Contractors hoping that the IR35 reforms due from the Office of Tax Simplification (OTS) will result in its abolition and them paying less tax are likely to be disappointed. That’s because any options considered by the OTS must be ‘revenue neutral’, generating the same amount of tax as IR35 in its current form.
This leaves the OTS with a fine line to tread between achieving the dual aims of simplification whilst maintaining tax yields. A further implicit requirement is that whatever solution the OTS recommends, it does not stifle the UK’s freelance and contracting workforce at a time when the economy so badly needs the flexibility and skills these workers bring to their clients.
Whatever solution the OTS IR35 review recommends, it is unlikely to take effect for some time. Not only that, but in the meantime IR35 is still in force and also being rigorously enforced by HMRC. So, it is vital that contractors stay outside of the legislation or pay the additional tax owing. Contractors concerned about their IR35 employment status can take ContractorCalculator’s free online IR35 status test.
Contractors may be worse off
Iit is quite possible that OTS will propose a solution that will leave contractors even worse off than they have been under IR35.
The shackles of maintaining tax yields imposed by the government leaves the OTS with far fewer options. Abolition with no replacement is not an option because there is no doubt that IR35 generates significant sums for the Exchequer.
But, by reducing the grey area between employees and genuinely self-employed contractors, it is possible many more contractors will find themselves classed as employees than under IR35. In fact, it highlights that under IR35 the uncertainly over employment status is as much of a weapon of the professional advisers defending contractors as it is for HMRC.
IR35 reforms – the option of client penalties
Client organisations may have cause for concern if the OTS takes the direction of disguised employment legislation found in North America.
Under the regime in the USA and the regime in Canada, it is the client who gets punished if a worker is initially misclassified as a contractor and then found to be an employee. The client pays the back taxes, employment insurances and penalties, not the contractors.
However welcome such an approach may be to UK contractors, in the longer term punishing clients will simply send them elsewhere for the skills they require. This would result in clients offshoring skills requirements, or even relocating outside the UK – either way it would mean lost tax revenues.
Introducing statutory contractor tests
IR35 reforms could also take the form of a series of statutory tests, such as those in force in Australia, or what has been proposed for the UK’s construction sector. Ironically, the danger of statutory tests means there are no shades of grey or special circumstances, which could result in more contractors being definitely classified as employees and taking on a greater tax burden.
We’ve yet to see a jurisdiction where statutory tests have been employed effectively and fairly to a contractor workforce. The Australian rules are draconian by our current standards and the proposals for labour-only subcontractors in the UK construction sector to be subject to PAYE, the so-called ‘deeming test’, would encompass a significant number of genuine sole traders in business in their own right.
Australia’s three-step process determines if a contractor is generating ‘Personal Services Income’ (PSI). If the answer is ‘yes’, the contractor’s PSI is treated as personal and not limited company income, with the contractor being taxed accordingly. If this were adopted in the UK, many contractors with a single client working on-site would almost certainly be caught inside the PSI rule, whereas they may currently comfortably sit outside IR35.
Tinkering with small business classification and taxation
Because so many contractors work through contractor limited companies and mitigate their tax liabilities by paying a low salary and high dividends, often sharing company ownership with a spouse, the OTS may look at mechanisms to identify personal service companies, or ‘PSCs’, and tax them differently from other small businesses.
Introducing IR35 reforms that identify and tax PSCs differently from other small businesses strikes at the very heart of the UK’s small and family business sector. Of the 4.8m small businesses in the UK, 1.3m are limited companies, so the scope for ‘the law of unintended consequences’ to impact negatively on all small and family firms is huge.
To an extent, the process of identifying personal services companies has become well established by the ‘services companies question’ on self-assessment tax returns. If a company shareholder delivers services personally, and greater than half the income in a tax year derives from this personal delivery of services, according to HMRC the company is a PSC. But currently, this definition has no real meaning.
IR35 reforms will require input from all concerned
However, it would be possible to apply the PSC classification to all small businesses operating as limited companies, charging them a greater rate of income tax and National Insurance Contributions (NICs) on dividends, potentially increasing tax yield significantly.
The damage that could be done is similarly significant, as there is a huge risk that the majority of companies affected are genuinely in business and not disguised employees, so will end up paying additional tax unfairly.
The OTS currently appears to be making all the right moves to ensure it is in full possession of the facts before considering what IR35 reforms might be appropriate, by involving contractors and the contractor services sector in its work. But it may take the combined efforts of a great many talented contributors to find IR35 reforms that achieve the aims of simplification and clarity, whilst sustaining tax revenues.