Outsourced Payroll is not a TUPE Transfer: Lessons from a costly VAT ruling
A recent tribunal decision shows that calling an arrangement a "TUPE transfer" does not make it one. For accounting firms and their HR teams, the case reminds them that employment status turns on legal realities and not administrative assumptions.
A specialist engineering and inspection business with around two dozen staff had always run payroll in-house. After a key team member was absent in early 2019, it outsourced payroll to an external provider, then switched to a second. From 2019 to 2022, it reclaimed input VAT charged by these providers. It argued that its workforce had been informally transferred and that they were supplying labour back to the business. Following enquiries in 2022, HMRC denied input tax claims totalling over £500,000, and the business appealed.
The tribunal dismissed the appeal. Looking at the economic reality of the arrangement, it found that no genuine transfer of employment contracts had taken place. Contemporaneous records showed no real change, annual accounts still listed the individuals as employees, and the business continued to control its staff day to day. What the providers actually supplied was payroll administration, not labour. Although HMRC did allow recovery of VAT on the providers' core processing fees, VAT calculated on top of net wages, salaries and National Insurance was disallowed. Thus, outsourced payroll remains a taxable service, but it cannot be used to manufacture input tax deductions from ordinary payroll costs.
The central lesson is that substance matters more than labels. Supervising staff, handling grievances, retaining dismissal rights and directing day-to-day duties are hallmarks of direct employment, whatever the paperwork says. Formalities matter too, as without executed transfer agreements, formal contract variations or proper employee consultation, employment contracts remain with the original employer, and employees cannot be moved to a new entity without their consent and documentation. Outsourcing a back-office function such as payroll does not change employment status unless there is a genuine, documented novation of contracts. Above all, written agreements, company accounts and everyday practice must tell the same story. Employers should review any arrangement where payroll or staffing is routed through a third party and check that the documentation matches how the relationship actually operates. They should also take legal advice before restructuring workforce arrangements to avoid both employment disputes and unexpected tax exposure.
