then the employee will be responsible for paying tax on their earnings directly to HM Revenue and Customs (HMRC), whereas an employee would be taxed on their earnings via deductions made by the engaging company.
Whilst an individual who is wrongly assessed may be liable for unpaid taxes, in light of the upcoming changes to the IR35 rules, the onus will fall to the company to complete the assessment of an individual and the company will be liable for failures relating to that assessment.
In this article we do not consider employment law in any detail but it is worth noting that being “self-employed” from a tax perspective does not preclude a person from being considered an “employee” for the employment law purposes. Meaning it is possible for HMRC to assess a person as self-employed for the purpose of tax, but an employment tribunal could on the same facts reach a different conclusion for the purpose of assessing whether an individual is entitled to certain employment rights.
We have not covered employment rights in any detail within this article but the principles for assessing employment status are broadly the same.
Employee vs. Self-Employed – What are the differences?
Under the Employment Rights Act 1996, an ’employee’ is defined as an individual who has entered into or works under (or, where they are no longer employed, who previously worked under) a ‘contract of employment’. For these purposes, a ‘contract of employment’ is defined as a contract of service or apprenticeship, whether express or implied, and (if it is express) whether oral or in writing.
Whilst this is starting point, there is no clear definition of or checklist of requirements which determine whether someone is employed or not employed, the relevant factors have instead been established through a number of cases on the subject.
Helpfully, HMRC has provided extensive guidance in its Employment Status Manual relating to determining employment status for tax purposes and provided a (non-exhaustive) list of factors it deems relevant to such assessment.
It is important to remember that assessments should be made on a case by case basis, considering each of the relevant factors and the weight given to each will be case dependant. This is particularly relevant in IR35 assessments because there is restriction on making group assessments of employees who appear to all be in the same position (known as “blanket” assessments under the IR35 rules).
When assessing whether an individual is an employee or self-employed, the following factors need to be considered:
The key question is whether the engager holds any right to control what work an individual does, where that work is done, when the work is done or how it must be done. If the individual has complete control over these aspects it is likely that he is not engaged under an employment contract. It may be less clear in examples where a skilled worker is given more flexibility over their work on grounds of their experience and the trust placed in that by the engager.
HMRC makes it clear that it is the existence of a right to control that is relevant to an assessment and not whether the engager actually exercises this right. Ultimately, the more control an engager has (whether or not exercised) the more likely that an employment contract exists for the purpose of this test.
There have been numerous cases which have considered the significance of control in determining employment status and it has long been held that it is an essential and necessary consideration (Ready Mixed Concrete (South East) Ltd v Minister of Pensions and National Insurance  2QB497) although, as with other factors, it will not be conclusive on its own.
2. Personal service
Is the individual obligated to carry out the work themselves or is that individual free to hire someone to do it, or is there a right to use a substitute to carry out the work. If the contract simply provides that the work must be done, and not specifically by the individual then this is less likely to meet the requirement of “personal service”.
The right of substitution may not necessarily meet the test for self-employed where an engager can limit the choice of substitution or there are other limitations such as circumstances, in which the right can be exercised by the individual.
HMRC guidance confirms that it is the existence of a right to substitute that is important not whether the right is exercised. However, the right of substitution must be genuine, i.e. if the engager can veto or limit the choice of substitution the right is unlikely to be genuine and this will add weight to finding an employment contract.
The relevant question is whether the individual uses their own equipment in carrying out the work and if they do, whether that equipment is essential. Where an individual provides equipment that is essential or fundamental in carrying out the work, it is more likely that they are self-employed. For example, the fact that lorry drivers were using their own vehicles was fundamental in deciding that they were not employees (Ready Mixed Concrete (South East) Ltd v The Minister of Pensions). However, the significance of this test on the overall assessment of employment status will differ according to different industries. The application of this test in circumstances where smaller equipment is involved has proven less helpful to the overall assessment in most cases meaning that in most cases, it is not sufficient to rely solely on this as a factor towards being self-employed.
4. Financial risk
This relates to the level of financial risk that the individual faces in doing the work. Essentially, the greater the financial risk the more likely it is that the individual is self-employed whereas those who are employees are not usually required to risk their own capital (investment as a shareholder is, according to HMRC, irrelevant).
Another consideration is how errors or mistakes are corrected. If an individual is required to fix any failures or mistakes in their own time and receives no payment for carrying out this correctional work then this points towards self-employment.
According to HMRC guidance, it is not the case that an absence of financial risk always indicates that an individual is an employee, nor does an absence of business organisation (a factor which was relevant in the finding by a court that session musicians, who did not risk their own capital, were freelance musicians).
5. Basis of payment
How an individual is paid and how often is one consideration of whether an individual is an employee. The general principle is that where an individual is paid a salary or fixed wage on a monthly (or weekly) basis, this will point towards that individual being an employee. Similarly, any additional payments such as overtime, long-term bonus or profit share will also be relevant. Whereas, contractors are often paid a fixed sum for a particular job.
Basis of payment should not be relied on solely for the purposes of assessing employment status as it can often be inconclusive when considered in silo. For example, there are examples of self-employed individuals who receive an hourly rate for their time and those who are employed who are paid by commission but equally have to meet expenses (financial risk) to carry out the work.
6. Mutuality of obligation
Put simply, where there is an absence of mutual obligation, there can be no contract between the parties and it is therefore impossible to determine employment status. There are two elements to the test of mutual obligation:
- the engager must be required to pay some form of remuneration; and
- the individual must be obliged to provide his or her own work or skill.
It is worth noting that these elements will form part of both a contract of service (for employees) and a contract for services (for those self-employed). Accordingly, as mentioned above, this is simply a starting point and not a sole indicator of one or the other. It bears no relevance to the mutuality of obligation, whether the individual is required to accept work, if offered, or whether the engager is obliged to offer it (Stephenson v Delphi Diesel Systems Ltd  ICR 471).
If you are able to establish the existence of a contract then you apply what HMRC refers to as the irreducible minimum requirements to see if the contract is one of employment. If the test fails then this points towards a contract for services. The irreducible minimum requirements of a contract of employment are:
- mutuality of obligation (as above);
- a sufficient degree of control by the engager (see point 1 above); and
- other elements of the contract being consistent with a contract of employment.
7. Holiday Pay, Sick Pay and Pension Rights
In relation to holiday pay, in most instances rights to paid leave under a contract will normally point to a contract of employment. The exceptions to this include where there are no rights to paid leave because the contract is a short-term contract or where rights exist pursuant to the Working Time Regulations (employed and self-employed workers may acquire paid leave rights where they are continually engaged for 13 weeks).
Statutory Sick Pay (SSP), Statutory Maternity Pay and pension rights are all employment rights which accrue if a person is employed, as such they are not indicators of employment.
The availability of SSP, only shows the intention of the parties, it is not a test for employment status. If a contract is later found to be one of employment, the right to SSP will follow.
Where a person is not entitled to sick pay, maternity rights and/or a pension scheme this is not necessarily an indicator of employment status and may just be due to the nature of the engagement (e.g. it is short term and they will not accrue during the relevant period). The absence of these rights (particularly for short term contract) cannot therefore be relied on for the purpose of assessing employment status.
With regards to holiday and sick pay, maternity rights and pension rights, you cannot always rely on the absence or presence of these rights in determining employment status. In fact, the test is the reverse and it is employment status itself (and length of contract) which determines the availability of these rights.
8. Part and Parcel of the Organisation
The test for this factor was developed by the courts in 1950, but its significance has been reduced and the courts have moved away from it being an overall test for employment (given the vague nature of the test).
HMRC guidance provides that it should be obvious that a person is carrying on business outside and separate from the organisation. However, in other cases this particular element may be difficult to distinguish and it will be down to the individual factors of the engagement. For example, a person may be integral to a team but it may be harder to establish whether that person is integral to the organisation.
9. Right to Terminate a Contract
It is common for employment contracts to include the ability for the individual to terminate their employment by giving notice (absence a serious breach) but this is not conclusive to determine that the contract is an employment contract. Whereas a contract for services for a fixed period is unlikely to include a right to terminate due to the length of the contract, As such, where an individual has a right to terminate on notice, this can indicate they are engaged under a contract of employment but it is in no way conclusive.
10. Opportunity to Profit from Sound Management
In respect of an individual who is engaged under a contract of services, it is likely that there is a causal link between the efficiency and speed of work and the level of profit or loss. For example, if the individual charges a fixed fee, the profit received in respect of carrying out the relevant services will be reduced if it takes longer or they are not efficient in doing so. This could be affected by a number of different factors such as penalty clauses for certain failures or service levels and delivery targets, which are less common in employment contracts. Again, the presence of these factors are not conclusive for finding a contract of service and should be considered in conjunction with all of the other relevant factors.
11. Personal Factors
There will almost certainly be factors that will be relevant to an assessment of employment status that are personal to the individual and their circumstances and which fall outside of the contractual arrangement with the engager. As with many of the other factors, these will need to be considered alongside the other factors (to the extent they are applicable) above. How much weight may be given to personal factors will be case dependent.
An example of where personal factors played a part in the assessment of employment status is in the case of an actress. The actress was moving between a series of engagements which were not intended to last for her entire working life. In this example, each engagement was not considered employment but a “mere engagement in the course of exercising a profession” (Davies v Braithwaite 1931 18 TC 198).
The HMRC guidance looks at a few key cases on personal factors, in particular the way in which employment status may be affected by how an individual carries out their occupation. However, it makes it clear that it is the intention of the parties that will be of fundamental importance to the assessment of employment status. If the contract (being freely signed by both parties) purports to be one of employment, this will usually conclude any assessment (see further in section 13 below) and personal factors will not override this.
12. Length of Engagement
As mentioned above, generally speaking the longer the engagement the more likely it is that it will be a contract of employment. However, length of engagement cannot itself be the only factor in determining employment status.
Where an individual is engaged for a long period, it is likely that an engager will (or will want to) exercise more control over the individual, for example to move them between tasks. It is also more likely that other factors may be present after extended periods of engagement such as integration into the organisation or there may be personal factors which are relevant. As has already been made clear, any assessment of employment status will need to look at all of the relevant factors in each case.
13. Intention of the Parties
Whilst the intention of the parties is not in itself conclusive to determine employment status, it will play a fundamental part where the relationship is unclear and where other factors have proven to be neutral on the matter. The true reality of the relationship between the parties cannot be altered by the parties putting a label on status it however where the relationship is ambiguous then the parties can remove this ambiguity by the very agreement itself (Massey v Crown Life Insurance  1 WLR 676).
If, having considered all of the factors, you consider the relationship and therefore the employment status to be borderline or unclear, then at this stage it will be acceptable to look at the intention of the parties. The intention of the parties does not need to be considered unless there is ambiguity in the relationship.
14. Exclusive Services
It is not unusual for both a contract for services or an employment contract to contain an exclusivity clause whereby the individual is restricted from providing services to another company or person. The existence or presence of such a clause does not provide conclusive evidence of either and as such exclusivity clauses are not considered to be an overall test for employment status.
Ahead of the impending changes to the IR35 rules, sections 1-13 above should provide a short summary on the factors HMRC will consider when assessing the employment status of an individual. Essentially, however it will come down to a case by case assessment looking at all of the relevant factors. In our experience, when conducting an IR35 audit we have found that HRMC will ask a lot of practical questions about the nature of the relationship with a worker – even down to asking whether the person uses office stationery and whether they attend office social events.
We have found that this has caused some companies who use lots of consultants to try to apply a blanket approach to assessing consultants for taxation leading them all to be taxed as employees (an approach which is not permitted under the new IR35 rules). We would therefore recommend consultants in this scenario carrying out a contract review and putting together a note setting out all of the relevant circumstances of their contract. This, alongside a tax indemnity given in favour of the end company, could be used to help end companies in concluding that there is no deemed employment relationship.
As further detailed in our previous article detailing the IR35 changes, companies will now be required to provide status determination statements after carrying out an IR35 assessment, as such we would recommend contractors or those who are self-employed doing these contract reviews to ensure they accurately reflect the intended nature of the relationship with their engaging companies.
This article is intended for general information only, applies to the law at the time of publication, is not specific to the facts of your case and is not intended to be a replacement for legal advice. It is recommended that specific professional advice is sought before relying on any of the information given. © Jonathan Lea Limited 2023.
How To Produce A Status Determination Statement For IR35
From our shop
Freelance Consultancy Agreement