In this fourth of our IR35 solutions series analysing potential solutions to IR35, and the challenges facing the office of Tax Simplification (OTS) as it reviews the IR35 legislation with a view to recommending an alternative, a range of possible replacements for and successors to IR35 are identified. So too are the reasons why they won’t work.
Part 3 of this IR35 solutions series established that IR35 in its current form is clearly not working – its original objective, to identify workers who are really ‘disguised employees’ and tax them accordingly, have simply not been met.
But is this a problem that can actually be solved? Is there even such a creature as a ‘disguised employee’, or are there just workers who perform tasks and get paid? And aren’t flexible, highly skilled knowledge workers exactly what UK PLC needs to consolidate the recovery and compete on a global stage?
Further barriers in the form of new and potentially costly legislation could fundamentally damage the UK’s competitiveness. Other countries with knowledge economies and a flexible workforce with similar characteristics to the UK’s have tried to address the issue of disguised employment. Their experiences provide important lessons for the UK policymakers currently considering options to replace or update IR35.
OTS has three basic options
There appear to be three basic options available to the OTS as it considers what alternatives to provide to the Treasury on IR35’s replacement or ‘simplification’:
- Do nothing – maintain the status quo and keep IR35
- Repeal IR35 and do not replace it
- Amend IR35 or replace it with something completely new.
The effectiveness of the option of keeping IR35 as it is very much depends on HMRC and its motivation to target contractors. That will in part be politically driven, but also based on the likely return on effort and investment. The little evidence available to chart the effectiveness of HMRC in generating IR35-related tax yield suggests that targeting contractors gives poor return on investment.
Is there even such a creature as a 'disguised employee', or are there just workers who perform tasks and get paid?
Option two, to repeal IR35 and not replace it, would be a victory of sorts for contractors and lead to certainty in contractor’s tax affairs. And with the Managed Services Companies legislation in force and apparently working well, it is unlikely that there would be wholesale migration away from contractor umbrella companies into contractor limited companies, as the reasons contractors choose umbrellas no longer hinge solely on IR35.
But would this second option be politically acceptable?
Change or replace IR35 with a successor – the options
So, what of the third option? To create a successor to IR35 in the form of amended legislation or an outright replacement presents a huge challenge. As the third article in this series has shown, the current tests of employment cannot be applied to the 21st century flexible knowledge workers.
So, what could form the basis of a new set of tests or alternative solutions? Here are some options:
- Pre-assessment of assignments or a certification scheme for contractors
- Empirical tests: eg >80% income from one client in one year or assignments lasting more than two years would be seen as disguised employment (similar to Australia)
- Shift the burden of proof onto clients and agencies (similar to the USA)
- A contractor can only work on projects, with ongoing work viewed as disguised employment
- Workers leaving employment on a Friday and returning to essentially the same job on a Monday as self-employed are automatically classed as employees and are taxed accordingly
- Provide employment rights to contractors passing ‘tests of employment’
- Introduce surcharges on dividends from ‘close’ companies
- Create a definition of a personal service company (PSC) and tax all remuneration as employment income
- Inclusion or absence of contractual restrictions, such as exclusivity, could indicate whether or not a worker is employed.
If new tests are introduced to determine whether a worker is a ‘disguised employee’ for tax purposes, and which differ from the current tests of employment to determine whether a worker is an employee and qualifies for employment rights, what implications would these tests have on employment status?
Can employment law and tax laws be separated in this way, or will these tests also be brought into employment tribunals as further evidence by specialist employment lawyers?
And the fact remains that, as highlighted in Part 3 of this IR35 Solutions series, there are tasks that can be performed equally well by employees and contractors where the only difference between the two situations is the existence of an employment contract and job title.
Lessons learnt outside the UK
Several other nations with flexible labour markets and free-market based economies similar to the UK have identified ‘disguised employment’ as a tax-avoidance issue and created their own legislation.
To the external observer, the ‘IR35’ equivalents in the United States, Canada and Australia have left contractors trading in those nations in similar legislative limbo to their UK counterparts (eg Canada), treated poorly (eg the USA) or battered with draconian legal sledgehammers (eg Australia).
In attempting to tackle the issue of tax avoidance as a result of disguised employment, no other country has yet arrived at a workable solution. This suggests two things: either the UK will be the first to do so, or – which is much more likely – there really is no solution because these is no such thing as a ‘disguised employee’; there are just workers who get paid.
Why IR35 solutions, successors and replacements won’t work
Complex tests, such as those currently applied to determine worker status, have been shown to be far too complex and ambiguous to provide the certainty that contractors require in their tax affairs and HMRC needs to generate tax revenues. And such tests simply can’t be applied to 21st century’s highly skilled knowledge workers for whom the concepts of ‘control’ and ‘substitution’ are an irrelevance.
On the other hand, simple tests are too transparent and likely to suffer from the ‘law of unintended consequences’, as has been the case in Australia, or will be quickly and easily worked around. Tests using company structures and law run the risk of catching huge numbers of innocent small businesses.
Making agencies and end-user clients responsible for the policing process, as is effectively the case in the USA, results in a poor deal for contractors. If applied to the UK, they might also lead to the very real risk of driving clients to find offshore service providers.
The OTS has been tasked with making recommendations about the wider issues of small business taxation, and it could be in that wider arena that there will be a solution to ensuring all workers pay their fair share of tax, irrespective of how they trade.
Part 5 of ContractorCalculator’s IR35 Solutions series summarises the analyses conducted in this and the previous three articles, suggesting what the IR35 landscape could look like once the review of IR35 has been completed.