Mills & Reeve: Technology Law Update

Getting ready for IR35

The introduction of the new tax regime for consultants in the private sector is arriving soon.

From April 2020, the change will see many larger private sector businesses required to deduct income tax and National Insurance contributions via payroll from fees for services. This will apply in situations where fees are paid to a personal service company, but where the individual performing the services would (but for the personal service company) ordinarily be regarded as an employee of the client company for tax purposes.

The change is likely to affect purchasers of IT services, as well as agencies and IT service providers. You may need to review your arrangements and contracts ahead of the change to ensure compliance.

Mills & Reeve tax partner Kevin Lowe explains the changes and offers practical tips here. 

Katy Carson

Employee non-compete clauses: what is acceptable?

When hiring for business-critical roles, a tightly worded non-compete clause is often an important element in the contract. Top-level staff will have access to confidential projects and important relationships. An unexpected or contentious departure can expose a business to significant risk. This exposure is heightened where the individual intends to join or invest in a competitor. The Supreme Court recently ruled on a non-compete clause, analysing it fully for the first time in a hundred years or so. The judges took the opportunity to refresh the law on restraint of trade, clarifying the circumstances in which words can be removed or “severed” to convert what would otherwise be an unenforceable clause into one that is legally effective.

Interesting wording

Ms Tillman was a senior recruitment consultant specialising in the financial services sector. She had entered into a contract of employment in which she had promised not to “directly or indirectly engage or be concerned or interested in” any competing business for a period for 12 months after the end of her employment. Her employers sought to enforce this promise when she left to work for a competitor. 

It is widely accepted that being “interested in” a competing business, in this context, can include holding any kind of shareholding, even a minority stake. The Supreme Court concluded that if the words "or interested" remained in the clause, it would be unenforceable as an unreasonable restraint of trade. However, if these words were excluded, the clause would be reasonable and therefore enforceable. So the judges had to decide whether to accept the employer’s request to strike out the offending words.  Two questions were important:

Firstly, could the offending words be removed without adding to or modifying the wording of what remained? In other words, did deleting the words satisfy the “blue pencil test”? The answer to that was clearly yes.

Secondly, did the removal of the words change the essential character of the contract which the parties had entered into? The Supreme Court decided to reformulate this question (which had emerged from previous case law) into the following: would removal of the words “generate any major change in the overall effect of all the post-employment restraints in the contract”?  The Supreme Court concluded that it would not and the offending words could be deleted.

Take away points

So where does this leave us?  

• Welcome news for businesses, as the courts are prepared to enforce reasonable post-termination restrictions. Clauses of this nature remain an important safeguard for employers to protect their business from unfair competition when an employee leaves, particularly where they are in possession of commercially sensitive information, trade secrets or key customer connections;
• Employers and their lawyers need to think carefully about how the clause is put together: each element of each restriction will need to be defended as reasonable;
• Restraining a departing employee from being a shareholder in a competing business (even if this is a minority interest) will be regarded as being in restraint of trade and therefore unenforceable; and
• You cannot assume that a court will necessarily be prepared to convert an unreasonable obligation into a reasonable one by striking out offending words, even if the blue pencil test is satisfied. The Supreme Court has attempted to make the criteria which will be applied clearer, but the issues will not always be clear cut.

Melanie James

Employment status, tax and the gig economy - what's new?

We’ve recently published two articles about the risks of making the wrong call about an individual’s employment status and the new developments employers should be looking out for on that front.

In April next year, new rules on personal service companies will increase the tax risks businesses are exposed to when engaging individuals via personal service companies. Our corporate tax partner Kevin Lowe explains here what steps businesses should be taking to get ready for this change.

There have also been some important new cases about employment status, particularly involving workers in the gig economy. In this briefing Charles Pigott explains the different but overlapping rules that determine how an individual is treated for employment rights and for tax purposes and assesses the significance of the recent case law on this subject.

Four key messages about EU staff and Brexit

The recent vote in the UK House of Commons to reject the EU Withdrawal Agreement may result in additional concern for EU staff and their employers in the tech sector.

Based on our experience of providing support to organisations in this area, including running briefing sessions for EU nationals, we think there are four key messages to get across in this context:

• Reassurance– the Government has confirmed that it will run the Settlement Scheme (the Scheme that will effectively protect the rights of EU nationals currently residing in the UK) for EU nationals and their family members who are residing in the UK on or before 29 March 2019 (ie, Brexit day), even in a no deal scenario. So irrespective of the outcome of the Brexit negotiations, the rights of EU nationals and their family members currently in the UK should be preserved.  The Government has confirmed this week that no fee will be payable for applications under the Settlement Scheme (although a £65 fee will still be payable (to be later reimbursed) for applications made during the current pilot phase which opened on 21 January).   
• Recruitment– the risk of a no-deal Brexit may have increased. It is not clear what immigration system the Government will operate for EU nationals who wish to come into the UK from 30 March 2019 in a no deal scenario, although it is likely that existing rules will apply in the short-term. Importantly, the transition period that would run until 31 December 2020 which has been agreed as part of the Withdrawal Agreement would not apply. Employers who have identified a specific EU national for a role, or who have recruitment processes involving EU nationals underway, should where practicable plan to ensure that EU nationals are appointed and resident in the UK by 29 March 2019, or as soon as possible thereafter, in case of a no-deal Brexit.
• Workforce planning– it is sensible for organisations to identify the areas where they tend to recruit a significant number of EU nationals, the potential risks associated with additional recruitment barriers and costs which may come into play, and actions that can be taken to mitigate these risks.
• Sponsor licence applications and compliance – based on the recent Immigration White Paper, it seems likely that the future immigration system will involve an extension in some form of the current points based system to EU nationals. This would mean that all employers who wish to recruit EU nationals would need to register as sponsors. Getting ahead of the curve and applying now for a sponsor licence may be a prudent step – although there is no guarantee this will be required. Furthermore, the consequences for existing sponsors of having their licence revoked as a result of compliance failures may be prove to be more serious in the post-Brexit world. So ensuring a high level of compliance may be more important than ever.

The Mills & Reeve immigration team can help in advising on Brexit-related immigration issues, providing support for EU staff, and assisting with sponsor licence issues. Please get in touch with Alex Russell if your organisation requires any advice in this area.

Alex Russell, Principal Associate

Welcome changes to the ABC of Entrepreneurs’ Relief

The changes to Entrepreneurs’ Relief announced in the UK Chancellor’s Autumn Budget (discussed here) rang alarm bells for some. So-called “alphabet shares” are often used to provide flexibility on the payment of dividends. The new regime (taking immediate effect on 29 October) had the unwelcome result that ER will not be available where the board has full discretion to allocate dividends between the different share classes.  

A tightening up of the qualifying rules for this important tax relief presented a real problem for those individuals who have shares in a company that has different share classes. In the typical alphabet share approach used to provide flexibility for the payment of dividends between different shareholders, the articles of association will normally give directors discretion on how to allocate dividends. This discretion means the shareholder is not entitled to a dividend and so will not qualify for entrepreneurs’ relief.

Corrections made at this stage could have had knock-on consequences on the shares’ valuation and relating to the employment-related securities rules.

Boards and shareholders alike have welcomed proposals made on 20 December to address the problem. Under the planned changes to the Finance Bill a shareholder will benefit from ER if the shares they hold:

• Represent at least 5% of the ordinary share capital; AND
• Enable them to exercise at least 5% of the voting rights in the company, AND
• Either:
  • Gives them an entitlement to 5% of the distributable reserves and 5% of the assets on a winding up; OR
  • In the event of a disposal of the whole of the ordinary share capital of the company, entitles them to at least 5% of the sale proceeds.

The new alternative (in bold) means that alphabet shares may still be able to qualify for ER, even if they have no entitlement as such to dividends, provided the other conditions are all met for the qualifying period.

Kevin Lowe

Jail for exporter of jet parts to Iran

A retired businessperson has been found guilty of exporting military fighter jet parts to Iran, in breach of export controls. Alexander George, along with two others, Iris and Paul Attwater, were convicted for using deceptive methods to ship the parts to Iran from 2010 to 2016.

Indirect shipping of fighter jet parts

Mr George purchased the fighter jet parts in the USA, and shipped them to his various companies in Malaysia and the United Arab Emirates. These companies then shipped the parts to Iran, which is subject to trade embargoes and sanctions which prohibit the export of military or dual-use items. Dual-use items are those which could have both civilian and military uses.

After becoming concerned about being investigated by the FBI and CIA, Mr George involved Mr and Mrs Attwater in the exportation of the parts through their aviation company. However, by 2010 a number of exports by the Attwaters’ aviation company had been blocked by HMRC. HMRC interviewed Mr George twice over the exports, and all three individuals were warned about exporting the parts without a licence. Despite these warnings, the trio then attempted further concealment of the illegal exportation. They set up a new company in Holland, through which the items were shipped to Malaysia before being sent to Iran.

Tough penalties

Following an investigation and prosecution by HMRC, Mr George received a sentence of two and a half years imprisonment. Mr and Mrs Attwater, who were sentenced in 2016, each received a suspended sentence of six months imprisonment.

It has been estimated by HMRC that Mr George made profits of more than £5 million from evading export controls, and Mr and Mrs Attwater benefited to the tune of £500,000. HMRC intend to undertake proceedings to recover the profits made by the group.

A clear example of the UK’s tough export controls in action

This case highlights that UK export controls apply equally to individuals carrying out activities in the UK, and to UK nationals carrying out activities abroad. Exporters of goods or technology that may have military or internal repression uses should check carefully whether their products are covered by UK or EU export controls.

Simon Elsegood

2018 Autumn Budget - plenty on offer for tech businesses, investors and fund managers

The Autumn Budget brought some welcome news for both technology companies, and investors and fund managers in this space.

• Last year’s Budget announced an action plan to unlock investment in innovative, high-growth businesses. The Budget announced several new initiatives. These will involve the British Business Bank working with pension funds to explore options for pooled investment in patient capital. The FCA will explore ways to support patient capital, with proposals for a new long-term asset fund and to allow unit-linked pension funds to invest. The Department for Work and Pensions will consult on the pensions charge cap to ensure that performance fees are not restricted in a way that hampers investment.
• The Government has earmarked more funding to support its Industrial Strategy objectives. The Industrial Strategy Challenge Fund will receive a £1.1 billion boost. Support Is promised for a range of initiatives across AI, the digital transformation of manufacturing, future mobility, DLT and cryptoassets, quantum computing and cybersecurity.
• We are pleased to see EIS/SEIS remaining safe. Also welcome are plans to launch a new approved EIS fund structure to invest in knowledge-intensive companies (KICs) following a consultation earlier in the year.
• Entrepreneurs’ Relief will be retained, with some changes.
  • An immediate change to ER is the new requirement that shareholders must be entitled to at least 5% of the company’s distributable profits and net assets, as well as holding 5% of the  issued ordinary share capital and voting rights. The introduction of these two new conditions mean that, for the first time, shares need to have real economic rights, preventing managers being bumped up to more than 5% by the issue of voting shares with no additional economic rights. This change will apply to all sales of shares on or after the date of the Budget. However, these additional conditions will not apply on sales of shares acquired by employees on exercise of qualifying EMI share options.
  • Also, for any shares sold after 5 April 2019, ER will only be available if the shares have been held for at least 2 years (up from 12 months).
• The intangible fixed assets regime will be updated following a recent consultation. Targeted relief for the cost of goodwill in the acquisition of businesses with eligible intellectual property is planned as from April 2019. Changes to improve the de-grouping charge rules will take effect from 7 November.
• The Annual Investment Allowance for qualifying plant and machinery will see a temporary increase to £1 million for 2019 and 2020.
• R&D tax relief will be retained with minor changes aimed at preventing abusive claims. These will restrict the tax credit that a qualifying loss-making company can receive in any tax year to three times the company’s total PAYE and NICs liability for that year.

Press comment has focused on the planned new digital services tax. Although headline-grabbing, this is not relevant to smaller businesses, as it will only apply to those with annual global revenues of over £500m. 

Dona Ardeman and Neil Pearson

Why investors and directors in flourishing tech start-ups need insolvency advice

“Financial distress” is often a way of life for tech start-up businesses. The definition of insolvency under English law is where a company is unable to pay its debts when due and/or its liabilities are greater than its assets on its balance sheet. A tech start up carrying any form of debt is likely therefore to be insolvent from the start whist the product it is developing takes shape and creates value.

What are the risks for directors?

It is a common misconception that a company cannot trade whilst insolvent. That is not true. Many companies trade insolvently. What the directors need to be aware of in these circumstances is firstly the duty to act in the best interests of creditors, in priority to, but not at the expense of, the position of shareholders and the other duties set out in the companies legislation.  Breach of this duty can lead to personal liability for the directors.

Secondly, the directors need to be aware of wrongful trading – the trading of a company with no reasonable belief that the company can avoid an insolvency process. Again, falling foul of this provision can result in personal liability for the directors for the loss caused.

Having said all of that, directors can mitigate that risk, in respect of an insolvent company, by taking legal advice, which is what the courts will expect. That advice should obviously be accurate, but most importantly, it should be practical, commercial and proportionate.

Getting the right advice

I have been advising companies in the tech sector in financial distress for over 15 years now. Too often, I see advice given by those who do not have enough industry expertise, knowledge or experience and state black letter law, which provides no flexibility to the directors to do what they do best as entrepreneurs and find solutions to the financial distress that the company is facing.

Last year, I was advising a board on its route to recovery. The company’s bookkeeper introduced an insolvency practitioner to the company who advised, without all the facts, that if the directors continued to trade, they would all lose their houses! 

After having corrected that misinterpretation of the position, I helped the board over the coming weeks with advice that gave them time to find new investment in the best interests of both the creditors and shareholders, leading to the company trading out of its financial distress and enhancing value for its investors.

Investor and lender representatives are most at risk

Claims against directors under the insolvency legislation for breach of their duties and obligations are rare, but as I always say to the boards that I advise, you do not want to be the test case.  If a company goes into an insolvency process, the insolvency practitioner will be looking for the party with the deepest pockets.

This is particularly relevant to investors and lenders who have representatives on the board. In those circumstances, the insolvency practitioner is likely to believe (most probably correctly) that those representatives will have insurance and the financial support of their investor employer. 

This, coupled with the fact that the representative is likely to be experienced in the sector, makes them an immediate target.

It is therefore paramount for investors to ensure that the boards of their portfolio companies, as well as their individual representatives, are getting sound, practical, commercial and proportionate legal advice.

This is to ensure, not only that their employees are protected, but also, in times of financial distress, that the boards of their portfolio companies are given the best chance and the most time to find solutions to the problems they face to protect and enhance value for investors.

Neil Smyth

New EU-wide crowdfunding regime proposed

The EU is planning to put a new structure in place to regulate crowdfunding. The initiative seeks to iron out national rule differences and introduce a single EU-wide regime for many types of crowdfunding.

This makes a lot of sense as crowdfunding is generally run through online platforms, and confining their activity to one country makes little sense in today’s connected world. The resulting fragmentation of the EU market is thought to be holding back the growth of crowdfunding as compared to other major economies. 2016 data from the Cambridge Centre for Alternative Finance valued European crowdfunding at €7bn, compared with over €200bn for the Asia-Pacific region and €35bn for the Americas.

What are the planned changes?

The proposed legislation aims to:

• establish a one-stop-shop access to the EU market;
• provide tailored rules for European crowdfunding services providers covering both investment-based and lending-based business models;
• open up opportunities to European investors while safeguarding a high level of investor protection in relation to crowdfunding services;
• define the requirements crowdfunding service providers have to fulfil in order to achieve authorisation, and provide a single point of entry for authorisation and supervision by a single authority, the European Securities and Markets Authority (ESMA).

What activity is within scope?

The proposals are intended to apply to all crowdfunding services that offer investors a financial return, with debt and equity arrangements both covered. It would not apply to reward or donation based crowdfunding activity, however, as these are viewed as different from financial services. Also excluded is consumer lending as this has its own regulations.

There would a cap on the size of transaction that can use the system. Crowdfunding campaigns to raise a total of €1m within any year would instead fall within the scope of the Prospectus Regulation and The Markets in Financial Instruments Directive (MiFID II) rules.

This proposal forms part of the EU’s Fintech Action Plan. This ambitious project includes a series of initiatives that aim to build on and promote the success of Europe’s growing Fintech sector.

Employer liable for disgruntled employee’s deliberate data breach

WM Morrisons Supermarket plc have been held liable to 5,518 of their employees for a deliberate data breach by a rogue employee, Andrew Skelton.

Skelton had been employed by Morrisons as a senior IT auditor.  In the course of his duties he was required to collate employee data for Morrisons’ external auditors.

Unknown to his employer, Skelton extracted a copy of the data for himself, consisting of the names, addresses, gender, date of birth, phone numbers, national insurance numbers, bank sort codes and bank account numbers of 99,998 Morrisons employees.  He later uploaded this copy data onto a file sharing website.  The data remained public for two months before Morrisons were alerted to the situation and took steps to prevent access to the data.

Skelton was convicted in subsequent criminal proceedings and sentenced to 8 years’ imprisonment for offences under the Computer Misuse Act and the Data Protection Act.  In sentencing, the Crown Court observed that Skelton had uploaded the data owing to a grudge that he bore the company following an earlier disciplinary warning.  The disciplinary warning had been unrelated to data security issues.

The later High Court judgment concerns Morrisons’ civil liability to its employees.

“Primary” liability under the Data Protection Act 1998 (the DPA)

First, the court considered whether Morrisons itself had any “primary liability” to compensate its employees for the data breach under the DPA.  Subject to one exception which was found to be irrelevant to the question of liability, the judge held that Morrisons had operated appropriate control mechanisms for data security under the DPA.

Similarly, having reviewed the evidence, the judge held that no-one else at Morrisons knew or ought to have known prior to the breach that Skelton was not to be trusted with data.

The company therefore had no “primary” liability to its employees for the breach.

 “Vicarious” liability

Once Skelton unlawfully copied the data for his own purposes he became a data controller under the DPA in his own right of the copy data on the memory stick.  He had then breached his own duties under the DPA.  The second aspect of the judgment concerns whether Morrisons were “vicariously” liable for Skelton’s breaches as his employer, despite the company itself not being “at fault”. 

The judge was satisfied that Skelton’s actions were sufficiently closely connected to his employment that the legal tests for vicarious liability were satisfied.  He also held that the DPA did not exclude the possibility of vicarious liability. 

However the judge was most troubled by the argument that in finding Morrisons liable, the court was in effect rendered an accessory to Skelton’s criminal aim of damaging the company.  The judge has granted permission to appeal the finding, and media reports suggest that Morrisons will appeal.

What should organisations do?

Aside from any appeal, the court has not yet ruled on what each employee’s claim is worth.  Organisations should ensure that appropriate data security measures, policies and procedures are in place and followed to help ensure that they have a defence to a primary liability claim. Organisations should also check whether their current insurance arrangements will meet potential compensation claims (for primary and secondary liability) arising from a data breach. The Morrisons claims were advanced both under the DPA and for misuse of private information and breach of confidence.

Class action claims will continue to be a risk for organisations.  By 25 May 2018 the EU General Data Protection Regulation and UK Data Protection Bill will come into effect, replacing the DPA and including measures intended to allow representative bodies (e.g. consumer law organisations) to bring compensation claims on behalf of affected individuals.

Claire Williams