An element of caution must be exercised here, however, as there may be other factors which affect the decision as to the worker’s status. It may be that the right to substitution is conditional upon the client being able to veto the substitute for whatever reason, or that the contract contains a ‘substitution clause’ but, the clause has never been utilised.
Freelance Consultants should therefore always seek to include a right of substitution clause in their assignments, both to truly reflect the assignment and to try to ensure that the assignment passes IR35. If you are providing a service, and not employment, another Consultant should be able to provide the same service and should be able to take your place. At the same time, you should note that there has been much debate about the right of substitution clause. Many commentators have leapt on the clause as being an essential key in a contractual agreement in order to ensure they fall outside of the IR35 legislation.
Recent court cases have further refined this right in contracts for services. The terms on the right of substitution do vary and here we consider those which are likely to lead to an acceptable right of substitution, and those which do not and which could lead to an assignment being caught by IR35.
An Employee is a preferential creditor (up to statutory limits) in the event of the employer becoming insolvent; they have rights to statutory payment in relation to unpaid salary and in lieu of notice; and if made redundant, there would be rights to a redundancy payment.
Being paid against invoice, incurring the risks of late payment, or of withholding, or of non-payment are all examples of risk. In the event of insolvency of the Hirer, the Freelance Consultancy business would merely rank amongst the unsecured creditors, some way down from the ordinary employees.
It is also important to demonstrate that a person operating their own business, on their own account, has the opportunity of profiting from sound management.
You should be able to satisfy as many of the above aspects as possible in order to avoid being caught within IR35 (Fail). The contract and the actual working arrangements should include working for a fixed price, agreeing to correct defective work at your cost, providing your own insurance cover etc.
In Express & Echo Publications Ltd. v. Tanton (1999), Mr. Tanton, the applicant, was a delivery driver employed by Express & Echo (the Company). There were many factors in this case which pointed towards Mr. Tanton being under a contract of employment; not least that HMRC took the view that he was an employee for which he was taxed accordingly. One factor, however, which Lord Justice Gibson, in the Court of Appeal found to be “a remarkable clause to find in a contract of service.” was Clause 3.3 which gave Mr. Tanton the right to substitute himself with another driver.
“In the event that the contractor is unable or unwilling to perform the services personally he shall arrange at his own expense entirely for another suitable person to perform the services.”
In addition to this, it was stated in paragraph 13 of the Schedule: “In the event that the contractor provides a relief driver, the contractor must satisfy the company that such a relief driver is trained and is suitable to undertake the services.”
Lord Justice Gibson held: “that, where a person who worked for another was not required to perform his services personally, as a matter of law the relationship was not one of employee and employer; and that, accordingly, clause 3.3 of the contract (not to perform any services personally) was a provision wholly inconsistent with the contract being one of service.”
It can be seen from both these cases that there was a ‘right of substitution’ but, that in Ready Mixed Concrete it was with the “knowledge and approval of the Company.” and in Express & Echo the Contractor had to satisfy the Company that the substitute was “suitable to undertake the services.”
Linking these court decisions to IR35, it is likely that assignments will fall outside of IR35 based on these rights of substitution, provided the clauses truly reflect the engagement circumstances and other contractual conditions do not counter this position.
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. Hirers and professional Freelancers who do not want an employment relationship (which also means assignments pass IR35) should ensure they have a strong clause on the right of substitution.
It will depend on having the right stated in all contracts in the chain between the individual and the hirer, the extent to which the right is fettered, and whether or not the right has been exercised during the contract.
There are usually two contracts to consider – Recruitment Business/Freelancer and Recruitment Business/Hirer – and it is usually the case that the Freelancer is not allowed to see the Recruiter/Hirer contract so cannot confirm that the right of substitution is contained within it.
It is often the case that any right of substitution clause is unreasonably fettered, i.e. substitution is subject to having the Recruitment Business’s and/or the Hirer’s prior written consent, which effectively means they could just say no.
In JLJ Services Limited v HMRC (2011) the Tribunal Judge stopped short of saying that the substitution clause was a complete “sham”, as he accepted that it was theoretically conceivable that one could construct a sequence of events that might lead to substitution taking place. Nevertheless, he believed that the clause was only included to “sustain non-employee status” and to achieve “the desired tax purpose”.
In seven years, no substitute was ever offered and it was perfectly clear that Allianz was interested in the qualifications and the individual suitability of Mr Spencer. They would have been equally interested in the personal suitability of any replacement. The Judge concluded that the substitution clause was one of the type always inserted in cases of this nature, having very little reality and that it should play virtually no part in influencing the Tribunal’s decision.
The case suggests that a long period of multiple assignments with one Hirer may affect the value of any Substitution clause, particularly if that clause is overly fettered.
Many assignment contracts contain statements that state that “…has the right to substitute another representative of the limited company to provide the services provided that the hirer is satisfied that the proposed substitute possesses the necessary skills, expertise and resources to perform the Services….”
This statement is not actually required. The reason being that if, by sending in someone without the skills, you do not supply the services in the contract you are in breach of contract. The hirer can then cancel the contract and seek damages/compensation.
A more relevant term would be to say “Any costs incurred in providing a substitute will be at the expense of the Company.” That nullifies the risk of sending in the substitute who cannot do the job.
If the assignment contract contains a clause about the client having control over the substitute choice, the evidence of a right to substitution is much weakened.
If the Freelance Professional does not pay the substitute, then it is not a substitute, but is in fact a change of supplier. If the Hirer chooses the substitute from a list of potential suppliers, the Freelance Professional is not supplying a substitute, but the client is arranging the services elsewhere. If the Hirer 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.
If the Hirer 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.
Where an employment relationship is not intended between Freelance Professional and Hirer, the assignment should allow for a full right of substitution. Elsewhere in the contract, there are terms on termination if the quality of work is not of sufficient level. This ensures that the Hirer can have the work completed to the right standard and that neither party falls into an employment relationship which they had not intended.
On the practical aspects of finding a substitute, contact with any recruitment business 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 business.
In IR35 cases that have gone before the Commissioners/Tribunals/Courts in most cases the right of substitution has been treated as just one clause amongst many unless substitution has actually taken place or the end client has confirmed that they did not care who provided the services.
It is usually the case that the Recruitment Business has selected the Freelancer’s CV and the client has interviewed the Freelancer. In this scenario it follows that the Hirer would often not be comfortable accepting anybody else to fulfil the assignment.
A genuine, unfettered right of substitution is a very positive and solid indicator of an IR35 position. If not, the assignment contracts will be disregarded by HMRC and the Courts. You should consider a lack of ‘Mutuality of Obligation‘ and a lack of ‘control‘, together with additional clauses supporting business and financial risk.
That said, by far the most important issue is the actual working practices, as a contract strong on all the key issues is not worth the paper it is written on if it does not reflect the reality – just like the reality of the ‘right of substitution’ clause!
The right, as opposed to the obligation, to provide a substitute is a pointer towards self employmentand if it is unqualified it is probable that the courts would consider it to be a strong pointer to self employment or determinative of self employment by itself.
However, a right to send a substitute must be genuine for it to be taken into account at all in deciding employment status. Where the true agreement between the parties is that the worker must undertake the work personally despite a written contractual term allowing substitution exists, the written clause will be ignored as a ‘sham’. Lord Justice Gibson made this clear in the case of Express and Echo Publications Ltd v Tanton (see ESM7210) where he said
‘Of course it is important that the Industrial Tribunal should be alert in this area of the law to look at the reality of any obligations. If the obligation is a sham it will want to say so.’
This applies equally to Tribunals determining employment status. You should adopt a similar approach and be alert to the possibility that a written contractual term may be a sham. Likewise, where there is an oral contract you need to be alert to the possibility that an alleged right of substitution may not be genuine.
It is important to note at this point that it is the contract with the recruitment business (i.e. the one the freelance professional signed) that is pertinent here. HMRC will consider the ‘sham’….
“More detailed guidance on ‘sham’ in the employment status context is provided at ESM1003onwards. Those instructions explain that the Commissioners and Courts will accept a written contractual clause unless they have evidence that it does not represent the true agreement between the parties. This means that if we are to dispute such a clause the onus is on us to demonstrate that it is a sham (or has been varied by an agreement subsequent to the contract being signed (see ESM1003)).
Considering the HMRC position it is sensible, if your contract purports to allow substitution, to establish how in practice you would be able to substitute. We recommend a simple outline to show how it could be feasible were the need to arise. This will then counter any objection HMRC may have based on the above.
“As explained above it is the right of substitution that is important. The fact that substitution has not actually occurred during a contract is not necessarily relevant. Workers with such a right are of course entirely free to carry out the work themselves if they wish. We may want to consider claims that there is a right of substitution critically if substitution does not occur over a long period of time. However, we should not automatically assume, in such cases, that this means that there is no real right of substitution.”
Again this is clear cut and unambiguous. You do not need to actually invoke the right. The right is enough in itself.
HMRC ( ESM1057):
“If, exceptionally, you decide a right of substitution is genuine but there are other terms that appear wholly inconsistent with self employment, Personal Tax (Technical) can provide advice. Such cases will be exceptional (for example, membership of the employer’s pension scheme and a common intention for employment expressed in the contract – but the Employer alleges the worker is self employed because of the right of substitution). Submissions should not be made simply because control exists alongside a right of substitution.”
In other words there would need to be exceptional circumstances to contend employment where a genuine right of substitution exists. It is important to point out that the need for personal service (i.e. a lack of the right of substitution) does NOT mean you ‘Fail IR35′. There are many other factors to be considered. However if you have a genuine right it is fair to say that in all but the most exceptional cases you will ‘Pass IR35′.