What is the impact of the off-payroll (IR35) changes on the VAT position for recruiters?

VAT expert, Scott Harwood, explores the interaction between VAT, IR35 and direct engagement and offers guidance for recruiters on how to mitigate their VAT risks.

Many recruiters use the model of introducing temporary workers who then engage directly with the end client. This model can be especially effective when the client has limited VAT recovery, because the worker will either be employed directly by the end client or work through their Personal Service Company (PSC) and operate below the VAT registration threshold. 

This approach is not always recognised or phrased as ‘direct engagement’ and may either appear via natural circumstances or could take the form of an offered scheme. As a result of the off-payroll working (IR35) changes, we are now finding that many temporary staff are being processed through the payroll. 

As most recruiters will be aware, the new IR35 rules can apply if a worker / contractor provides their services through their own limited company, or another type of intermediary, to the client. The IR35 rules try to ensure workers, who would have been taxed as employees if they were providing their services directly to the client, pay broadly the same Income Tax and National Insurance contributions as employees. 

In essence, if the worker looks and feels like an employee, they should be taxed as an employee. However, it is important to note that the IR35 rules do not make the worker a legal employee – they are simply taxed as if they were one. 

Is IR35 affecting the VAT position? 

Practical evidence suggests that IR35 is affecting the VAT position.

We have a growing number of recruiters who are discovering an unexpected VAT consequence. This is generally causing an effect in two main areas:

• Because the recruiter is having to recharge their costs as a principal, VAT is charged to the client by the recruiter. This can create a sticking VAT cost for the client and affect competition.
• VAT is being charged to the recruiter. This can cause some cash-flow concerns and result in a sticking VAT cost for the recruiter (for example, where they are operating the Nursing Agency Concession).

Furthermore, there seems to be a growing number of recruiters caught out by this effect. HMRC is raising assessments and retrospective adjustments are being made. A 20 per cent cost hike is far too much for most recruiters to manage, and we’ve seen a number of businesses go into administration.

Is it correct IR35 affects the VAT position?

Technically, IR35 doesn’t affect the VAT position. Application of IR35 alone should not affect whether VAT suddenly becomes chargeable or not. However, the VAT position could well change if arrangements or contracts have been altered as a result of IR35.

For example, if a PSC continues to engage directly with the end client, but the worker is regarded as inside IR35, there should still be a contractual supply (including for VAT purposes) from the PSC to the end client. The recruiter should not need to levy VAT solely on the basis the worker’s PSC fees have been processed via payroll on the PSC’s behalf.

However, using this same example, if the reality is the worker is now working through the recruiter, then the recruiter would need to charge and account for VAT to the end client unless any reliefs can apply.

What are the historic VAT risks?

If the IR35 tests now require the worker to be processed via payroll, and nothing else has changed, HMRC could potentially challenge the previous set of circumstances. Was the analysis of the previous arrangements correct, or were the services always provided by the recruiter as a principal (as opposed to introducing them as an agent)?

Furthermore, where VAT costs remain unidentified, this can accrue and result in a large financial hit with the risk of penalties for one or more of the parties.

What can recruiters do to protect their VAT risks?

Firstly, as a housekeeping exercise, it’s a good idea to review your contractual terms with workers and clients. Fees can be drafted as VAT inclusive or VAT exclusive. This important clause affects whether VAT can be passed on to a customer, or if it is instead paid by the recipient of the fees. Such clauses can also be overridden by any additional agreements between the parties, including emailed fee quotes. With suitable protective clauses in place, the ability to defend against any future HMRC direction is greatly improved. 

Secondly, it is very important to understand all the contractual arrangements in your own supply chain. This will give you confidence in your tax treatment, and may also allow you to explore other, more tax efficient, options. It is always difficult to defend against any HMRC enquiry if you’re on the back foot.

Summary

Rightly or wrongly, the changes to IR35 appear to be making VAT ripples throughout in the sector. There is no single correct answer on how best to mitigate VAT or tax risks due to the wide variety of contracting arrangements.

HMRC’s continued interest means it is very sensible to allocate some time and resources to reviewing your own arrangements to ensure your business is operating on a sound footing.

If you are looking for some advice on managing the interactions between VAT, IR35 and direct engagement within your recruitment business please speak to Scott Harwood or your usual RSM contact.