Contracted Out Services: Understanding Their Role and IR35 Implications

Contracted out services, also referred to as outsourcing, have become an essential strategy for organizations across both the public and private sectors. From large-scale IT implementations to cleaning services, outsourcing enables businesses and institutions to access specialized expertise, manage costs, and focus on their core operations. While this approach offers many advantages, it also intersects with complex tax and employment legislation, most notably IR35 and Off-Payroll Working rules, which can have significant implications for both service providers and clients.

This article provides a comprehensive guide to contracted-out services, explaining what they are, how they work in practice, their benefits and risks, and how they interact with HMRC’s regulations.

What Are Contracted out services?

A contracted-out service occurs when an organization receives a service from a third-party provider instead of performing the work in-house. Unlike simply hiring an individual contractor, Contracted out services involve the outsourcing company taking full responsibility for the delivery of the service, managing staff or contractors, and assuming financial and operational risk.

Examples of contracted-out services include:

• IT support and software development
  
• Digital transformation projects
  
• Facilities management, including cleaning and security
  
• Health services or staffing solutions in hospitals
  
• Marketing and creative projects

The defining characteristic of a contracted-out service is that the service provider delivers outcomes, not just labour, and is accountable for the results. This distinction is critical because it determines whether IR35 and Off-Payroll Working rules apply.

Contracted out services and IR35 / Off-Payroll Working Rules

IR35 legislation, introduced in the UK, and the Chapter 10 Off-Payroll Working rules, regulate how contractors working through Personal Service Companies (PSCs) are taxed. These rules aim to prevent disguised employment, where a contractor works like an employee but benefits from tax advantages intended for businesses.

Under the Off-Payroll Working rules:

• Public sector organizations have been subject to these rules since April 2017.
  
• Medium and large private sector organizations became subject from April 2021.
  
• Clients are responsible for determining whether a contractor falls inside or outside IR35, unless the engagement is a genuine Contracted out services.

A crucial point highlighted in HMRC guidance is that if a client engages services rather than labour, there is no obligation for the client to determine the IR35 status of the contractors involved. Instead, the service provider assumes responsibility, effectively shifting IR35 obligations down the contractual chain.

However, this “exception” has been perceived as a loophole. It has led to the emergence of consultancies and managed service arrangements designed to place PSC contractors with clients while avoiding direct IR35 responsibilities. HMRC emphasizes that the arrangement must reflect commercial reality, not merely the wording of a contract. Simply labeling a labour supply contract as a “managed service” does not suffice.

Characteristics of Genuine Contracted out services

Identifying a genuine contracted-out service requires careful assessment of how the engagement is structured and operates in practice. The key characteristics include:

Engagement Process

A legitimate contracted-out service often involves a formal tender or proposal process. The provider outlines:

• The full scope of work
  
• Timelines and resource allocation
  
• Pricing and fees
  
• Expected outcomes and deliverables

A contract that simply requires a single individual to perform a day-rate task does not meet the standard for a contracted-out service.

Worker Identification and Control

In a true Contracted out services, the service provider controls all aspects of workforce allocation:

• The consultancy decides which workers will carry out the work.
  
• Workers’ names are generally not specified in the contract, except for key managerial personnel responsible for service delivery.
  
• The client cannot interview or select individual workers.

This ensures that the provider bears responsibility for selecting and managing personnel, rather than the client.

Management of Project and Workers by Contracted out services

Management responsibilities clearly rest with the service provider:

• The provider oversees day-to-day operations and ensures the project meets contractual requirements.
  
• Workers report to the provider, not the client.
  
• Integration into client teams is minimized; work may be carried out remotely or at the provider’s facilities.

This separation of control is essential for distinguishing a contracted-out service from a labour supply arrangement.

Financial Risk

A Contracted out services require the provider to assume financial responsibility:

• Providers may be liable if the service is not delivered as promised.
  
• Contracts often include mechanisms for managing service levels, dependencies, acceptance criteria, and dispute resolution.

By contrast, time-and-materials contracts carry little financial risk and may not qualify as a contracted-out service.

Payment Structure

Genuine contracted-out services are often fixed-price or deliverable-based, meaning:

• Fees are agreed upfront, based on outcomes rather than hours worked.
  
• Providers manage payment to staff and subcontractors internally.

This structure contrasts with arrangements where the client sets day rates for individual contractors, which more closely resemble agency work.

Determining Whether a Contracted out services

It is not always immediately clear whether an engagement qualifies as a contracted-out service. The following factors help organizations make this determination:

Nature of the Supplier’s Business

The type of business providing the service is critical. For example:

Supplier Type	Likely Contracted-Out Service?	Notes
Digital Transformation Service Integrator	Yes	Provides outcomes and manages entire project delivery
Recruitment Agency	No	Primarily supplies labour; minimal control over project delivery
Facilities Management Company	Yes	Supplies teams, materials, and manages service delivery
Individual Contractor	No	Acts as a worker, not as a service provider

Verification can be done via Companies House by checking the Standard Industrial Classification (SIC) code of the supplier.

Contract Terms

A genuine Contracted out services contract typically includes:

• Agreed deliverables, deadlines, and quality standards
  
• Clear definition of responsibilities for both parties
  
• Profit or payment tied to successful service delivery
  
• Specification of goods, materials, and labour involved

Practical Implementation

The way the service is delivered is just as important as the contract itself:

• Who controls workers day-to-day—the client or provider?
  
• Who bears operational and financial risk?
  
• Are workers integrated into client teams or managed independently?

HMRC stresses that commercial reality trumps contract language. If the arrangement looks like a disguised labour supply, it falls under IR35 rules.

Benefits of Contracted out services

Contracted-out services offer multiple advantages, particularly for organizations seeking efficiency and flexibility:

1. Cost Efficiency: Organizations avoid hiring, training, and maintaining full-time staff for non-core activities.
   
2. Access to Expertise: Providers often possess specialized skills that would be costly or impractical to develop internally.
   
3. Focus on Core Functions: Outsourcing allows organizations to concentrate on strategic priorities.
   
4. Risk Management: Responsibility for service delivery, quality, and compliance is transferred to the provider.
   
5. Scalability: Services can be scaled up or down depending on project requirements.

Risks and Challenges

While beneficial, Contracted out services carry potential risks:

• Misalignment of Responsibilities: Confusion over who is accountable for service delivery or tax compliance.
  
• HMRC Scrutiny: Improperly classified arrangements may trigger penalties and audits.
  
• Contractual Disputes: Ambiguity in terms can lead to disagreements between clients and providers.
  
• Hidden Costs: Management, monitoring, and risk mitigation may increase the actual cost of outsourced services.
  
• IR35 Exposure: Misclassified arrangements may bring the engagement into the scope of Off-Payroll rules.

Public Sector Implications: The NHS Example

Contracted out services are particularly relevant for public sector organizations like the NHS:

• Government Policy Support: Outsourcing is encouraged to improve efficiency.
  
• VAT Benefits: Public bodies can reclaim VAT under Section 41(3) of the VAT Act 1994.
  
• IR35 Responsibility: The NHS or other public sector clients are not responsible for IR35 checks when engaging genuine contracted-out services. Responsibility lies with the service provider.

This creates an environment where carefully structured outsourcing can reduce administrative burdens and allow public sector bodies to focus on service delivery.

Best Practices for Implementing Contracted out services

Organizations can reduce risk and ensure compliance by following these best practices:

1. Verify Supplier Credentials: Check business nature and SIC codes to ensure the provider is legitimate.
   
2. Align Contract with Practice: Ensure that the reality of service delivery matches contract terms.
   
3. Define Scope and Deliverables Clearly: Avoid ambiguity in responsibilities, performance standards, and timelines.
   
4. Monitor Performance: Conduct regular review meetings and document outcomes.
   
5. Maintain Documentation: Keep clear records of decision-making, resource allocation, and communications.
   
6. Mitigate IR35 Risk: Ensure all parties understand their obligations under Off-Payroll rules.

Best Practice	Purpose
Supplier verification	Ensures engagement is with a genuine service provider
Contract alignment	Prevents contrived arrangements that may fall under IR35
Clear deliverables	Reduces risk of disputes and service failures
Performance monitoring	Ensures project quality and timely delivery
Documentation	Provides evidence of compliance in case of audits

Conclusion

Contracted out services are an essential tool for organizations seeking flexibility, expertise, and efficiency. By clearly distinguishing between services and labour, organizations can benefit from outsourcing while managing IR35 and Off-Payroll Working obligations.

Key takeaways include:

• Genuine contracted-out services shift responsibility for workforce management, financial risk, and IR35 compliance to the service provider.
  
• HMRC emphasizes commercial reality over contractual labels; simply using terms like “managed service” does not exempt IR35 responsibility.
  
• Careful planning, documentation, and adherence to best practices can maximize the benefits of contracted-out services while minimizing risks.

For both public and private sector organizations, properly structured Contracted out services can provide cost savings, access to expertise, and operational efficiency, making them an invaluable component of modern organizational strategy.