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KEY POINTS
- The tenth anniversary of IR35 may be time for a rethink.
- Why were the IR35 rules introduced?
- IR35 concepts and complexities.
- Deemed employees are not real employees.
- Are the burdens worth the revenue raised?
- What are the altenatives to IR35?
This year marks the tenth anniversary of the personal services legislation, familiarly known as IR35. It was announced in the 1999 Budget, revised in September of that year, and came into force in April 2000.
A decade is a long time in tax, and it is time to take stock. Should IR35 remain unchanged, be recast, or disappear altogether?
Having given some consideration to the matter, this article proposes its abolition, and that may surprise you. After all, Britain is facing the biggest budget deficit for 40 years; in September 2009, corporation tax receipts fell by 27% so surely this is the time to invent new taxes, not abolish old ones?
But IR35 is, I suggest, a special case.
Why was it introduced?
Individuals providing services have always had the option of providing services via a company. Incorporation gives limited liability, protects the engager from employment rights, and presents a more solid image to external clients.
Historically, the relationship between the director and his company led to a string of non-tax cases, such as Winter v Westward Television [1977] EAT/589 (on employment rights as against the client) and Catherine Lee v Lees Air Farming [1960] 3 WLR 758 (on whether a director of a service company was also a ‘worker’ and so covered by the New Zealand Worker’s Compensation Act 1922 when he died).
However, the years leading up to the introduction of IR35 saw several significant changes to the tax system which combined to make incorporation more fiscally attractive. They included the following:
- the fall in the rate of corporation tax rate for small businesses from 25% in 1995 to 20% in 1999; over the same period, the basic rate of income tax also fell, but only to 22%;
- on 6 April 1999, the employer’s National Insurance contribution increased from a tapered rate (between 3% and 10%) to a fixed 12.2%; and
- on the same day, advance corporation tax (ACT) was abolished, making the payment of dividends simpler and improving companies’ cashflow.
Working via a company, and paying a salary slightly above the personal allowance and taking the balance in dividends thus became very tax efficient. These advantages, together with increasing computerisation, incentivised employers to migrate workforces into composite service companies.
I recall senior Inland Revenue staff complaining about a newly-privatised train company which insisted that its workers be engaged via composite companies.
A similar structure was used for doctors’ secretaries working in a hospital in the south of England. Neither the train staff nor the secretaries understood their service companies. The work was being done by others, on their behalf. As one Revenue official said to me at the time, the Government had to act or National Insurance contributions would have become a voluntary tax.
There was one further change. On 1 April 2000, the corporation tax rate for small companies was reduced to 10% on the first £10,000, with a marginal rate on profits up to £50,000. Therefore, in the very same week IR35 was introduced, it became even more fiscally attractive to work through a company.
The heart of the problem
IR35 is conceptually simple. It asks only one question: ‘would the worker have been employed by his client if there was no intermediate company?’
If the answer is yes, the engagement falls within IR35 and the worker’s company has either to pay the earnings as salary, or account for National Insurance contributions and PAYE on deemed salary.
Establishing the answer to the simple question raised by IR35 is, however, very difficult. There are no clear definitions of employment and self-employment; instead, the tests derive from numerous employment, tax and negligence cases, and are thus subject to adjustment as new decisions emerge from the courts.
This complexity creates a huge grey area either side of the employee/self-employed line, and this in turn caused the following difficulties:
- Most of those potentially affected by IR35 adjust the contracts under which they work, so that they contain terms indicating that they are outside IR35; for example, their written contracts give them rights of substitution, require them to provide their own equipment, and state that they are not subject to the control of the engager.
- Proving whether these contracts reflect the reality of the engagement is burdensome for HMRC – very often, by the time they investigate a service company, the engagement has long finished, the staff at the engager can’t recall the working arrangements and they most definitely don’t want to be involved in a tax investigation.
- Where the facts can be established, an expensive and time-consuming court case may be needed to resolve exactly where the line falls between employment and self-employment.
Unfairness
The other problem that besets IR35 is unfairness. The April 1999 press release said that new legislation was needed, partly because service company structures had damaging social consequences. It said that the workers within them:
‘may find their terms and conditions altered – perhaps losing entitlement to sick pay or maternity leave. They may even lose their jobs without entitlement to notice or redundancy pay. They will usually have no right to any claim for unfair dismissal and may lose their entitlement to social security benefits through a failure to make adequate contributions.’
However, the new legislation did nothing to redeem this situation. IR35 deducts employee’s and employer’s National Insurance contributions from the workers’ deemed salary, because the individuals are deemed to be ‘disguised employees’ of their clients.
But employment law does not recognise this status. Thus, they cannot claim unfair dismissal if their engagement is terminated, they have no rights to statutory redundancy, and cannot normally obtain Jobseeker’s Allowance.
Those within IR35 thus make a greater contribution to the Exchequer than a ‘real’ employee, because their service companies pay both employer and employee National Insurance contributions, but they receive none of the social protection given to regular employees.
Burdens and inefficiencies
Almost 1,500 members of the Professional Contractors Group (PCG), the representative body for small freelance businesses, have been subject to IR35 enquiries since the legislation was introduced.
However, a recent independent survey of PCG members indicates that only 7% of those investigated were found to be within IR35.
This 7% figure is considerably lower than HMRC’s results from its random enquiry programme, which found a 32% error rate for income tax self-assessment tax returns, 15% of which involve sums in excess of £1,000.
The National Audit Office report published in 2006 stated that company tax random enquiries ‘detected errors by companies in around 40% of returns, with under-assessments of tax of around £2,700 on average’.
This low figure for IR35-focused enquiries is worrying. More disturbing still is the length of time that the enquiries last. The PCG survey indicates that, in almost 50% of cases, the investigation continued for more than five years, with a further 17% lasting between one and five years.
Given that only 7% of those investigated were found to be within IR35, the time spent on these enquires represents a huge drain on HMRC’s resources. This might matter less if there was a superfluity of investigative staff, but of course the opposite is true.
Recent years have seen massive headcount reductions at HMRC; between 2005 and 2008, the department lost 18,832 full-time equivalent posts, and has now promised further reductions.
It is not for me to suggest where HMRC should invest its increasingly scarce resource, but IR35 enquiries seem to be particularly unproductive.
There is an obvious counterpart to this waste of HMRC time – the burden these enquiries place on the company under investigation. Most tax advisers have clients who have undergone HMRC enquiries and we know the stress these investigations cause.
Five years is an unacceptably long period for any tax enquiry and it would be astonishing if the individuals involved did not suffer at least some psychological and emotional damage.
Remember, too, that the vast majority of these companies are found to be outside IR35. This means that they are genuine businesses, trying to compete in an increasingly difficult economic environment.
Running a business while under the shadow of an HMRC investigation – particularly one which lasts for more than five years – is a truly arduous task.
The personal stress suffered by those under enquiry is compounded by two factors. First, the money involved in a successful IR35 investigation can be significant.
HMRC will seek to collect employer and employee National Insurance contributions on 95% of the turnover, plus interest and penalties, on all engagements within IR35 during the last six years.
These sums can bankrupt a small business, and the threat of such a heavy financial sanction is bound to have a damaging effect.
Second, most tax investigations are relatively private affairs, involving HMRC, taxpayers and their advisers.
But IR35 is different – in order to establish whether an engagement is within or outside the legislation, HMRC frequently make contact with the service company’s clients.
Tangling with the taxman is not popular with any business, and there is thus a high risk that this HMRC intervention will harm client relationships – even if, as is likely, the engagement is found to be outside IR35.
Revenue raised
All this might perhaps be justified if IR35 was filling the hole in the nation’s tax coffers. Indeed, when IR35 was introduced, the Red Book estimated that it would raise £900 million per annum; this figure was confirmed by Dawn Primarolo, speaking in Parliament on 3 May 2000.
However, in May 2009, following a freedom of information request, the PCG was told that IR35 had raised only £9.2 million in the five years from 2002/03. This is less than £2 million a year, not even 0.2% of the Red Book figure.
It is no doubt true that the legislation also has some deterrent effect, so that a percentage of people pay more than the personal allowance as salary in the hopes of avoiding an IR35 enquiry.
Quantifying this is difficult. Perhaps the new question on P35s and self-assessment returns will allow HMRC to make a better estimate of the sums involved.
My own experience, however, is that the majority of those potentially affected pay little by way of salary, and instead seek to escape IR35 by restructuring their working arrangements.
The consequences of abolition
If IR35 was simply abolished, would there not simply be a recurrence of the avoidance it was designed to stop? The simple answer is no. First, IR35, for all the reasons discussed above, is a very cumbersome piece of anti-avoidance legislation and doesn’t stop very much at all.
Specifically, IR35 singularly failed to prevent the flight to packaged service companies, a key driver for the introduction of the legislation in 1999. Between 2002 and 2006 the number of people using packaged companies more than tripled – from 65,000 to 240,000.
These figures come from the joint Treasury/HMRC consultation document on managed service companies (MSCs) at paragraph 2.29. This document explains the failure of IR35 as follows:
‘There are existing rules (the intermediaries legislation) to ensure that the correct tax and National Insurance contributions treatment is applied, but these rules are in the vast majority of cases not being followed by MSCs …Enforcing the current rules is difficult with MSCs because of the large and growing number of workers involved and the resource-intensive nature of the legislative test. Furthermore, even when a debt has been established as the result of an investigation by HMRC, MSCs can escape payment because they have no assets and can generally be wound up or simply cease to trade, with workers moving to a new MSC.’ (Paragraphs 1.2 and 1.4.)
New draconian legislation was therefore introduced – the MSC rules and their associated transfer of debt provisions. Packaged service companies are today both tax-inefficient and heavily penalised.
The MSC legislation serves another important purpose too. In the past, vulnerable low-paid workers such as cleaners had been transferred to such packaged structures, often unwittingly, and had lost their employment rights in the process. This is no longer possible.
The fiscal landscape has thus radically changed since 1999. Those who remain in service companies are capable of running their own businesses; the overwhelming majority wish to provide services to clients, not as quasi-employees, but as genuine providers of consultancy or advice.
Finally, what consequences will abolition have for the tax take? It is clear that the amounts of money involved here are small; they shrink even further when offset against the wholly disproportionate time spent policing the legislation, dealing with enquiries and checking contractual arrangements.
Time is money: both HMRC and the service companies would be more productive if IR35 was abolished.
Alternatives to abolition
Apart from the extremes of leaving IR35 untouched or abolishing it entirely, is there a third way? There are alternatives, of course, although a proper discussion would require a longer article.
Some front runners include the following suggestions.
- A simple, statutory status test, along the lines of that proposed in the recent consultation document, False Self-employment in Construction. But, as that document showed, this simplicity is achieved at the price of fairness. A simple test would catch many who are genuinely running their businesses on a self-employed basis, forcing them to pay employed levels of tax and National Insurance contributions with none of the commensurate benefits.
- Make the engager pay the tax and National Insurance contributions. This was the original proposal when IR35 was announced, back in April 1999. It was roundly rejected by engagers, who rightly pointed out that it was difficult for them to establish whether the case-law tests were met, and impossible for them to know whether the small company had other clients. The service companies were also concerned that engagers would protect themselves from HMRC audits by simply deducting PAYE and National Insurance contributions from all payments, without trying to discover whether the engagement was within or outside the rules. In short, neither side was happy, and the rules were changed to those we have today. Reverting to this option is thus a non-starter.
- Wait for the tax system to be reformed. If there was little difference between the tax burdens on employment when compared to that on incorporated small businesses, the need for IR35 would evaporate. Many people, including myself, have pointed out the discrepancies between the taxes levied on employment, self-employment and incorporation, and have advocated a small business review. But radical change is rarely quick, and may never happen at all. Retaining the burdensome and ineffective IR35 regime until the entire small business tax structure has been reformed is unnecessary and unfair.
- Use the minimum wage. This option would require those within service companies who charge on a time basis to pay themselves the minimum wage for the hours billed to clients. The taxes raised would replace, and probably surpass, the money being raised by IR35, and the mechanism would be clear and simple. However, it would be necessary to define which service companies fell within the rules, as directors of most small companies are currently outside the scope of the minimum wage, unless they (exceptionally) have explicit contracts of employment. This arguably concessionary treatment followed discussions between the ICAEW Tax Faculty and the then DTI (see Taxline, April 2000).
Abolition of IR35 would be simple, quick and certain. But if unacceptable, the minimum wage option is a reasonable alternative; however, consultation will be necessary to ensure that it is workable, fair and simple.
It’s the economy, stupid
I began this article with a reference to the economy, and it is appropriate to finish here too. If Britain is to emerge from the current recession, we need vibrant businesses, operating flexibly and efficiently.
The small service companies which are potentially affected by IR35 allow larger businesses to deliver projects on a flexible basis. The service company consultants provide specific skills for a period and then move on to another engager. Surely this is what modern business needs?
Is it not appropriate, now more than ever, to free these companies from the shackles of IR35, without worrying whether they have a genuine right of substitution, or whether their client allows them to use a home computer?
IR35 was introduced at a time when packaged incorporation threatened the National Insurance contributions take. The new MSC rules now prevent what IR35 failed to stop.
Today, IR35 is a high-cost, high-stress, low-revenue part of the tax system, and is overdue for abolition. Ten years is long enough.
Anne Redston is a visiting professor at King’s College, London. She has advised on IR35 since it was introduced, and her book, IR35, Personal Service Companies, is published by CCH. She is currently advising the Professional Contractors Group, but the views in this article are her own.
