IR35 in the private sector: Could the new rules impact M&A?

From April 6 2021, IR35 rules relating to the payment of off-payroll contractors operating through limited companies will apply to firms in the private sector who work with contractors. The debate about the impact of these rules on contractors and the companies that engage them has been raging for years now. But here we’re going to take a different perspective and look at what impact the rules could have on M&A.

The rules, which have been applied to public sector contract work from 2017, were postponed from their initial start-date in April 2020 due to the COVID-19 pandemic. Despite persistent attempts from contractor bodies, other industry groups and some MPs to further delay or scrap the rules, they are now set to come in this year.

What are the rules?

The new IR35 legislation is aimed at closing a perceived tax loophole through which self-employed workers are thought to use limited companies to pay less tax. The rules dictate that if a contractor’s actual working (rather than contractual) relationship with a client is more akin to an employer-employee relationship, the worker’s income should be taxed the same as a payroll employee’s would be.

If this is the case, the contractor is considered a “deemed employee” and falls within the scope of IR35 legislation (often referred to as being “inside IR35”) and must pay additional tax and National Insurance (NI) contributions on their income.

Currently, contractors who provide services to a private sector client through an intermediary company (usually their own limited company), must determine their own IR35 status according to their working relationship with clients.

According to HMRC, this arrangement has led to many contractors erroneously deeming themselves as outside the scope of IR35 legislation for tax purposes. The Treasury has therefore looked to tighten the rules in order to close the apparent loophole.

From April 6 2021, the responsibility for determining a contractor’s IR35 status will move from the contractor themselves to their private sector end-client. This means that the firm working with the contractor will be responsible for calculating the contractor’s tax and NI contributions from their pay if they deem them to fall within the scope of the rules.

What are the liabilities business owners face?

Being liable for determining the IR35 status of contractors engaged by their company, as well as for handling the PAYE and NI contributions of any contractors deemed to fall inside IR35 means that businesses who engage limited company contractors now face a mountain of new paperwork and rules to comply with.

First of all, business owners will need to perform status determinations on any contractors they employ. For some business owners, this may mean making determinations on a handful of freelance workers, for others it could mean going over a businesses’ working relationship with hundreds of contractors.

Once determinations have been made, the business will need to ensure that all the relevant parties are fully up-to-date on the decision and its implications. This means not just the contractor themselves, but the heads of relevant departments such as HR, accounting, finance, procurement and tax.

If any contractors are deemed to be inside IR35, then the cost increases from Employer’s NI and potential increases in day rates will need to be factored into accounts, while systems and processes will need to be in place to ensure that inside IR35 workers are paid in the correct, compliant way.

This may sound like a lot of work and there will doubtless be many businesses out there that seek to take shortcuts in order to avoid this. Reflecting this challenge, HMRC has announced a 12-month grace period from the date the rules come in, during which businesses will not face penalties for any genuine mistakes made in attempts to comply with the rules.

This will be comforting for many business owners and will provide significant leeway for getting used to the rules and implementing the processes needed to comply, without fear of incurring penalties.

However, intentional non-compliance will receive no such grace period and the Treasury will be looking to come down especially hard on those purposefully dodging the rules. What’s more, once the year is up HMRC scrutiny of mistakes will be unavoidable, so business owners will need to use the valuable leeway to make sure they are fully compliant with the new rules.

Are there any exemptions?

Undoubtedly, business owners at companies who engage limited company contractors will be looking for any legal loophole available to avoid the burden of IR35 compliance. However, the only real exemption that exists in the rules is for small businesses.

This exemption is based around the definition of a “small business” from the Companies Act 2006 and means that a business will be exempt from the new rules if it satisfies two or more of the following criteria:

Annual turnover not exceeding £10.2 million.

A balance sheet total of not more than £5.1 million.

An average of no more than 50 employees for the financial year.

In a situation where a business meets two or more of these criteria for two consecutive financial years, responsibility for determining IR35 status will remain with any contractor that they engage.

However, if a small business becomes part of a group of businesses or a joint venture, the criteria will apply to the group or joint venture as a whole, meaning that the aggregate revenue, balance sheet total and employee headcount will determine exemption.

As a result of these criteria, many businesses that stand on the cusp of growing beyond the definition of a small business or that are considering joining a group or joint venture may still need to prepare for applying the rules at some point.

What might the M&A impact be?

Understandably, the bulk of the focus on IR35 so far has been regarding its huge impact on contractors, who could see take-home pay fall by as much as 20 per cent if they are deemed to be inside IR35, and the companies who hire them and now face a massive increase in admin work.

However, the introduction of the rules could perhaps have an as-yet-unseen impact on M&A, with numerous potential ramifications for business acquisitions, exits and growth strategies.

Selling a business
For business owners whose companies engage limited company contractors and who are hoping to make an exit from their firm, the new IR35 rules could raise considerable issues. First of all, the increased workload and liability that comes from being responsible for determining the status of contractors could have a detrimental impact on the valuation of the business.

Of course, how much of an issue this is will depend in large part on how reliant the business is on its freelance workforce. For businesses that make heavy use of contractors, though, the burden of IR35 is something that could influence how much a potential buyer is willing to pay.

Selling a business that uses contractors could also be impacted due to the likelihood of contractors increasing their day rates in response to the new rules. As mentioned earlier, contractors that are classed as inside IR35 could stand to lose as much as 20 per cent of their take home pay to increased tax and NI contributions. With this in mind, it is understandable that many will look to increase their day rates to guard against this.

If there is a widespread increase in contractor day rates, then businesses that are reliant on a sizeable freelance workforce could see a serious impact on their profitability and cash flow, which will in turn have an impact on a sale of the business.

Finally, the new IR35 rules could raise a conundrum for small companies that are considering being acquired as the next step in their growth. If the company is acquired by a larger counterpart then it is likely that they will lose their small business exemption and become liable for determining the IR35 status of any contractors they engage.

While, on its own, the issue is unlikely to deter a small business owner from pursuing a sale, the increased liability and impact on cash flow and profitability could, again, impact what the purchaser is willing to pay.

Buying a business

For those looking to buy a business that engages contractors, the issues are essentially reversed. The most pressing consideration is from a due diligence perspective. With liability for the PAYE and NI contributions of any PSCs that the target acquisition engages, acquirers will need to be meticulous in scrutinising the labour supply chain of their target business.

This liability would mean that any interest or penalties for late payment of either tax or NI would fall squarely on the business that engages them, as would criminal liability for non-compliance with the rules.

If a target acquisition is found to be either unprepared for the new rules or is outright non-compliant, then the acquirer will face the choice of either abandoning the deal, or proceeding and facing a costly and time-consuming task of bringing the company in line with the law.

Again, IR35 could also have repercussions for small business owners looking to grow, this time from a buyer’s perspective. As with being acquired by a bigger company, if a small company chooses to grow through acquisition, it could quickly find itself falling outside of the small business exemption.

Should buyers and sellers be worried?

Again, it should be emphasised that the issue of IR35 alone is unlikely to be enough to deter someone from either buying or selling a business. What it undoubtedly does, however, is add another facet to consider during the buying or selling process. Not to mention another burden during business ownership itself.

For those looking to buy a business that uses contractors, the issue is largely one of due diligence: fully familiarising oneself with the responsibilities and liabilities now facing business owners and, once a deal has been completed, ensuring compliance with the rules.

For business owners looking to make an exit, it is possible that engaging inside IR35 contractors may prove to be something of a sticking point in achieving the hoped-for valuation. One thing that is certain though, is that ensuring full and efficient compliance with the rules will go a long way to reassuring potential buyers that the IR35 burden isn’t a deal-breaker.

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