The right of substitution and IR35
The right of substitution is critical to freelancers determining if they are caught by the punitive IR35 taxes. Recent court cases have refined further this right in contracts for services. The terms on the right of substitution do vary and we examine those which are likely to lead to an acceptable right of substitution, and those which do not and which will lead to being caught by IR35.
Almost all agency or client contracts have terms covering the right of substitution, however sometimes these terms are too restrictive and would not stand up in court as a valid right. Clients and contractors who do not want an employment relationship (which also means contractors are not caught by IR35) should ensure they have a strong clause on the right of substitution.
As far back as the 1960's, the courts declared that if the personal service of an individual was not required, and instead a substitute could carry out the work, then an employment relationship could not exist. Since IR35 taxes are applied where an effective employment relationship is in place, arguing that the contractor has a valid right of substitution is now one of the strongest defences against the Inland Revenue asserting an IR35 relationship. The following guidelines are taken from high authority court cases dating back over the last 40 years, and reaffirmed in cases this year.
Contracts where it is unlikely that the right of substitution is valid – caught by IR35
The most common problems with a substitution clause occur where either the contractor has little to do with the arranging of the substitute or is not involved in paying the substitute.
If the contractor does not pay the substitute, then it is not a substitute, but is in fact a change of supplier. If the client chooses the substitute from suppliers it has put forward, the contractor is not supplying a substitute, but the client is arranging the services elsewhere. If the client can refuse to allow the substitute to carry out the services without given any reasons why, then it is not likely that a right of substitution ever existed.
Contracts where it is likely that the right of substitution is valid – outside of IR35
If the contractor arranges and is responsible for paying the substitute, then this is a valid right of substitution If the contractor trains its substitute, that also indicates a valid right of substitution.
If the client rejects the substitute on grounds of insufficient skills to carry out the services, this has been found not to remove the right of substitution and is just a quality control issue. Another substitute could be suitably skilled and accepted by the client.
During IR35 investigations, in our experience the Inland Revenue is unsurprisingly seeking to implicate that it is the client who would pay for, or arrange for, any change of contractor. This would mean that the right of substitution was invalid and would go a long way to ensuring the contractor is caught by IR35 and has to pay the taxes. Contractors should be aware of this during investigations and seek professional advice.
Where an employment relationship is not intended between contractor and client, the progressive contracts are now allowing for a full right of substitution. Elsewhere in the contract, there are terms on termination of the contract if the quality of work is not of sufficient level. This ensures that the client can have the work completed to the right standard and that neither party falls into an employment relationship which they had not intended.
Contractors often remind us of how simple the practical aspects of finding a substitute are. A phone call to any agency will result in dozens of CV’s of persons with the right skills who could quickly carry on the contract which will continue generating revenue for your company.
Article supplied by TreasureGuard