ContractorCalculator has crunched the numbers to reveal that many employees start paying a 60% tax rate well before they hit the £150,000 earnings threshold. That’s fuelling a new boom in disguised employees, which is likely to lead to further anti-avoidance measures that will ultimately harm genuine contractors.
This stealth tax potentially affects an estimated 625,000 taxpayers, according to the latest data available in HMRC’s Personal Incomes Statistics 2009-2010 (page 37, table 3.5), resulting in many opting to incorporate a limited company as a tax avoidance strategy, and increasing the level of disguised employment as a result.
So, where does this 60% tax rate come from? Well, it’s all down to how the personal allowance for employees is reduced. From the start of the 2010-2011 tax year, employees earning over £100,000 lost their personal allowance (the amount that can be earned tax free) to the tune of £1 for every £2 earned over the £100,000 threshold. This "stealth tax" was contained in the following sentence below the HMRC tax tables: From the 2010-11 tax year the Personal Allowance reduces where the income is above £100, 000 - by £1 for every £2 of income above the £100,000 limit. This reduction applies irrespective of age.
This results in a marginal tax rate of 60% between earnings of £100,001 and £114,950. The rate then drops back down to 40% between £114,950 and £149,999 before then leaping to 50% for those earning over £150,000.
A tax rate of 60% is pretty shocking. And for those salaried employees who’ve just secured that dream promotion/new job to take them into a six figure income band, it’s a huge slap in the face. That’s hardly the progressive tax system that rewards hard work and enterprise we’re being sold by the current coalition government.
Here's what the tax looks like in a chart:
Here’s what that looks like in a tax table that shows the equivalent tax bands, but without the personal allowance reduction:
| Income Tax | Rate | From | To |
|---|---|---|---|
| Basic rate | 20% | 0 | 35,000 |
| Higher rate | 40% | 35,001 | 100,000 |
| Stealth rate | 60% | 100,001 | 114,950 |
| Higher rate (again) | 40% | 114,950 | 150,000 |
| Additional rate | 50% | 150,000+ |
You can see that between £100,000 and £114,950, income earned is taxed at 60% income tax, before falling back to 40% between £114,950 and £150,000.
More of these 60% rate taxpayers are opting to adopt avoidance strategies that, for many high-earning employees, include taking the ‘Friday to Monday mob’ route into disguised employment – by leaving employment on a Friday, incorporating a limited company, and returning as a ‘consultant’ on Monday.
As genuine limited company contractors will already know, it is possible to keep earnings below £100,000 and avoid the 60% marginal rate by adopting a range of legitimate tax avoidance strategies. These include deferring dividends, increasing payments into company pension schemes and income splitting with a spouse.
Unfortunately, the current tax regime is driving employees to adopt the same strategies but without becoming genuine businesses. The better administration, and enforcement, of IR35 has been promised by the IR35 Forum to be delivered in time for the March 2012 Budget. We have been told genuine contractors have nothing to fear from the new regime. Disguised employees clearly do, but this is a case where tackling the disguised employment symptoms will not remove the non-progressive tax regime cause.
Lowering tax rates will reduce tax avoidance, encourage entrepreneurialism and increase the tax revenues that are so desperately needed. Keeping them high, on the other hand, will dampen entrepreneurialism and ensure greater numbers of disguised employees and a dip in tax revenues. History shows that would be likely to result in further anti-avoidance measures, and such measures would almost certainly drag genuine contractors into lengthy, expensive and ultimately unprofitable HMRC investigations.