The tax consequences of a change of employment status

Following discussions with the profession on a legislative solution to the issues highlighted in 'Demibourne', ACCA and HMRC can provide you with the following update:

The Special Commissioner's decision in the case of Demibourne Ltd v Revenue and Customs Commissioners highlighted a number of tax issues for employers and their employees which can arise as a consequence of a recategorisation of employment status. These issues relate to a situation where income tax and National Insurance contributions (NICs) has been paid in relation to the re-categorised income, but by the wrong legal person.

The Demibourne case confirmed that where an employment relationship exists, the employer is responsible for deducting tax from payments made to the employee in accordance with the PAYE regulations and HMRC does not have the discretion to choose whether to collect tax from the employer or the employee. This can lead to a situation where HMRC is obliged to seek recovery of PAYE tax and NICs in relation to income from the employer on which tax has previously been paid by (or on behalf of) the employee under self assessment.

Over recent months HMRC has engaged with the main bodies of the tax and accountancy profession and business to identify a solution to the issues highlighted in the Demibourne case. As a consequence of this dialogue a legislative solution has been introduced.

Amendment to the PAYE regulations to extend the limited circumstances in which HMRC can make a direction to transfer a PAYE liability from an employer to an employee. This new authority to make such a direction will apply where:

(a) the employee has received relevant payments (including notional payments) in relation to which the employer is required to deduct or account for tax in accordance with the PAYE regulations

(b) the amount of tax which the employer was required to deduct or account for in accordance with the PAYE regulations in relation to the relevant payments exceeds the amount of tax actually deducted or accounted for, and

(c) HMRC considers that a liability to tax has been assessed on the income in question a self assessment made on or behalf of the employee; or where a self assessment has not yet been made but HMRC considers that income tax has been paid in relation to the income in question as a self assessment payment on account or as a sub-contractor deduction.

The following rules will apply in relation to any direction made under the new authority:

• the amount specified in a direction issued to the employee will be restricted to the amount of income tax that HMRC considers has been assessed or paid by (or on behalf of) the employee under (c) above
• the amount of tax determined by HMRC under regulation 80 of the PAYE regulations as unpaid tax payable by the employer will not include any tax specified in a direction for the year in question
• the employee's entitlement to a 'PAYE credit' under regulation 185 of the PAYE regulations for tax not deducted/accounted for by the employer will be exclusive of any amount specified in a direction for the year(s) in question.

In practice this will produce the following outcomes for the worker and employer respectively:

• (for the employee) the employee's self assessment for the year(s) in question will remain undisturbed. The tax already assessed in accordance with the self assessment will equal the transferred PAYE liability. Where a direction is made in relation to tax paid as a payment on account of tax payable under self assessment, the employee's entitlement to include a PAYE credit in the self assessment for that year will be reduced by the amount of tax specified in the direction.
• (for the employer) the employer will be relieved of PAYE liability otherwise due under the PAYE regulations to the extent of the amount (or combined amounts) of tax specified in a direction to an employee(s) for the year(s) in question. However, the employer will remain liable for any PAYE tax in excess of the amount(s) directed to employees along with interest and any penalties.

There are no corresponding amendments required to the National Insurance contributions regulations as HMRC already has legal authority to off-set wrongly paid Class 2 and 4 contributions against Class 1 (employee) contributions properly payable.

Assuming Parliament agrees, these changes will be introduced in the 2008 Finance Act. In order for the changes to have legal effect in time for the new tax year, however, a resolution under the Provisional Collection of Taxes Act 1968 was passed on 18 March 2008 giving them statutory effect from 6 April 2008.

The Statutory Instrument and explanatory notes provide further guidance.