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Contractors Beware Dragonfly Consulting Case

Newsletter issue - October 08.

Many independent workers offer their personal services through their own companies for a variety of reasons. They don't want to be tied into one company as an employee, and using their own limited company allows them to have more control over the tax they pay. The final customer often prefers this arrangement, as they are not treated as the worker's employer, so don't have to be bothered with the various employment regulations.

So everyone is happy except the Tax Inspector who collects less tax and NI. The Inspector can question the relationship between the client and the worker, and if he decides that it is really one of employee and employer, in spite of all the various contracts, agency and service company in place, the extra tax due will fall on the worker's own company. This is collected through either the Personal Service Company rules (known as IR35) or the Managed Service Company regulations (MSC).

If this set-up is familiar to you, but you are feeling smug because you have an 'IR35 proof' contract, you may need to think again. The recent tax case Dragonfly Consulting Ltd demonstrated how the contract between the agency and the final client can knock for six any clever contract drawn up between the worker's company and the agency. HMRC have proved that the entire stream of contracts needs to be considered and compared to what actually happens on the ground.

The key legal point to prove is whether the worker is independent. If the worker can substitute another person to complete the tasks for the client, he is considered to be independent and IR35 will not normally apply. The agency may agree to include a substitution clause in the contract with the worker's company, but if this clause is not reflected in the contract with the final client it is ineffective. Even if a substitution clause does exist in the agency/client contract it will be ignored if the client tells HMRC or the tax tribunal that it would never actually accept a substitute for the worker.

To ensure your working arrangement with your client will stand up to challenge by HMRC you need to see all the contracts in the chain, and be sure your client would agree to accepting a substitute if asked to.