This article has been published on Taxation.
There has been considerable controversy in recent years concerning labour structures which seek to exploit perceived tax efficiencies and to mitigate the costs of engaging temporary labour. With the upcoming increases in employer National Insurance these pressures continue to increase. In recent years, HMRC has invested heavily in compliance activities, while the government has announced that further legislation targeting non-compliant umbrella companies will be introduced from April 2026.
A Typical Labour Supply Chain.
A typical labour supply chain might look like as follows:
The end client or hirer.
Recruitment agency – responsible for sourcing labour and providing a service of temporary labour to the end client.
Umbrella company – acts as the engager and payer of the worker.
The worker (temp) – provides the service to the end client.
In practice, labour supply chains can often be substantially more complex – for instance the end client may appoint a ‘neutral vendor’ to manage their relationships with recruitment agencies and the ‘tier one’ agency may work with other agencies to find labour. The umbrella company itself may outsource the operation of payroll to another party.
The temps themselves may be employees of the umbrella company (contracts of service), or they may be engaged under contracts for services. In the latter case, the operation of the agency workers legislation in ITEPA 2003, Part 2 Chapter 7 is such that these individuals are brought into the PAYE system, provided that the individuals are subject to supervision, direction or control (or to the right thereof) as to the manner in which they provide their services even though they are not formally employed by any party.
Agencies often have terms with the end client which means that services are provided under a ‘cost plus’ model, which in theory means that employment costs are directly passed through to the client. However, agreements often in practice calculate costs on an estimated basis. This, combined with significant competitive pressures, creates a powerful incentive for agencies to seek to increase margins through reducing employment and other costs.
Origins of the Current Position
It has been an aim of the government and HMRC over many years to impose more responsibility on end users and
agencies for the compliance of their labour supply chains. Following the introduction of the intermediaries legislation (almost inevitably referred to as ‘IR35’) in 2000, a succession of structures have been used to drive tax efficiency for the engagement of temporary labour. It is beyond the scope of this article to give a detailed timeline, but it is important to understand the reasons for the current focus on this area.
A common form of planning was the payment of travel and subsistence costs to workers, in conjunction with a salary sacrifice arrangement. An individual engaged under an assignment-by-assignment basis was not able to claim tax relief for travel expenses but if each assignment was part of an ‘overarching contract of employment’ then the individual could be considered to be visiting a succession of temporary workplaces.
From 2016, legislation was inserted into ITEPA at s 289A to remove the prior system of P11D dispensations, and replace it with a new statutory exemption for paid expenses. At the same time, the legislation disallowed the exemption in cases where the expenses were paid in conjunction with a salary sacrifice arrangement (very broadly defined). As a result, many agencies who had benefited from employer NIC savings were faced with a shortfall.
Other structures were developed in order to continue to seek savings. In the industrial temp market, a structure that later came to be known as ‘mini-umbrella companies’ (MUC) came into use. Under a MUC arrangement, the workforce is split into multiple small limited companies. Each of these companies claims to be independent from each other and are therefore potentially eligible to benefit from the VAT flat rate scheme and from the NIC employment allowance.
Over years HMRC has dissected those supply chains and advanced arguments that the structures constituted fraud. In the First-tier Tribunal case of Elphysic Limited and others (TC9126) HMRC won a partial victory with the tribunal agreeing that the scheme was fraudulent and that the VAT flat rate scheme could not be used, nor that the MUCs were entitled to the employment allowance. However, HMRC was not able to show that the directors of the companies themselves had knowingly entered into a fraudulent arrangement (in part because of a perception that they were unwitting ‘pawns’ rather than facilitators of fraud) and therefore was not able to forcibly de-register the companies for VAT purposes under the Ablessio principle.
In our experience, MUC is still being promoted by some parties and, indeed, the case is subject to appeal to the Upper Tribunal. End clients and agencies should be extremely careful to determine whether this structure is involved in the provision of labour to them.
HMRC’s approach to labour supply chain risk
HMRC has taken an increasingly active role in attempting to police the sector and our perception is that their compliance activities continue to increase, no doubt impacted by recent high-profile announcements of the recruitment of additional compliance staff.
HMRC’s dedicated labour provider’s unit (LPU) has been significantly expanded in the last few years. It is a multi-disciplinary team but many of its enquiries are led by VAT compliance specialists.
In some instances, non-specialist teams from HMRC will undertake reviews of labour suppliers with the LPU providing technical support, but in our experience this has the potential to cause a degree of frustration for clients. The areas at stake are complex and dealing with the specialist team directly may provide a more straightforward path towards resolution. Advisers assisting with a current enquiry being handled by a non-specialist HMRC team may therefore wish to ask them to include the LPU in their work.
In our experience the LPU is respectful and reasonable in its dealings with taxpayers seeking to be compliant. In particular, there has been a marked emphasis on encouraging companies to re-formulate their labour supply chains, rather than the traditional focus on simply reaching a monetary settlement. Handled correctly, therefore, an interaction with the LPU is an opportunity for a client to de-risk its supply chain.
Nonetheless, HMRC has taken enforcement action against arrangements it considers egregious. In a recent example, freezing orders were obtained in relation to £171m of employer NIC on workers provided to the NHS by Ducas Ltd and other suppliers. HMRC alleged that the company engaged with agencies to provide workers which it stated it would employ, when in reality, it was outsourcing the engagements to two other companies who were paying the workers gross via personal service companies. The case hinged on the provision of fraudulent documentation, with Ducas invoicing its customers for employer’s NIC liabilities that it was not paying to HMRC.
About the Guidelines for Compliance
Many readers will be familiar with HMRC’s Guidelines for Compliance series. In the words of HMRC these ‘offer HMRC’s view on complex, widely misunderstood or novel risks that can occur across tax regimes’. GfC12 Help with labour supply chain assurance was published in January.
The guidance is lengthy and arguably does not provide much new content, but it does bring together different sources of guidance in one convenient package.
Potential risk indicators for users of temporary labour to consider are covered in the guidance. Where these arise, HMRC states that businesses need to be able to show what actions have been taken to provide reassurance. Many of these factors are straightforward to identify and do not require specific tax analysis. Examples include:
Unknown suppliers in the chain.
Chains that seem long for no clear commercial reason.
Profit margins that appear unrealistic given the number of tiers in the chain.
Suppliers that are reluctant or unable to provide information.
Changes of bank details.
Changes of directorships, multiple directorships, previous failures and bankruptcies.
Changes of business name, including subtle changes / similar names.
The business address on Companies House is registered as Companies House.
Payment requests received from third parties or offshore entities.
New companies with limited trading history or where the service description is not associated with the supply required.
Supplier insolvency where the new supplier continues supply of the same workforce.
No online presence.
Changes to directorships (such as UK to foreign nationals).
Overseas directors.
HMRC includes a ‘questions to ask yourself’ section which is useful for formulating a conversation with a new business or one that is not engaging with the relevant considerations:
What labour supply chain risks are the biggest concern for your business and how far do your assurance practices mitigate this?
Do you know what risk indicators to look for when risk assessing your chains?
How often do you check if there have been changes to your chain and re-assess risk during contracts?
Do you have visibility through your whole supply chain to your workforce?
How do you verify that your suppliers are assuring the chain below and workforce on your behalf?
Does your staff have training available to help them identify and report supply chain issues?
Do you have appropriate procedures in place to act upon indicators or evidence of fraud and other risks within your labour supply chains?
Who is making employment status decisions?
Who pays your workforce and how are they being paid?
How is your workforce protected from exploitation while working for you?
What do you have in place for workers to report any concerns?
A recent case – Cheema Constructions Services Ltd and another (TC9418) – gives some indications of the protections that a due diligence process can provide to engagers of temporary labour. In this case, Cheema engaged Woodside Contracts Limited to supply labour only subcontractors in the construction industry. The case considered whether Cheema could be made liable for VAT under the Kittel principle. While there was no dispute between the parties that there had been a loss of tax, HMRC was unable to successfully contend that Cheema knew, or should have known, that there was a fraudulent evasion of VAT.
The tribunal commented on the value of the due diligence undertaken by Cheema. While noting that there was a level of due diligence which Cheema had adjusted and developed over time, the judge stated that ‘the tribunal should not unduly focus on due diligence. It is simply one feature that can be weighed in the balance when considering whether a taxpayer knew or should have known that its purchases were connected with the fraudulent evasion of VAT’.
In short, in the author’s opinion, due diligence is a necessary step but, in itself, is not a substitute for a business being able to answer fundamental questions of how the labour it is being supplied with is paid. In particular, if a due diligence process encounters evasion to data requests, claims of commercial confidentiality and promises around costs that appear ‘too good to be true’, businesses will need to consider their position very carefully.
Looking to the future
In the autumn Budget 2024 the chancellor announced that the government intends to legislate to make agencies responsible for ensuring that the worker is subject to full deduction of PAYE and NIC. Where there is no agency, the requirement would rest with the end client. The proposed date these changes will come into effect is April 2026.
The policy paper Tackling non-compliance in the umbrella company market makes clear the government’s concerns that the labour market is not delivering for workers or businesses and specifically references MUC and other ‘abuse’ of umbrella company structures. The red book estimates that £2.8bn of additional revenue will flow from these measures by the end of 2029-30.
Making the agency formally responsible will make it substantially easier for HMRC to pursue underpayments of PAYE or NIC without having to show that fraud occurred or otherwise use transfer of debt provisions, which has to date proven difficult.
On 4 March, the government issued a consultation response which reaffirmed the proposals to make agencies responsible for the operation of PAYE in the Autumn Budget. In addition, the government has decided that:
An amendment has been tabled to the Employment Rights Bill that will provide a statutory definition of an umbrella company and extend worker protection obligations to umbrella companies similar to those that already exist for agencies.
While stressing its strong support for undertaking due diligence in labour supply chains, the government has decided to not make this a formalised requirement in legislation.
There are no current plans to change legislation to further target abuse of the VAT flat rate scheme or employment allowance.
Developments are moving at pace and, with little detail yet of how the legislation will work, further knock-on consequences may become apparent in the future. For now, one possible implication is that many agencies will decide to bring their workforce in-house. A role will still no doubt exist for compliant umbrella companies, but agencies and end-clients who now have the potential for direct liability without HMRC needing to show fraud has occurred will want to be 100% sure of the compliance of their payroll offerings.
Conclusion
If there is one overriding conclusion that can be taken from GfC12 it is that HMRC considers it is critical that users of temporary labour understand what they are outsourcing and who to. It is not enough to rely on assurances from the supplier, and outsourcing this process to an adviser or neutral vendor, in itself, is also insufficient. Agencies are expected to ‘know the businesses that make up your supply chains and how the workforce is engaged and paid’.
The government’s aim is that April 2026 will bring about an ‘enough is enough’ outcome sufficient to level the playing field for all parties, which would be welcomed in many quarters. Whether this will be achievable though, remains to be seen.
Key Points
Businesses using temporary labour need to understand the supply chain being used.
All parties in the supply chain need to undertake due diligence but this is particularly important for
recruitment agencies.HMRC’s GfC12 provides a framework on which to base a due diligence approach.
Expected future legislation may cause agencies to consider whether they should cease outsourcing
labour.