In this third 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, the reasons why the legislation was doomed to fail as being unenforceable are examined.
IR35 started life as an orphan. From the outset, IR35 took the sort of employment law solution normally created by employment law experts and judges and applied it to a taxation problem to be solved by contractors and tax inspectors. The tests of employment are simply too complex to work when being applied to what is essentially an everyday taxation issue. The established tests of employment have also been shown to be unrealistic when applied to 21st century knowledge workers.
The tests of employment are simply too complex to work when being applied to what is essentially an everyday taxation issue
Then there is the major flaw that IR35 relies heavily for enforcement on self-certification by contractors. That contractors should rush forward to voluntarily sacrifice up to 25% of their income in order to comply stretches credulity, although many contractors initially did just that out of ignorance.
The final nail in the coffin of IR35 is the issue of enforcement and the low probability of contractors being found out and successfully tackled. HMRC certainly lacks the resources and expertise to effectively enforce the legislation now, and its enforcement earlier in the decade was highly variable, particularly when the scoreboard of successful prosecutions versus HMRC defeats is examined. Was IR35 doomed to failure from the outset?
Can simple, objective tests determine if a worker is a ‘disguised employee’?
HMRC and the courts always stress the need to focus on the reality of a relationship between worker and hirer when determining employment status. But when the reality of modern knowledge workers is examined in greater detail, it’s obvious that employment law simply hasn’t kept pace.
Contractors and freelancers frequently perform tasks that are also performed by employees. Employees complete projects also undertaken by contractors. Employees stay with an employer for a few months and move on. Contractors can be with a client for years. So what exactly is there to distinguish between the two?
That contractors should rush forward to voluntarily sacrifice up to 25% of their income in order to comply stretches credulity
And can a truly objective set of tests be created to distinguish between workers who exhibit exactly the same characteristics in reality, and only differ in their contractual relationships that convey rights and a job title on one worker and not on another.
The key tests as they are applied to knowledge workers: complex and not relevant
The tests of employment used under the IR35 legislation to determine whether a worker is a ‘disguised employee’ who should be taxed accordingly suffer both from their complexity and their irrelevance. They are based on years of case law that, when applied in their true context at a tribunal or in a court, are interpreted by legal experts, who seldom even agree themselves on what the case law means.
So how can mere contractors and tax inspectors, who are already highly skilled in their own right in their own areas of specialisation, be expected to become employment law experts as well?
And do control and substitution, currently considered by experts to be ‘killer factors’ when determining employment status, really apply to knowledge workers? An expert is usually hired because they are just that – an expert. Of course the client won’t want a substitute sent in the expert’s place.
Can a knowledge worker – such as an IT software developer, engineer, accountant or other highly skilled individual – be told exactly how in detail to perform their role, such as what specific line of code to write or how to perform a calculation? Clearly not, otherwise they would not be highly skilled knowledge workers.
HMRC relies on fear and contractors have called its bluff
Like any law in a democracy, tax legislation largely works because most of the population consent to abide by it. Most people understand that taxation is necessary and largely abide by the rules. The ‘carrot’ for doing so is that taxation buys the public sector services we all require. HMRC also wields a ‘stick’ in the form of penalties and interest charges when taxpayers are caught not abiding by the rules.
But laws don’t work when people don’t consent to be governed by them. And historically, if a law is perceived to be grossly unfair, mass disobedience can result. Fortunately, the law-making process in the UK has become pretty effective over the centuries, but it does still throw out the occasional anachronism, like IR35. What gives HMRC any moral authority to determine whether a worker is employed against their will, take their money and give no rights in return?
IR35 is a law that, experts agree, was poorly drafted and with no notice taken of the consultation process. It takes a huge chunk of the affected taxpayer’s income and gives nothing in return, is hugely complex, is based on irrelevant rules and has been implemented on an almost random basis. Occasionally, it has even destroyed the lives of completely innocent small business owners.
Is it any wonder, especially when you consider HMRC lacks the resource to enforce the tax code, that many contractors choose to take a risk, call HMRC’s bluff and ignore IR35?
Fortunately, the current legislative landscape is another planet compared to that of 1999. Both the government and the OTS appear to be receptive to input from experts and affected parties. But the flaws that have rendered IR35 impotent await as potential traps for those deliberating its replacement.
Part 4 of ContractorCalculator’s IR35 Solutions series will start to identify and evaluate what solutions might come to replace IR35, and whether it’s not contractors and contracting who are at fault, but the wider tax system.