Employment Status – Expensive If You Get It Wrong!

Jennifer Adams considers some of the key factors in deciding whether someone is employed or self-employed.

The question whether or not a worker is an employee is always a hot topic for HM Revenue & Customs (HMRC). Checking that employers have correctly determined the employment status of the persons who work for or with a business is one of the prime checks carried out by HMRC during a PAYE compliance visit. Getting it wrong can be expensive because should a business treat a worker as self-employed when he is really an employee then the tax risk falls on the business, not the worker. The factors relevant in deciding the employment status of any one individual can be complex; therefore this article covers the basics only. For specific problems, specialist advice is recommended. 

Many answer this question by considering the financial aspect only. Readers will already know the different tax and NIC treatments attached to employment in comparison with self-employment. However, the distinction is vital generally since, for example, only employees qualify for social security payments, employment protection rights, protection of wages on their employer's insolvency, the benefit of their employer's common law duty of care, and protection under the health and safety legislation.

The issue as to whether a worker is employed or self-employed is often unclear; the reason being that ‘self-employment’ is not defined in statutory law. This lack of clarity has resulted in numerous Court cases over the years and although some HMRC officers would like to think that tax law is of primary importance when deciding employment status, the reality is that invariably, it is employment law that takes the lead. From those cases various indicators have been established, pointing towards either a ‘contract of service’ (employment) or a ‘contract for services’ (self-employment). The subject has been deemed so relevant that HMRC have produced a separate manual on the subject - the Employment Status manual (www.hmrc.gov.uk/manuals/esmmanual/index.htm).

The main case that is nearly always referred to in a case concerning employment status is Ready-Mix Concrete (South East) Limited v Minster of Pensions and National Insurance [1968] 2 QB 497. HMRC consider this case to be so important that its details are reproduced in HMRC’s Employment Status manual (www.hmrc.gov.uk/manuals/esmmanual/esm7030.htm).

In that case, the judge stated that for there to be a contract of employment, three conditions (tests) must be present:

(i) mutuality of obligation test; 

(ii) control test; and  

(iii) economic reality test (specifically: ‘The other provisions of the contract are consistent with it being a ‘contract of service’’). 

It is important to note that the judge in this case was only considering whether the worker was an employee and not the specific question as to whether the worker was employed or self-employed. 

(i) Mutuality of obligation test – The employee agrees to provide his own work and skill in the performance of service for his employer in exchange for remuneration.  Whether the employer must pay the employee irrespective of whether there is work or not has been considered in a number of cases, each being decided on its own merits, such that there is no hard and fast rule. However, the emphasis has invariably been that the employer should provide work or pay money should no work be available and the employee, in turn, is obliged to perform the work himself however long or short a time that takes.

(ii) Control test - the employee agrees that in performing the service he will undertake the work under instruction of the person who has engaged him to a sufficient degree to make that person the employer. The worker must be under contract to provide a personal service, giving their own time and effort in doing so. Where unrestricted substitution is possible the contract is strictly not one of personal service because it can apply to someone else; thus the contract should not be classed as employment. However, the courts have sometimes ruled that the occasional power of delegation need not prevent a worker from being deemed employed (see the Employment Tribunals case MacFarlane v Glasgow (www.bailii.org/cgi-bin/markup.cgi?doc=/uk/cases/UKEAT/2000/1277_99_1705.html&query=MacFarlane+and+v+and+Glasgow&method=boolean)).

The level of control need not necessarily be very high but it is important that there is some degree.

This is a recent case, but again is not a tax case rather one heard by the Employment Appeal Tribunal. It was held that an employer does not have to exercise day to day control for there to be an employment relationship.

The claimants were caretakers of a small estate in Surrey. The owners only visited the estate about twice a year. In between their visits the claimants looked after the grounds and did various other jobs. There were no fixed hours or arrangements, but there was a written agreement between the parties wherein there were references to ‘employment’.

It was held the fact that the owners had relinquished day-to-day control to the two claimants was not conclusive of the fact that the owners had no control. They had a contractual right to control, whether they chose to exercise it or not. 

(iii) Economic reality test – The important point to note here is that the first two tests must be passed first; then attention is turned to this, the third and final test. This test is to decide whether the worker is in business on his own account and as such the courts will look as such questions such as whether the worker used his own equipment, was able to make a profit from the work, whether he was obliged to make good any defects in work, whether he has indemnity insurance, etc. However, one or all of these factors being present need not mean that the worker is self-employed – the overall picture needs to be considered.

An outsider’s view is important.  Recent tribunal hearings have taken account how an outsider might view the arrangement between the worker and the business to whom services are being provided. Does the worker seem to be just one of the employees to an outsider?  For example, is their name on the internal or external staff telephone or e-mail list or even the staff circulation list for the firm's Christmas party? (they may be invited but it should be by separate invite).

As well as written guidance, HMRC has also placed an employment status indicator (ESI) tool online (www.hmrc.gov.uk/calcs/esi-01.htm). The ESI requires completion of an online questionnaire about the terms and conditions applying to a worker and the work undertaken. 

With the subject of employment status being so complex it is unwise to rely solely on the ESI tool as the definitive answer. However, it can be useful in showing the type of questions HMRC are likely to ask. The tool is not without its limitations, as it cannot be used to check the employment status of a number of types of workers, including company directors, agency workers, and entertainers.