IR35 Factors, IR35 Compliance, are you caught?

Many contractors will have heard of the long-running 'Dragonfly IR35' case, which concluded at the High Court in September 2008.

The ruling is well-known not only for the £99,000 tax bill owed by the contractor at the heart of the case, but for the implications of the ruling on future IR35 status enquiries.

This article provides a simple guide to the Dragonfly case, and its implications for contractors.

Links to more robust and full legal analysis of the case have been provided at the end.

Dragonfly Consultancy Limited - Background

John Bessell, an IT systems tester, is a director of Dragonfly Consultancy Limited (and a 50% shareholder). He disputed that IT contracts performed for his client, the AA, between 2000 and 2003 were caught by IR35 and took his case to a hearing of the Special Commissioners. The total tax liabilities claimed by HMRC amounted to £99,000.

Special Commissioners hearing

At the hearing, Commissioner Charles Hellier dismissed the appeal. He concluded that Mr Bessell's limited 'right of substitution' was not a pointer towards self-employment and the control exerted by the client upon Mr Bessell was also a strong indicator of 'employment'.

Commissioner Hellier also concluded that the intention of the parties was irrelevant.

"Overall I find nothing which points strongly to the conclusion that Mr Bessell would have been in business on his own account."

You can download the Special Commissioners decision (DOC) and the PCG's summary of the decision (PDF).

High Court Appeal

The Professional Contractors group supported Mr Bessell in bringing his appeal to the High Court due to the wide-reaching IR35 implications of the case.

On the day, the judge - Mr Justice Henderson - agreed with the view of the Special Commissioners that Mr Bessell's IR35 defence was weak and dismissed the appeal.

Despite some pointers towards 'self employment' (Mr Bessell paid for his own training and equipment, for example), overall there was not enough evidence for his contract work to fall outside the IR35 rules.

The judge said that it was 'unassailable' that Mr Bessell had a relationship of employment with the AA - "In my opinion he would have been an employee had he been directly engaged by the AA."

Implications for IR35 defences

Dragonfly - employment status points

Roger Sinclair, in his excellent analysis of the case (see link below), makes some interesting points:

1) The case involved a number of contracts with the same client, starting before IR35 even became law. Later on, some 'IR35 friendly' clauses were inserted. This fact could imply that the new clauses were there solely to get around the IR35 rules.

2) Substitution: the agency-client contract contained no substitution clause at all. The substitution clauses in the contractor-agency contracts varied, but the lack of any unfettered right of substitution in the agency-client contract was a very strong pointer towards Mr Bessell being an 'employee' as per the employment status rules.

3) Control: Mr Bessell's later contracts were amended to remove references to his need to comply with staff rules and regulations while on contract. This was seen by the judge as IR35 avoidance as Bessell's first two contracts made specific reference to him performing his work under the client's direction/supervision.

You can read more about the main factors which are used in employment status cases in our IR35 compliance guide.

Contracts should reflect working practices

Several tax and legal experts say that it is now more important than ever for contractors to ensure they use IR35 compliant contracts - and it is essential that such contracts reflect their true working practices.

According to employment status experts, Bauer & Cottrell, the key message from the Dragonfly case is that the contracts in the chain did not reflect the working practices and consequently the parties understanding of the reality of the relationship.

"IR35 concerns 'relevant engagements' which unfortunately means each individual contract and extension. You should have each contract reviewed together with the working practices. If a contract has been extended resulting in any changes to the services provided and/or the working practices this will also need to be reviewed." - this comment relating to the fact that Mr Bessell had a 'right of substitution' clause added to his contract at a later date.

You can read more in our article on IR35 status and minimising your risk.

Contracts need to mirror each other

Another important point is that the two contracts in the Dragonfly case (agency-client, and agency-contractor) did not mirror each other.

HMRC argued that even though the agency-contractor contract contained a substitution clause, the reality of the contract wouldn't allow this to happen as the client specifically required Mr. Bessell to work on project.

Significantly, the agency-client contract did not contain a substitution clause at all.

In his IR35 podcast, accountant Steve Crouch points out that contractors should ensure that the contract between the contractor and the agency (the 'lower' contract) mirrors the contract between the client and the agency (the 'upper' contract).

Further resources

You can read download the full legal analysis of the Dragonfly High Court ruling by Roger Sinclair here (PDF).

You can analyse the full Dragonfly Judgement (High Court) here.