Contractors face a long haul before any of the proposed measures to improve employment status certainty can be evaluated and introduced. And that assumes any future government decides to act.
The Office of Tax Simplification’s Employment Status Review recommends measures that include the merger of income tax and National Insurance Contributions (NICs) and improving HMRC’s guidance and tools. Less positively, the OTS also recommends examining how a statutory employment test might work.
“This is a difficult area with no simple solutions,” highlights OTS tax director John Whiting. “We identify both direct ways of simplifying things – such as streamlining definitions – and indirect ones, which would take the heat out of the issue.
“Some should be acted on in the short to medium term, others are promising routes to reform that warrant further work but which would mean major changes.”
ContractorCalculator was one of the contributors to the evidence underpinning the report and our CEO Dave Chaplin was invited to give direct evidence face-to-face to the OTS team.
Limited company contractors will be impacted by the report’s outcomes
As a result of its analysis, the OTS concludes that there has been a structural shift towards self-employment that has many drivers. However, the report also notes that: “There are no obvious quick and easy improvements that could be made to achieve a useful difference to the employment status situation.”
Although the employment status review specifically excluded IR35, the OTS highlights that employment status case law is used to determine whether a limited company contractor is a ‘deemed employee’ for tax purposes. As a result, the OTS acknowledges that: “Personal service companies (PSCs) may be affected by any outcomes from this review, if taken forward by the government.”
ContractorCalculator CEO Dave Chaplin believes that in a worst case scenario, it could mean limited company contractors potentially finding themselves the subject of a draconian statutory employment status test, akin to that enforced in Australia.
“Whilst certainty will be of huge comfort to contractors, and a bonus compared to the current situation with IR35, it won’t be a benefit if greater numbers of contractors are misclassified into the ‘employment’ category. This could be the result of any statutory test.”
Tax differentials and HMRC overriding choice are driving the problem
The OTS report states that: “Employment status is not determined by choice, it is determined by fact and law for the courts to decide.”
Chaplin disagrees: “Part of the problem causing uncertainty is that there is more tax yield to be gained from employees than from contractors and the self-employed. As a result, HMRC gets involved in what should be a decision made by the contractor and their client, and the taxman’s default position is that the worker is employed. If there is freedom to contract, employment status is not an issue.”
Chaplin’s position is borne out by the report’s findings: “Evidence was taken from the OECD data which suggested that in countries where tax and NICs are more closely aligned there is a reduction in self-employment and the likelihood of people entering self-employment, and the duration of time people spend self-employed.
“The various tables within the OECD data suggest the UK’s diminishing combined tax and social security rates, moving between employment to self-employment to incorporation, are not typical internationally.”
“A statutory employment test needs to be explored further”
Of greatest concern is the OTS recommendation that there are grounds for a statutory employment test, suggesting that “there are two approaches possible:
- A detailed, complex exposition that would aim to reflect all relevant case law
- A simple or pragmatic set of rules that would have rough edges.”
Chaplin’s concern is that many have tried to create such a test in the past and failed, pointing out that the report itself says: “Over the years, various tests have been proposed and many factors considered, but despite many attempts by the judiciary, there is no one single test.”
The report continues: “Our findings concluded no one country had adopted a full statutory test but many use a number of indicators (often built up from case law) to determine an individual’s status. There are, however, a number of examples of countries that have adopted quasi-statutory tests to determine atypical groups, including Australia (withholding tax), Italy, the USA (ABC test) and Ireland (withholding tax).
“Where there are tests in place, they can be complex and can take a considerable amount of time to get agreement with the relevant authorities and establish employment status. One needs to consider if this is an effective method and would argue the case for a simple, easily managed system to be put in place within the UK with strict criteria that cannot easily be worked around.”
“So, if the UK’s finest legal minds have failed develop a statutory test, and no other country with similar challenges has created an effective yet fair test, why does the OTS think that a statutory test would work this time?” says Chaplin.
A simple test could also mean a draconian test
A simple short set of quantitative tests may be the only workable solution, but this could also equate to draconian, dragging in too many contractors who are genuinely in business on their own account.
“The test would also need to replace IR35, so it is likely that enforcement will be very difficult,” continues Chaplin. “But we know from experience that enforcement is already very difficult. There needs to be financial incentives for client firms to get it right, and a massive penalty for getting it wrong.
“The cost of all of this enforcement and compliance work just because the tax rates are different is crazy. Surely this is another strong argument for merging income tax and NICs?”
The freelancer limited company is low priority
The OTS has considered the concept of the freelancer limited company, saying: “We have also looked at the idea of a ‘third way’ – an intermediate status between employed and self-employed. Overall we are not recommending it as a way forward but we do not dismiss it and would welcome further input addressing some of the issues we highlight.”
Contracting sector experts are split over the issue. The Association of Independent Professionals and the Self-Employed (IPSE) CEO Chris Bryce is in favour: “Many industry experts have been calling for a freelancer limited company. We are glad the OTS recognises the potential of this idea and we agree that it needs to be developed further.”
In contrast Derek Kelly, managing director of Parasol and ClearSky Contractor Accounting parent group Optionis is “not hugely enthusiastic” about the idea, commenting: “For me, such a change could create more problems than it solves – as well as reinforcing the notion that personal service companies (PSCs) are somehow different to other businesses.”
The OTS agrees with Kelly, saying: “If the freelancer limited company route is followed, then there is a risk we are straight back into IR35.”
Improving HMRC’s guidance and the ESI
One area that would merit immediate attention is HMRC’s guidance about employment status and its online Employment Status Indicator (ESI) tool. These would benefit from both updating and adapting so they could be used by contractors to determine their own employment status. For example, the case law underpinning the ESI has not been updated since 2005.
The OTS explains: “Businesses, professional advisers and representative bodies often told us that they found HMRC guidance and publications to be out of date, and that they did not keep pace with developments in working practices.
“In particular, the opinion was often expressed that there were very few examples which could be easily applied to some of the most common professions and practices seen in today’s marketplace. We think that the idea of a joint working party to look at the case law underpinning the ESI would go a long way to answer these concerns.”
HMRC won’t reveal the workings of the ESI
As the developer of ContractorCalculator’s Free Online IR35 test, Chaplin has strong views on this topic: “For all this to happen they need to get the ESI tool very accurate, on an ongoing basis, and be transparent with how it works, and ensure that whatever answer it gives can be relied on when contractors take the test.
“That would be asking too much. And I think HMRC would be concerned that it would be gamed to get the ‘right’ result. So, while this is a good idea, can't see it happening in practice.”
The OTS says it has not included IR35 as part of its review due to the work by the IR35 Forum and its recent review of the implementation of IR35. Worryingly for contractors, the OTS plans “to explore if there is any synergy between the recommendations for IR35 purposes and those of the OTS under this employment status review”.
Merging NICs and income tax – the ‘elephant in the room’
According to the OTS: “Employers’ NICs is the real ‘elephant in the room’. If progress is to be made in ‘solving’ employment status as an issue, it is difficult to see how this can really be made without tackling NICs. The OTS has recommended the integration of income tax and NICs in the past in a number of our reports and we do so again.
“The starting point is more honesty and transparency about the levy: if more people realise how much it costs/raises, would there be more support for looking afresh at how to raise the money involved?”
“Reducing the differential between the different tax and NICs rates and treatments for different income streams would reduce the incentives to distort behaviour, and simplify the system for taxpayers, advisers and HMRC.
“Such a move towards a single tax and national insurance system was considered to represent a considerable simplification of payroll administration for employers, as well as reducing HMRC administration.”
However, Chaplin highlights that it would take a brave politician to grasp this particular nettle: “Employers’ NICs raise about £60bn each year. Can you imagine the outcry if this were to be transferred to contractors and employees as income tax? Just adding income tax and employee’s NICs to give a single headline rate of personal taxation will be enough of a shock.”
Chaplin concludes: “This is another excellent piece of work by the OTS that correctly highlights the issue that contractors face with employment status and proposes a range of effective long-term solutions, with the exception of the statutory test that could backfire.
“Whether the next government chooses to take action is of course what will determine whether contractors will benefit from the proposed measures. The body of evidence for root and branch taxation reform including the merging of income tax and NICs is mounting. But is there the political will in any party to actually take action?”