What is the difference between a “contract of service” and a “contract for services”?

Employment Status – Employed or Self-employed?

(UK relevant – What factors determine a person’s employment status? Who makes the decision? What if I do not agree?)

These are the common-law terms that are used to distinguish employees from persons who are self-employed. The terms are confusing and are not defined anywhere in legislation. The term:

  • “contract of service” relates to a person in employment (as in the case of a domestic servant who is described as being “in service”)
  • “contract for services” relates to a person who is self-employed and who provides services to clients.

The term “contract of service” is, however, referred to in the employment and tax legislation. A person who works under a contract of service is:

  • an “employee” for payroll purposes, and
  • an “employee” for employment rights purposes, and
  • a “worker” for other employment rights purposes.

In contrast, a person who works under a contract for services, i.e. a self-employed person, is neither an employee nor a worker. There is no requirement for an employer to put such a person on the payroll; rather payment may be made on invoice. There is no entitlement to any of the employment rights available to employees and workers.

How, then, are these two terms to be distinguished? Traditionally, there are two key tests to identify an employee, i.e. a person who works under a “contract of service”. These are:

  • “mutuality of obligation”, i.e. both parties to the contract have obligations to each other, the employee to perform work as directed, the employer to pay for the work performed
  • the “degree of control” exercised by the employer over the work performed by the employee.

Other factors, however, have been taken into consideration when courts and tribunals have endeavoured to distinguish between employment and self-employment. These include:

  • whether the individual must perform the work personally, or is able to send a qualified substitute
  • the nature of the pay and benefits that are provided by the employer
  • whether or not the individual has a business structure
  • who decides on how the contract should be performed
  • the extent of the financial risk borne by the individual
  • who provides the materials and equipment necessary for the work.

The duration of the contract is also important; the longer the engagement, the more likely it is that the relationship is employment.

Another simple way of distinguishing employment from self-employment is to consider what it is that the employer is “buying”:

  • if the employer is “buying” an employee, there will be a lengthy recruitment process in order to find just the right person
  • if the employer is “buying” a service, the person who will provide the service is likely to be selected by recommendation or simply by choosing an ad in Yellow Pages.

A person who is self-employed in one kind of work may also be an employee in some other kind of work. A self-employed tradesman who works in a pub in the evenings would have to go on the pub’s payroll for that evening work. The fact that a self-employed person is registered as a subcontractor under the Construction Industry Scheme, or has a VAT registration number, or a self-employed reference number, does not mean that that person is self-employed in every job the person does.

HM Revenue & Customs (HMRC) describes the process of assessing employment or self-employment as “picture-painting”. In other words, a person’s employment status cannot be properly identified unless the whole picture is considered. One particular factor, such as whether the employer or the individual provides the equipment and materials, does not, in itself, prove employment or self-employment. All of the relevant factors must be considered and, in all cases, it is the employer that must make the decision. The employer has all of the liabilities if a person is wrongly identified as being self-employed.

In most cases it is not difficult to correctly recognise employment and self-employment. The problem area is contractors, whose work often demonstrates factors that point to both employment and self-employment.

If a self-employed person believes that a client has wrongly decided to treat the working relationship as a “contract of service”, there are two options:

  1. Use the online interactive Employment Status Indicator provided by HMRC. It may be used by employers and individuals but its reliability depends on the accuracy by which the questions are answered.
  2. The parties to the contract can ask for the situation to be reviewed by a Status Inspector in the employer’s tax office.

Both of these options may be explored furtherĀ here.

At the end of the day, however, it is the employer who must decide whether a particular person is working under a “contract of service” or a “contract for services” and, in the event of a compliance audit by HMRC, bear the heavy financial consequences of getting it wrong.

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Payroll Update 2013