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The case for using Independent Consultants
by TonyAskham at 08:29 19/02/01 (Conference Papers)
Shout99 Conference by Tony Askham, Bond PearcePDF fileClick on the icon to download a PDF of this conference paper, 59 KB

Companies decide to offer employment to workers or alternatively outsource the task to independent consultants for a variety of reasons. In some cases, skills shortages may mean that it is difficult to recruit permanently, in other cases such skill shortages mean that retention of permanent staff is virtually impossible especially for small and medium size businesses ( 1 ). For other companies, the driver behind such decision is the length of the project or whether there are indeed long-term employment prospects for the worker. For other companies, decisions may rest around headcount numbers and profitability per employee. For others the choice is governed by the hidden employment costs in areas such as holidays, sickness, redundancy costs and the potential risk of the costs of removing the employee from the business (redundancy and unfair dismissal).

As these hidden employment costs rise for employers for social policy reasons, driven primarily by E.U. legislation, so many employers look for ways to reduce the burden on them and seek what flexibility is left in a heavily regulated labour market in the UK. The use of independent consultants apparently gives employers a chance to overcome that problem ( 2 ).

However some see the use of such independent contractors as posing a challenge to the easily regulated employment market and the government is confused about their social and fiscal policy to their use. Those who argue against the rise in the number of people now engaged as independent consultants do so on the basis that many of them do so not through choice but because their "employer" forces them to contract in that way. This concern is best expressed in the language of the Government’s IR35 press notice ( 3 ) in which after setting out the fiscal reasons why it intended to tax certain independent consultants as if they were employees, the notice went on "Businesses employing their workers directly say that they are unable to compete with those encouraging the avoidance at which the new legislation is aimed. As a result, ordinary workers can find they are unable to compete for jobs with those willing to participate in such arrangements. But those who do participate often have to pay a price in terms of loss of protection under employment law. They may find their terms and conditions altered - perhaps losing entitlement to sick pay or maternity leave. They may even lose their jobs without entitlement to notice or redundancy pay. They will usually have no right to any claim for unfair dismissal and may lose their entitlement to social security benefits through a failure to make adequate contributions". This confused thinking is mirrored in the HM Treasury Red Book for the 1999 budget which stated that "Provision of personal services through intermediaries can provide scope for tax avoidance, leave workers unprotected by employment law, and result in the loss of benefit entitlement."

Whilst there is no doubt that certain employers may have decided to close down certain in house functions and out source them, the policy difficulties are clear yet puzzling. It appears that it is perfectly acceptable for labour market policy reasons for an employer to outsource the function to a large or medium size service provider but unacceptable to allow the existing workforce to leave as employees and come back to undertake the function as independent consultants. A simple analysis is that size matters. Outsource your I.T. function to EDS, IBM, Cap Gemini or whoever, or your administration to one of the major accountancy firms, you will not be open to criticism. Carry out your outsourcing by allowing your previous IT team to carry out the work and you will be told they are in disguised employment and that you are in some way exploiting them. In cases where the employer is forcing the employee into that situation it could be argued that there is a social issue where protection is required although in such circumstances existing employment protection may well give a sanction ( 4 ). Where there is no compulsion it is difficult to see what the difference between the two situations is.

For many independent consultants this lack of clarity in Government thinking and repeated assurances that it wants a flexible labour market whilst proceeding ever more rapidly to introduce labour market protection, is both puzzling and annoying. For their clients there is an increased risk that having contracted on the basis that the independent consultant is not an employee or even a "worker" for employment law purposes, it may transpire that the law may decree that he is.

As I have outlined above there are a variety of reasons why employers decide on the use or not of independent contractors. Equally there are a number of reasons why individuals decide to contract as consultants and not as employees. Consultants primarily exist in the knowledge-based sectors, especially as I.T consultants, education and engineers ( 5 ). In other knowledge-based sectors such as law and accountancy market pressures have led to the expansion in size of the practices so that the issue of employment status occurs less frequently.

Consultants decide to set up business and contract in this way because they wish to be in charge of their own destinies and run their own business. Many will command higher fees in the market than the comparable salary because the employment costs fall on them and not the client and the extra fee is profit for the risk-taking involved. Some faced being pushed into management roles rather than technical ones whereas as consultants they can carry out tasks they choose to compete for. For many in the middle age there is no choice in that employers are reluctant to employ them but happy to use their expertise and experience as consultants. For many it is also a lifestyle choice not to be burdened with the chore of working at times stipulated by their employer. As consultants they can choose whether or not to seek a contract at any time.

These are all good and fair reasons why people active in the labour market should be allowed to decide in what form they contract with those that wish to purchase their services. It is difficult to see why Governments need to interfere with this freedom but many do and the attack on this freedom is increasing in the United Kingdom. Some argue that there should be incorporated into UK law a statutory right to be "self-employed" ( 6 ). Unlike many European countries where there are Trade Unions "representing the rights of the self employed and Government departments to specifically reflect their views, until recently no such representation existed for those who were consultants. In the last two years the rapid growth of the Professional Contractors Group, the largest growing members’ organisation in the UK, reflects the concerns of those who want this freedom.

The real difficulty facing employers and consultants is to understand the law, which underpins the legal differences between being classed an employee and being classed as self employed. As I have demonstrated above, the reality is that differentiating between a genuine business and disguised employment is very difficult and is often merely a factor of size. But the difference is crucial in three key legal areas. First, "employees" enjoy key statutory employment protection rights against unfair dismissal and redundancy ( 7 ). Secondly, an employer owes his employee a duty of care to provide a safe place of work, a safe system of work, safe plant and equipment and competent staff ( 8 ). This duty is not owed to an independent contractor. Further an employer is under a duty to take out and maintain insurance against personal injury sustained by their employee in the course of their employment ( 9 ). A self-employed person is responsible for his or her own insurance. Thirdly, the determination will be key to dealing with the tax treatment of payments made by the employer to the individual concerned.

However even these three issues do not fully cover all the difficulties faced by employers and consultants in determining the consultant’s status. Consultants may contract in a variety of different guises. Some may contract as individuals, some like the writer, as partners in a partnership, some using an unincorporated business name and some through limited liability companies. The law gives wide protection against discrimination and also regulates working time and holidays. This type of legislation protects not only employees but also "workers".

Further, the right to be self-employed or be a small business and not to be treated as an employee of one’s client is set to be further eroded over the next year or so. Three specific measures will impact severely on this freedom. First, Section 23 of the Employment Relations Act 1999 ( 10 ) allows the Minister, by Regulation, to extend employment rights to groups other than employees. The Government has pledged to consult on the measure before introducing the regulations but any extension of rights to "workers" will concern employers and make them nervous of contracting with individuals. The DTI’s explanatory memorandum on the Bill said "The Government is concerned that existing employment legislation (limited as it is to giving benefits to the narrowly defined "employees") has become both uncertain and out of date to meet changing job patterns." The document goes on to refer to "significant numbers of economically individuals now uncertain if they qualify or else clearly fail to qualify for most if not all employment rights."

Secondly, the Employment Relations Act 1999 gave the Minister power to amend the Regulations governing employment agencies. Whilst this power seems at first innocuous many in the consultancy industry have fears that the definitions and restraints in the amended Regulations, which are currently out for consultation, will inhibit the use of personal service companies.

Finally, the taxation measures in the Finance Act 2000, the Welfare Reform and Pensions Act 1999 and the Regulations made under the latter ( IR35) treat 95% of all receipts of Personal service companies as deemed income of the individual consultant and impose income tax and National Insurance liabilities accordingly. The Government’s own impact assessment identified that up to 66,000 businesses might close ( 11 ).

Surprisingly both this assessment and the second assessment ( 12 ) concluded, "it is thought that most businesses facing new liability for tax and N.I.C.s will wind up their service company and employ their workers direct". What precisely was in the mind of the draftsman of this statement is unclear given the use of the expression "businesses" and the implication that in some way the Service Company was a vehicle of the client and not the worker.

The IR35 legislation is the subject of a judicial review ( 13 ) for hearing on the 13-15 March 2001. The challenge seeks to overturn IR35 on the basis that it is a disguised state aid and in contravention of the right to the free movement of services contrary to E.U. law.

Given all that is set out above, how do the Courts seek to differentiate between "employees" and those in business on their own account? Being flippant one could say with great difficulty! The answer is that the Courts have over the last 150 years developed a series of tests to ascertain the employment status of an individual. How the tests develop depends to an extent on which area of law the case deals with. The courts might seek to find employment status in a personal injury case more easily than in a taxation or employment case ( 14 ).

So what are these tests? They include the following:

  • Whether the individual must carry out the work in person or whether he/she can send a substitute ( 15 );
  • the degree of control which the "employer" has the right to exercise over the way in which the work is performed (16 );
  • the extent to which the individual is integrated into the "employer’s" organisation ( 17 );
  • the economic reality of the situation, in other words is the individual really in business on his or her own account (here the Court will be interested in such matters as who owns or provides the equipment used to carry out the work, who hires the helpers, the reality of the financial situation i.e. who bears the risk of losses and has the opportunity of making a profit) ( 18 );
  • the so called "multiple" test under which all of these issues are examined in the context of particular circumstances of the case ( 19 );
  • the duration of the relationship; whether the individual works for just one or a number of "employers";
  • how the individual is paid and for what, in other words is he or she paid an hourly rate, regardless of productivity, or only on completion of a job;
  • whether there is mutuality of obligation between employer and employee i.e. is the employer obliged to offer work and is the employee obliged to accept it ( 20 );
  • how the parties see the relationship, in the terms of the documents they have used to create that relationship, the practice they have adopted to implement it.

In practice Employment Tribunals and Courts base their decision on an overall view having applied some or all of the above tests. Cases as to whether an individual operating through a personal service company can be "an employee" are rare. Employment Tribunal decisions have suggested that the employment Tribunals might be prepared to look behind the existence of a personal service company. In the only reported case where this has happened a worker who was employed by the respondent company was re-engaged through a contract with a personal service company. The Employment Appeals Tribunal commented "there is no rule of law that the importation of a limited company into the relationship prevents the continuation of a contract of employment." ( 21 )

However, for certain employment law matters and in particular the law on discrimination a different test applies. The Sex Discrimination Act, the Race Relations Act and the Disability Discrimination Act all for instance, provide for protection from discrimination to "workers".

The Race Relations Act 1976 section 7, specifically gives protection against discrimination against "contract workers". The section applies:

"to any work for a person ("the Principal") which is available for doing by individuals ("contract workers") who are employed not by the Principal himself, but by another person, who supplies them under a contract made with the Principal".

The protection given by this section is broad enough to cover discrimination against employees of a concessionaire in a department store by that store, when the persons in question were not employed by the store, but were held to be working "for" it within sub-section (1) ( 22 ). The breadth of this section can go even further when allied to the definition of "worker" contained in section 78 of the Race Relations Act. The Act deliberately casts the definition of the term "employment" in much wider terms than standard employment protection. It includes not only therefore "employees" but also some independent contractors provided that they execute work or labour personally. This wide definition used in conjunction with the "contract worker" provision at section 7 provides protection to a very wide variety of people ( 23 ).

Similarly, the Sex Discrimination Act 1975 gives a definition of "employment" deliberately wider than that for normal employment protection and extends to those under a contract "personally to execute any work or labour". It thus covers not only "employees" but also some categories of self-employed.

The extension of the definition is not infinite, and in order to come within the definition the dominant purpose of the contract must be for the supply of one of the parties’ personal work or labour.

Similarly, the Sex Discrimination Act has a specific provision relating to contract workers which is contained in section 9. This section is in the same terms as under the Race Relations Act. The effect of these provisions can be graphically illustrated by a 1995 decision of the Employment Appeal Tribunal. In that case a licensed employment business and agency had a contract to provide personnel for consideration by BP. Any staff supplied were paid by the Agency who in turn invoiced BP.

The complainant worked under such arrangement from May 1988 as a Project Account Assistant working at BP’s office. In May 1991 she stopped work due to pregnancy and in June she approached BP with a view to returning to work. She was refused permission to take up her old job. She brought a claim for discrimination on the grounds of sex. The complainant was successful against BP.

On appeal, the EAT held that the complainant was entitled to bring a complaint under section 9 of the Sex Discrimination Act against BP acting as Principal because they had discriminated against her as a contract worker by not permitting her to return to work after absence due to maternity. However, the EAT held that the complainant was not "in employment" under section 82. That definition must be taken to refer to a contract between the party doing the work and party for whom the work is done. It was not necessary to give an extended construction to the definition of "employment" in order to give effect to the policy of the statute given the contract worker provision in it.

The Disability Discrimination Act 1995 section 12 also contains similar provisions relating to discrimination against contract workers and the same definition of "employment" as do the earlier discrimination legislation.

A recent case illustrates widespread effect of these provisions in cases of outsourcing of the type under discussion. In that case involving the Disability Discrimination Act, an IT contractor was an employee of his own service company. That service company entered into a contract with an Employment Agency and the Agency in turn entered into a contract with a Life Assurance Company for the provision of the services of the IT consultant. This is a usual and well-recognised scenario in the sector.

After a while the Assurance Company in question refused to continue to use the services of the consultant. The latter believed that this was because he was disabled. He complained to an Employment Tribunal who rejected the notion that he was contract worker for the Assurance Company. Similarly, they rejected any argument that he was in fact in disguised employment. They pointed to the existence of the three contracts in question as clear evidence that there was no contract of employment.

On appeal, the Employment Appeal Tribunal upheld the appeal by the contractor holding that in a case where an individual was employed in an unbroken chain of contracts between himself and the end user, the end user was the "principal" and thus the contractor could sue the Assurance Company direct ( 24 ).

Laws on Working Time and National Minimum Wage extend the rights given not just to "employees" but to "workers". A "worker" here is someone who does work permanently for someone else and who is not "genuinely self-employed". The issue of working through a service company is not dealt with in any of the DTI’s guidelines on either piece of legislation. It is certainly arguable that the definition of "worker" is wide enough to cover many of those who work through service companies, partnerships etc direct to an end user.

Given then that it is clear that ascertaining the status of consultants is difficult for those who are directors and shareholders of a personal service company is there a difficulty in ascertaining their status within that company? There is a large volume of case law regarding shareholders, and specifically those who have a controlling shareholding in a company. These cases address the issue of whether they may be employees of the company for the purpose of making claims against the Secretary of State under the Insolvency provisions in the Employment Rights Act 1996 ("ERA"). Cases also indicate an expansion of the principles into a general employment law context ( 25 ). In this article we consider whether a director of a company, who is also a controlling shareholder of that company, can make a claim for redundancy payments against the Secretary of State if the company becomes insolvent.

Past case law has suggested that a director who had a controlling interest in the company’s shares could not be regarded as a servant of a company (at least for redundancy purposes) because he was not subject to effective control by the company in his capacity as a worker. On the basis that he was a shareholder who could dictate to the company, he was often found not to be an employee.

In the case of Buchan the issue of whether the alleged contract of service between the controlling shareholder (and director) and the company was a bona fide arrangement was raised. It was suggested that the fact the director is also the controlling shareholder is but one factor to be taken into account when determining the issue ( 26 ).

Mr Buchan owned 50% of the shares in his company and the issue considered was whether Mr Buchan could claim redundancy payments from the Secretary of State. Buchan was heard with another case, Ivey. Mr Ivey owned 99% of the shares in a company and was also a director. Because both men were able to block any decision to terminate their own employment or could amend their own terms of service, the Employment Appeals Tribunal (“EAT”) concluded that both men controlled their companies to the extent that they were not employees. It is suggested that this distinction was drawn from a policy point of view.

After the Buchan case however, the issue of what constitutes "control" was examined closely. Buchan and Ivey had been careful not to state that there was a rule of law to the effect that a controlling director cannot be an employee of the company. The case of Fleming ( 27 ) re-emphasised that the existence of a controlling interest (in that case the Managing Director owned 65% of the shares) was a relevant, but not a decisive factor.

Then came the case of Bottrill ( 28 ). The Court of Appeal held that a person with a controlling shareholding can also be an employee for the purpose of making claims against the Secretary of State under the Insolvency provisions of the ERA. Whether or not an employment relationship existed was to be decided by having regard to all the relevant facts. Where the person concerned had a controlling shareholding it was likely to be a significant factor in most situations – and could even be decisive – but it was a relevant factor and not determinative. The factors, which a Tribunal would be likely to consider, include:

  • Whether or not there was a genuine contract between the company and the shareholder;
  • The circumstances in which the contract came into existence (was it made at the beginning of the Director’s relationship with the company or was it only made in anticipation of possible insolvency?);
  • What the parties actually did in accordance with the contracts; and
  • Generally how genuine was the contract of employment.

In Bottrill Mr Bottrill became the Managing Director and holder of the sole issued share in a company called Magnatech UK Limited in March 1994. The shareholding was intended only to be temporary, the ultimate intention being that the Magnatech Group of companies in the USA would invest in the UK company and acquire some 80% of the equity. A draft agreement giving effect to that arrangement had been prepared but the company became insolvent before it was executed. In August 1994, Mr Bottrill had signed a “contract of employment” which set out his duties, working hours, holiday and sick pay entitlements and his remuneration. It was provided that he would be paid a salary, set at a level mutually agreed with fellow directors and reviewable on an annual basis. Thereafter, he worked the hours indicated in the contract and had no employment elsewhere. PAYE and National Insurance contributions were deducted from his salary in the normal way and he was not paid any Director’s fees. In addition to Mr Bottrill, the company had one other employee Director and two employees. The company got into financial difficulties and, in April 1996, a receiver was appointed and Mr Bottrill was dismissed. His claim was for redundancy and other debts owed by the company to him. This claim was rejected by the Secretary of State on the grounds that he was not an employee. He took applied to an Employment Tribunal, which upheld his complaint against that ruling.

The factors, which led the Tribunal to conclude that Mr Bottrill was an employee included that:

  • his 100% shareholding was temporary and that his control of the company was only theoretical;
  • he had paid tax and national insurance as an employee;
  • he worked fixed hours and was not engaged in any other employment;
  • he was entitled to holidays and sick pay; and
  • The contract of employment was signed and dated and indicated that he was an employee.

The EAT dismissed the Secretary of State’s appeal and the Court of Appeal rejected the Secretary of State’s further appeal.

At this stage, therefore, the position of a shareholder "employee" was uncertain as Buchan and Bottrill appeared to disagree. The decisions of the EAT in Smith ( 29 ) and Sellers ( 30 ) seem to have resolved this uncertainty. The cases were initially decided along the lines of Buchan and Ivey. The EAT, in separate decisions, ruled that they should also have been considered in the light of Bottrill (the decision of the Court of Appeal was not available to the tribunals at the time). This suggests that although the EAT is not expressly overruling Buchan and Ivey, it is suggesting that the law in Bottrill is more likely to be "good law". Additionally, the case of Connolly seems to have expanded the principal in Bottrill to a general employment context. Mr Connolly was pursuing a claim for unfair dismissal against the company he had formerly been a majority shareholder of. In doing so he had to show that he had been in employment for two years and his contract of service with the company therefore came under scrutiny. The EAT found that he had been employed by the company and the fact that he had stood to gain financially if the company did well and that he was a skilled entrepreneur was irrelevant to the question of whether he was an employee.

The conclusion, therefore, is that where a shareholder of a company is also a director or an "employee", there are many factors to be taken into account in deciding whether he or she is truly an employee. Just because the consultant is a controlling shareholder, does not mean that he is not an employee of the personal Service Company.

Some suggest that the safest way for the end client to contract is through an agency and in doing so the client will be protected from employment related claims. The argument suggests that contracting direct with the personal Service Company of the contractor is more risky. Recent cases show, however, that merely contracting through an agency does not, of itself, give any protection against such claims ( 31 ). If a client exercises sufficient control over the consultant to show that an employment relationship exists the fact that the contractual arrangement is through will not of itself protect the client from employment liability. What is far more likely to protect the client is to contract with a consultant through the consultant’s service company using a form of contract that shows the contract is one of consultancy not employment. If an agency is to be used it is essential to ensure that the terms that the agency contract with the consultant or the personal Service Company comply with those between the client and the agency. Any difference in these terms allows the court to look at both to try and construct a contract of employment between consultant and the client.

It is the interest of both the clients and the consultant to ensure that the relationship properly describes the commercial reality of the relationship. Usually, properly documented, it will be possible to clearly demonstrate that the relationship is one between the client and the personal service company and not one of employment between the client and the consultant. The need to comply with the proposed Conduct of Employment Agencies & Employment Businesses Regulations also means that there is need to clarify the terms on which the relationship between client and agency and agency and consultant is to be conducted.

Clients do, however, need to be even more alert when they contract direct with the consultant and not through a Personal service company. Here, as is apparent from the Motorola case, there is a real risk that the wrong arrangement ( 32 ), even through an agency, will leave the client exposed to employment claims.

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The case for using Independent... TonyAskham - 19/02
    Title is slightly misleading TheGhost - 19/02
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