Appendix 3: Non domiciled employees: dual contract arrangements
(Adapted from an article in Tax Bulletin 76 – April 2005)
Dual contract arrangements are popular with foreign domiciled employees who work both in and outside the United Kingdom (UK). Although there is nothing to prevent an individual from entering into an employment contract with more than one employer, HMRC has concerns that employers, employees and their advisers provide written contracts that do not reflect the reality of the situation. This appendix first appeared as an article in Tax Bulletin 76 (April 2005). It explains how HMRC offices approach enquiries into dual contract arrangements. In summary, HMRC believes that the commercial reality in some cases may be that the employee has just one employment.
The question of the existence or otherwise of an employment usually arises for tax purposes where there is doubt over whether income derives from employment or self-employment. Once it has been established that an individual performs services as an employee, there is generally little difficulty in attributing earnings to a particular employment relationship.
The Employment Income parts of the Income Tax (Earnings and Pensions) Act 2003 (‘ITEPA’) charge to tax earnings “from” employment. Although ITEPA does not attempt a comprehensive definition of employment, section 4(1) provides that “employment” includes “any employment under a contract of service”.
Chapter 5 Part 2 ITEPA contains the rules for determining the taxable earnings of employees (and office holders) who are resident, ordinarily resident or domiciled outside the UK. Section 21 taxes the full amount of any general earnings for a tax year in which the employee is resident and ordinarily resident, but not domiciled, in the UK except to the extent that they are “chargeable overseas earnings” for that year. Section 22 provides that the taxable amount of chargeable overseas earnings is the full amount remitted to the UK in that year. Section 23 describes how to calculate chargeable overseas earnings. By section 23(2), “general earnings for a tax year are overseas earningsfor that year if:
- in that year the employee is resident and ordinarily resident, but not domiciled, in the UK
- the employment is with a foreign employer and
- the duties of the employment are performed wholly outside the UK.”
“Foreign employer” is defined in section 721(1) ITEPA as meaning “in the case of an employee resident in the United Kingdom, an individual, partnership or body of persons resident outside the United Kingdom and not resident in the United Kingdom or the Republic of Ireland …”
Where the employment is in substance one whose duties fall to be performed outside the UK, the requirement that the employee performs the duties of the employment wholly outside the UK is subject to section 39. This provides that duties performed inside the UK, which are “merely incidental to” duties performed outside the UK, are to be regarded as performed outside the UK. In Robson v Dixon 48 TC 527, Pennycuick V.-C. observed that:
“the words “merely incidental to” are upon that ordinary use apt to denote an activity (here the performance of duties) which does not serve any independent purpose but is carried out in order to further some other purpose.”
So duties performed in the UK that are of the same type as those performed overseas are not merely incidental, even if performed for only a very short time.
The calculation of chargeable overseas earnings is set out in three steps in section 23(3). The first step is to identify the full amount of overseas earnings. The second and third steps adjust this figure by deducting allowable expenses and applying any limit required by section 24. Section 24 imposes a limit on how much of an employee’s general earnings are chargeable overseas earnings where the duties of an associated employment are performed in the UK. The limit is the proportion of the aggregate earnings for that year from all the employments concerned that is reasonable having regard to the nature of and time devoted to the duties performed outside and in the UK respectively and to all other relevant circumstances.
Dual contract arrangements
The legislative scheme outlined above is advantageous to employees or office holders who can show that they are:
- resident and ordinarily resident but not domiciled in the UK and
- perform duties of an office or employment under a foreign employer wholly outside the UK.
As chargeable overseas earnings are taxed on remittance, there is a clear incentive to ensure that such earnings are paid overseas and to minimise the amount of earnings remitted to the UK. However, the requirement that the duties of the employment are performed wholly outside the UK presents problems to foreign domiciled employees whose jobs require them to work partly in the UK and partly abroad. Earnings from an employment with duties performed in and outside the UK would be taxable under section 21 wherever received. An employee may therefore be offered two employment contracts, for example:
Contract 1 covering the performance of duties in the UK and
Contract 2 with an associated employer resident overseas covering duties performed in the rest of the world excluding the UK.
The intention is that earnings from employment contract 2 will be chargeable overseas earnings and therefore taxable under section 22 only when remitted to the UK. For this reason, dual or multiple employment arrangements are popular with foreign domiciled employees whose duties are performed partly in the UK and partly outside the UK. The arrangement is generally that the individual enters into two separate written contracts, frequently referred to as the UK employment contract and the overseas employment contract.
Enquiries into dual contract arrangements
HMRC offices may make enquiries in order to check whether the earnings under the overseas contract are chargeable overseas earnings. They may also consider whether there is in fact a single employment contract not withstanding the production of two written contracts. This approach has generally been deployed where there is concern that there has been an attempt to split a single employment to exploit the legislation that provides for chargeable overseas earnings to be taxed on remittance.
Employers, employees and their advisers maintain that there are separate and distinct employments. They invariably argue that the employee performs a different role with different responsibilities under each contract of employment and that the duties under each do not overlap and are not dependent on each other. In many cases written contracts have been drafted that fairly represent the true employment relationships and include a proper job description along with details of the remuneration package and other entitlements (annual leave etc) relating to each employment. Care has been taken to ensure that the roles described in each contract are capable of independent existence with proper regard given to what would happen on termination of one of the employments. Best practice has recognised the importance of maintaining separate payroll and expenses regimes and different line management and reporting arrangements.
Where there are two employment contracts and the written contracts reflect this, dual contract arrangements provide a legitimate way to structure an individual’s employment relationships. Where the arrangements reflect the true employment relationships, enquiries focus on:
- whether the employee has in fact performed substantive duties under the overseas contract in the UK
- whether a section 24 adjustment is needed to address an imbalance between the earnings from the UK and overseas contracts.
Given the way in which modern business operates and the ease and speed of communication, some employees may find it increasingly difficult to avoid performing substantive UK duties under their overseas contracts. For example, an employee who is responsible under their overseas contract for servicing the business of overseas clients may have to respond to a telephone call or e-mail from a worried overseas client with an urgent problem when the employee is in the UK. Formulating and communicating a response to such a problem would be regarded as a fundamental duty under the overseas contract. It follows that the performance of such duties in the UK will not be merely incidental to the performance of duties outside the UK as they will be of equal importance to the overseas duties. It is the quality of the UK duties and not the time devoted to their performance that determines whether they are merely incidental.
In a number of cases, the duties required under each purported employment contract are defined according to where those duties are performed. For example, the UK contract states that the duties of the employment are all those duties performed in the UK whereas the overseas contract states that the duties of the employment are all those duties performed wholly overseas. Employees and their advisers may contend that all overseas duties are duties of the overseas employment and all UK duties are duties of the UK employment. On that analysis, duties performed in the UK in connection with the business of the overseas employer are performed under the terms of the UK contract and are not duties of the overseas employment.
HMRC does not consider that the existence of separate and distinct employments is determined by the terms of written contracts where the main distinction between the duties required under each contract is geographical. There are concerns that arrangements of this nature artificially divide a single job so earnings attributable to overseas duties can be treated as chargeable overseas earnings. HMRC has received legal advice that supports a robust challenge to such arrangements.
The commercial context
As a result of the legal advice referred to above, HMRC considers that a dual contract arrangement based solely or mainly on a geographical split of employment duties without commercial underpinning is vulnerable to challenge on the grounds that there is in reality a single employment with duties in and outside the UK. In such cases, HMRC offices should fully investigate the facts and circumstances including the commercial rationale and context and assess an employee to tax where the evidence shows that there is in fact a single employment.
HMRC takes the view that a dual contract arrangement is unlikely to work unless there are two distinguishable jobs. For example, a French resident employer ‘A’ sends employee ‘B’ who is domiciled outside the UK to establish an office in London for its UK subsidiary ‘C’. A requires B to work in its Paris office servicing their existing portfolio of French clients two days per week. On the other three days, C requires B to work in London. This is likely to constitute a proper basis for B holding separate employment contracts with A and C.
In order to decide whether the arrangements create two employments, rather than artificially divide a single employment for tax purposes, it is appropriate to look at the economic advantage that an employer gains from the employee’s activity. If the contractual arrangements are to have any meaning, they must be seen in the context of the underlying commerciality of the arrangements. Regardless of there being two written contracts, HMRC would not accept that there were two employments if the risks and rewards relating to work done in the UK and overseas were in fact substantially borne and received by a single employer. Moreover, an arrangement requiring a written contract between an employee and a UK employer which provides only for the performance of duties in the UK would appear artificial if the employer’s business extends outside the UK.
An employer’s interest does not lie in having the employee work in a defined geographical area but in an economic activity that benefits the employer. An employee may perform duties overseas that directly benefit the business of the UK employer. When performing those duties, the employee is not working for the overseas employer but for the UK employer overseas. If the arrangement were genuine, the employee would not be paid by the overseas employer to work for the UK employer overseas. If that is what the contract requires, it would indicate a lack of commerciality. Conversely, an employee who performs duties in the UK that directly benefit the business of the overseas employer is working for the overseas employer in the UK. It is difficult to imagine circumstances in which contracts that can require an employee to work for the benefit of a UK employer whilst being paid by an overseas employer or vice versa would be offered by employers that were not associated.
Various mechanisms exist for allocating costs to another entity that benefits from an employee’s services. These include transfer pricing adjustments. It has been suggested that such adjustments restore the commercial equilibrium and thus support the existence of separate employments. However, the fact that such adjustments are necessary indicates that the employer has misjudged the commercial reality of the arrangements. Separate employers do not for sensible commercial reasons pay employees to work for someone else, with or without transfer pricing.
Dual contract arrangements are sometimes used when a UK resident employee holding one employment with worldwide duties first becomes ordinarily resident. Some individuals who are self employed before they arrive in the UK become employees with dual contract arrangements on attaining UK resident and ordinarily resident status without any significant change in the way in which they carry out their professional activities. In other cases, recruitment material suggests that the employer has a single vacancy to fill and a dual contract arrangement is only implemented following the appointment of a non-domiciled individual. In such scenarios, HMRC offices will test whether the facts reflect commercial reality.
Overseas contracts and UK duties
Where the commercial reality shows the existence of separate employment contracts, it is sometimes argued that contractual terms that prohibit the performance in the UK of duties connected with the business of the overseas employer, preclude HMRC offices from arguing that the employee has performed duties of the overseas employment in the UK. These arguments are based on the UK duties being “ultra vires”.
HMRC does not consider that the presence of such clauses allows the performance of duties in the UK that clearly benefit the overseas employer to be ignored. To that end, both employers ought to be closely monitoring the employee’s UK activities. For example, where the employee has performed substantive duties in the UK that directly benefit the overseas employer, HMRC would expect the UK employer to mark the fact that the employee is effectively abusing its time and take appropriate disciplinary action. And if the UK work in question was valuable, the overseas employer should take it into account when calculating bonus entitlement. It is possible that clauses like this are frequently waived or ignored and may be inserted to create a misleading impression.
Tax impact where dual contract arrangements fail
Where the facts indicate that there is, in commercial reality, only one employment contract whereby the employee performs duties for the benefit of one employer both in and outside the UK, all of the employee’s general earnings will be taxable under section 21 ITEPA. As earnings attributable to overseas duties will not be chargeable overseas earnings, tax will be charged on receipt rather than on remittance to the UK. The identity of the “employer” will depend on all the facts and circumstances of the individual case. However, the UK entity that receives the benefit of an individual’s services will be obliged to apply PAYE to all payments of PAYE income made to the employee during the period that the employee works for that entity. This is because the UK entity will either be the employer or (for the purposes of section 689 ITEPA) the relevant person.
If there are genuine separate employments but the employee has performed substantive duties in the UK for the overseas employer, then all earnings from the overseas contract will be taxable under section 21 in the relevant year. They will not qualify as chargeable overseas earnings under section 22 because the duties of employment with a foreign employer will not have been performed wholly outside the UK in the year in question. There is unlikely to be an obligation to operate PAYE on earnings from the foreign employer, as that employer will not have the necessary presence in the UK for PAYE purposes, and the UK employer will not be the relevant person in relation to duties performed by the employee under the separate overseas employment.
Where for tax purposes the facts indicate that despite the existence of two written employment contracts, there is a single employment covering UK and overseas duties, there could also be National Insurance consequences. If it is found that the earnings relating to overseas duties are attributable to employment with the UK employer, there will be liability to pay further National Insurance.