“Outsourcing is tax abuse” – Truth or Myth

 

Alan Nolan looks at the phenomenon of labour supply outsourcing arrangements.

The benefits of outsourcing can be substantial - from cost savings and efficiency gains to greater competitive advantage. On the other hand, loss of control over the outsourced function is often a potential business risk – both financially and reputationally.

It is not clear whether HM Revenue and Customs (“HMRC”) is against outsourcing in general or, as is more likely, it remains concerned that the lowest point in the supply chain will not remit PAYE/NIC deductions and VAT over to HMRC at the appropriate time.

HMRC has issued significant guidance on supply chain due diligence.

• Advice on applying supply chain due diligence principles to assure your labour supply chains – last updated 10th May 2021.
• 10 things about due diligence: supply chain assurance.
• How to spot missing trader VAT fraud – April 2018.
• Supply Chain Due Diligence Principles – Check, Act, Review – July 2019.
• Employer Bulletin 87 – “Mini Umbrella Company Fraud” – December 2020.  
• “Mini umbrella company fraud” guidance – 10th May 2021.

The common theme is to promote supply chain due diligence principles as set out in the publication issued by the Fraud Investigation Threat Response Unit in July 2019.  The stated ambition was “to support the UK private and public sector to apply Supply Chain Due Diligence Principles in assuring the financial, legal and tax integrity of their supply chains”.

Is due diligence enough? Can an outsource arrangement simply be considered as “abusive” or “unlawful” and what counter-avoidance measures does HMRC have in place to deter those seeking an advantage to which they would not ordinarily be entitled?

The first question is whether Government has done enough to prevent tax leakage through outsourcing.

The National Procurement Strategy sets out Government’s ambitions and priorities. If, as part of this strategy, Government insisted on direct employment by the first party in the supply chain i.e., its supplier, then any perceived problem with outsourcing may be eradicated overnight.  

The downside could be that labour costs increase due to lack of flexibility, resulting in the taxpayer being left to foot the bill through higher taxes leading to higher prices for the consumer and a potential increase in inflation.   

HMRC has long since recognised that outsourcing (as a risk) has been prevalent in labour supply chains and so, has introduced anti-avoidance provisions which limit the eligibility criteria for both the Employment Allowance for National Insurance Contributions and the VAT Flat Rate Scheme which have both been highlighted as being open to misuse. 

This is the reason why legislative changes to restrict eligibility criteria have been made. 

Limited Cost Trader

On 23 November 2016, Government announced the introduction of a new 16.5% VAT flat rate for businesses with limited costs taking effect on 1st April 2017.  The term “limited cost trader” is defined as one whose VAT inclusive expenditure on goods is either:

• less than 2% of their VAT inclusive turnover in a prescribed accounting period
• greater than 2% of their VAT inclusive turnover but less than £1000 per annum if the prescribed accounting period is one year (if it is not one year, the figure is the relevant proportion of £1000).

This change restricted the differential between the standard rate and the limited cost trader rate (3.5%) whilst maintaining the obvious administrative convenience of the scheme.     

Employment Allowance

The employment allowance was introduced in 2014 in the National Insurance Contributions Act 2014 and was initially a relief of up to £2,000.  In April 2015, it was reformed to exclude employers of personal or domestic staff (except care or support workers) and from April 2016, the value of the relief was increased to £3,000 and single director companies were excluded.

Further reform took place in April 2020 to increase the allowance to £4,000 and restrict access to employers whose NICs liability in the previous tax year was under £100,000.

HMRC’s eligibility for Employment Allowance: further employer guidance was updated on 7th May 2020. Within this publication, there are important considerations for public sector contracts and “connectivity” between companies. 

The guidance confirms that companies are connected for the purpose of claiming the Employment Allowance if a company has control of another company or they are under the control of the same person or people, for example companies linked in a group.     

Due diligence processes should incorporate questions relating to “connectivity” to ensure that the supply chain has a commercial purpose and has not been artificially disaggregated, merely to obtain a tax advantage which would not ordinarily be available.   

Domestic Reverse Charge

With effect from 1st March 2021, the domestic VAT reverse charge was introduced for most supplies of building and construction services. However, most notably, it does not apply to labour supply services.

HMRC’s Investigatory Powers

Our team of dispute resolution specialists has seen an increased number of cases involving the denial of an input tax credit under the Kittel principle of “known or should have known”. 

The European Court of Justice (’ECJ’) judgement in the case of Axel Kittel & Recolta Recycling established the Kittel principle which states that a taxpayer who claims input tax on transactions which he knew or should have known were connected with fraudulent evasion of VAT should be denied his right to claim that input tax.

The ECJ made it clear that if a VAT registered trader, at the point of his purchase, either knew or should have known that he was taking part in a transaction connected with the fraudulent evasion of VAT, that registered trader must be regarded as a participant in that fraud.

Aspire has represented a number of companies who have been de-registered for VAT and/or served with VAT Assessment Notices under the Kittel principle. Broadly speaking, the Kittel principle can be divided into four limbs:

1. Was there a tax loss?
2. Was the tax loss as a result of the fraudulent evasion of VAT?
3. Was the transaction in question ‘connected with’ that fraudulent evasion of VAT?
4. Did the recipient of the labour services, at the time he entered into the transaction, know or should he have known that it was ‘connected with’ fraudulent evasion of VAT.

Historically, the Kittel principle has applied to Missing Trader Intra Community Fraud (MTIC) “goods” cases.  However,  HMRC has now started to apply these principles to labour supply chains.

Therefore, due diligence processes must incorporate active questions on VAT returns and payments to HMRC. 

Mini Umbrella Companies (MUCs)

The concept of outsourcing to small suppliers has been around for a number of years and continues to be the subject of media scrutiny.

HMRC has confirmed that “there is not a standard MUC fraud model”.  Therefore, it is not clear whether HMRC is challenging arrangements where tax liabilities have been established or is suggesting that by simply entering into a supply chain which involves MUCs somehow constitutes fraudulent or abusive behaviour, or both.

The term “abuse”, applicable to the VAT system, operates on the basis of a test comprising two elements which must both be present.

1. The transaction is capable of economic justification.
2. There is no contradiction between the claim made by the taxable person and the aims and results of the legal provision.

Where there is a supply of labour (economic justification) and, should a VAT registered business apply for and be authorised to use the VAT Flat Rate Scheme, and the aim of the scheme is fulfilled (the legal provision) then a transaction should not be able to be described as abusive.   

The problem arises when a supplier knowingly does not satisfy the eligibility criteria for the scheme, or seeks an advantage by declaring the wrong VAT sector which results in a lower VAT percentage rate, or fails to file VAT returns and make payments to HMRC.

Once again, testing the credibility, legitimacy, and legal/tax compliance of labour suppliers throughout the supply chain, by way of due diligence, is of critical importance. 

Importance of Supply Chain Integrity

Adhering to HMRC’s Supply Chain Due Diligence Principles will undoubtedly identify any non-compliant suppliers and, in the event of a fraudulent transaction, can provide a defence against a Kittel assessment.               

In consultation with an Officer in HMRC’s Fraud Investigation Service (“FIS”), Aspire developed and implemented a manageable supply chain due diligence programme covering all types of extended supply chain arrangements.

FIS do recognise the difficulties encountered in performing due diligence.  In 2019, as part of our discussions, a HMRC Officer wrote.   

“In a perfect world where resource is not an issue DD could be a full-time job for someone, that’s how resource intensive it can potentially be. Back in the real world, suppliers have to undertake some checks to protect the integrity of their supply chains but should focus on the greatest risk.  Identifying those risks is key and comes with experience”.  

We took this advice onboard which now forms part of our recommended risk assurance strategy for all parties to the supply chain including corporate directors.

If you require advice about how to mitigate the risks associated with outsourcing your labour supply chain, please contact us at enquire@aspirepartnership.co.uk