ContractorCalculator’s analysis of HMRC’s IR35 policy objectives – or target tax yields – as outlined in its Intermediaries Legislation (IR35) discussion document show that they are based on weak analysis and flawed assumptions.
IR35 is too complex and unenforceable, and no longer fit for purpose. The taxman has promised its Treasury masters that tougher enforcement of IR35 will generate £430m, alongside the existing £520m in tax it believes that the deterrent effect already generates.
Yet these targets are based on incorrect data and assumptions. HMRC needs to conduct a great deal more research and analysis of the contracting market to fully understand how much tax it can realistically expect from the industry.
In this second of a series of three articles summarising ContractorCalculator’s response to HMRC’s IR35 discussion document, we highlight that HMRC’s policy objectives are unrealistic and that a major research and analysis exercise should be undertaken to completely understand the contracting market and realistic tax yields.
IR35 was doomed to fail from the outset
Since its introduction, tax experts have routinely criticised the Intermediaries Legislation, or IR35, as being poorly thought through and badly constructed. To start with, the legislation is just too complex for ordinary taxpayers such as contractors to understand. Being based on employment law, IR35 needs employment law experts to understand and implement it.
HMRC’s mainstream inspectors just don’t have that expertise; in fact there are only around 40 IR35 experts in the whole of HMRC’s 56,000 strong workforce who must police at least half a million workers. This small team has a limited capacity of only around 250 cases per year.
Furthermore, contractors are highly skilled knowledge workers. That means they are typically highly savvy and motivated to do exactly what is needed to ensure IR35 does not apply to them, including hiring expert advisers to shut down inquiries before they get going.
And being experts, contractors will almost always fail any control-based test, as was highlighted by tax tribunal judges in the recent IR35 cases Marlen, Primary Path and ECR Consulting. Being controlled, as defined by employment case law, is the main factor in many IR35 cases.
IR35 simply cannot work effectively in 2015, fifteen years after it was introduced, because the disguised employees it was created to detect and tax just don’t exist anymore at the mid to top end of contracting.
The policy objectives are based on a flawed understanding of contracting
According to HMRC, IR35 should be generating an additional £430m of tax revenue that is currently lost as a result of contractor avoidance activity. The deterrence effect of the legislation, that is the amount of tax collected because workers are too frightened of IR35 to consider incorporating, is claimed to be £520m. That means HMRC thinks IR35 should be generating £950m, or nearly a billion pounds in tax.
These targets are HMRC’s policy objectives and respondents to the discussion document have been asked to find ways of helping the taxman achieve these objectives. But HMRC has shown it has limited understanding of how contracting works compared to the permanent employment market.
An ideal outcome of this discussion document will be for HMRC to understand where it is lacking in knowledge and to commission much more in-depth research and analysis. Otherwise it will keep telling its Treasury masters that they can expect the extra £430m from the contracting sector each year and keep failing to deliver.
Employees and contractors don’t get paid the same
A major flaw in HMRC’s reasoning is their assumption that employees and contractors get paid the same. In the discussion document HMRC compares two lawyers with the same skills: one a contractor and the other an employee. The case study has the employed lawyer on an annual salary of £70,000 and the contracting lawyer on gross fees of £70,000 for delivering the same role.
There’s no way a contractor doing a similar role to an employee will be paid the same gross fees as the employee’s salary – that just not how the contracting market works. This is a very important point, because it also shows that contractors actually pay more tax than employees, which HMRC does not seem to understand.
Using a more realistic example of an in-house employed senior IT developer and an IT contractor, if the employee is on an annual salary of £70,000 the equivalent contracting day rate is £500, so the annual gross fees for the contractor will be £110,000 (based on £500 x 220 working days).
The employee generates £30,612 in tax from a combination of income tax, employee’s National Insurance Contributions (NICs) and employer’s NICs. Taking into account the costs of running their company, the contractor will actually pay £36,153 in tax.
This figure is for April 2016 onwards, after the new dividend tax changes take effect. The tax goes from £31,746 to £36,153 due to the new dividend taxes. If that same contractor was forced into IR35 they would pay £43,095 in tax. They would be paying about £13,000 more in tax simply for choosing to be a contractor rather than an employee.
More research is needed as tax yields are based on incorrect information
This means that the estimates of the tax yield lost as a result of IR35 avoidance are significantly overstated – not only is disguised employment no longer the problem it was fifteen years ago, but the tax yields in the discussion document don’t add up due to the differences between salary costs and costs of hiring an equivalent contractor.
The taxman has wrongly assumed that any new IR35 legislation will compel those ‘disguised employee PSC workers’ to stay using the same trading vehicles and pay considerably more tax. They won’t. They will either continue to fight the legislation (and continue to win) or consider going back on the payroll, earning less as an employee than they were as a contractor, and the tax generated for the Exchequer will be roughly the same.
The net result will be a reduction in the flexible workforce and not an increase in total tax take. This is why HMRC badly needs more accurate market information and it should commission a survey to understand the rates of pay for people in certain sectors dependant on whether they are salaried or contractors.
Changing the test to supervision, direction and control (SDC) is not a solution
One of the solutions proposed in the discussion document is to simplify the test used to determine whether a worker is caught by IR35, cutting the complexity of IR35 and making it easier to implement. However, the tests and case law used to determine employment status originate from the 1960s, and the UK’s finest legal minds have been unable to simplify them.
The replacement suggested by HMRC is to use the supervision, direction and control test (SDC) currently used for the agencies legislation. But this test is merely a sub-set of the control test currently used for IR35 and because the vast majority of contractors are experts, they are rarely considered to be controlled according to employment case law.
Furthermore, contractors will develop strategies to ensure they are not under any SDC, and so the situation will become exactly like it is with IR35. So, any major reform of IR35 will need to be more fundamental than simply replacing the existing tests.
The next and final part of ContractorCalculator’s response to HMRC’s Intermediaries Legislation (IR35) Discussion document notes that HMRC has indicated that IR35 will not be abolished, so introduces a potential solution and highlights how much more work HMRC must do before making any legislative changes.