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Firms who act early should not fear the Off-Payroll reforms

The Off-Payroll reforms to IR35 threaten a damaging fallout for parties in the flexible labour supply chain who fail to take early and decisive action to understand and comply with the legislation.

The rushed implementation of the rules in the public sector has resulted in rife non-compliance among hiring organisations, widespread false-employment, increased hiring challenges, and delays and damage to projects.

Rather than risk a repeat on a far greater scale, private sector firms should take advantage of the minor delay to the extension of the rules to ensure that they are well-equipped to manage their responsibilities come April 2020. There is time, but firms need to act now.

How has HMRC justified its Off-Payroll contractor pursuit?

To appreciate the importance of fair and accurate compliance processes, firms need to understand the problems with HMRC’s blinkered view of self-employment and IR35, and how it impacts contractors. This can be illustrated using the example of two contractors:

Contractor A operates outside of IR35, but HMRC considers the contractor to be caught by IR35. For the hirer, the fee paid to contractor A is comparable to the employment costs of engaging a permanent equivalent.

Contractor B operates outside of IR35, but HMRC also believes that they are within scope of the legislation. Contractor B commands considerably higher fees than their permanent counterpart would earn in salary.

HMRC attempts to justify its pursuit of contractors using the concept of a ‘payment wedge’. This is described in a recent report by the Organisation for Economic Cooperation and Development (OECD) as: ‘the net amount that government receives as a result of taxing the employee’s labour income, inclusive of social contributions’.

In simple terms, the 'payment wedge' is referring to the total amount of taxes extracted from the gross cost of hiring an employee. This is their salary plus secondary Class 1 employers National Insurance contributions (13.8%) and the Apprenticeship Levy (0.5%). The two taxes paid by the employer when hiring an employee are referred to in law as the "employment taxes." Further taxes of employee's National Insurance and Income Tax is deducted from the salary. The sum of all those taxes is the "payment wedge".

When justifying IR35, HMRC applies this concept to hypothetical contractor A, arguing that the Off-Payroll rules are intended to catch thousands of workers like contractor A who it believes are essentially "deemed employees". This, it claims, results in a significantly diminished payment wedge.

Why HMRC’s Off-Payroll campaign is misguided

There are several problems with the taxman’s pursuit of this shortfall. The first is that, while HMRC scapegoats contractors as the tax avoiders, the bulk of the perceived tax due – roughly 84% - consists of employment taxes - the ones paid by employers on top of the workers salary. The new Off-Payroll rules (Chapter 10 of ITEPA) now require that these be paid by the fee-payer, not the contractor - which they were, and still are, in the original IR35 legislation (Chapter 8 of ITEPA).

In truth, contractor A’s arrangement is rare. The majority of contractors, such as contractor B, charge a ‘freelancer premium’. This is dictated by market forces, and exists to compensate the contractor for the risk that they are taking by working on a contingent basis.

If contractor B moves into a permanent role, the freelancer premium ceases to exist, meaning less tax is generated for HMRC. However, the taxman’s refusal to acknowledge the freelancer premium has resulted in a skewed perception of the supposed tax shortfall resulting from self-employment.

And while HMRC claims that the Off-Payroll rules target only ‘deemed employees’, strong evidence suggests that the genuinely self-employed have been affected in the public sector. Application of the taxman’s Check Employment Status for Tax (CEST) tool has resulted in disproportionately high numbers of contractors being deemed within scope of IR35 at Network Rail, HS2 and the Met Office, amongst others.

What’s the best way to prepare for Off-Payroll?

Forward thinking and thorough compliance practices are required to prevent similar consequences in the private sector, which threatens legal conflict and the breakdown of flexible working arrangements.

The first step is to profile and gauge the IR35 risk of your contingent workforce by assessing each individual with an accurate IR35 assessment solution. CEST has been exposed as defective and biased, and currently being re-developed by HMRC, whom the ICAEW recently suggested would not be ready until March 2020. That's way too late, as firms need to get their house in order way before the start of 2020. Taking a blanket assessment route is unlawful, as firms need to demonstrate reasonable care, and the best contracting talent will go elsewhere.

There are various alternative solutions to CEST. IR35 Shield is ContractorCalculator's own tool, which was first built in 2009 and was revamped in 2016. It's an AI-powered compliance solution which supplements instant, case law-backed assessments with features such as volume audits, real-time analysis of status issues, and group level financial risk reporting.

Armed with the insight gained from assessing your workforce, you can better understand your IR35 risk. IR35 Shield provides a clear overview of the IR35 risk and its fiscal impact, as well as offering compliance recommendations. This can be used to help form strategies and policies to manage compliance, for which factors such as risk, cost and time should be considered.

Status determinations and communication with contractors

Status determinations need to be communicated to contractors, and many are calling for this to be a legislative requirement. Contractors who are outside of IR35 will be seeking such assurances as soon as possible. Contractors deemed caught by IR35 are likely to challenge their status, meaning available options will need to be considered urgently. These may include:

  • Identifying potential changes to contracts and working practices to mitigate IR35 risk
  • Negotiating a fixed-term contract – contractor concedes employee status in exchange for workers’ rights
  • Negotiating improved rates to compensate contractors for tax increase

Where new arrangements are made, full transparency concerning rates is essential. The public sector has already witnessed potentially unlawful practices whereby contractors have had rates advertised to them from which employment costs have then been unlawfully deducted. Anything that could be construed as legal misrepresentation risks being contested in court.

These errors were likely a result of considerable confusion and misleading guidance from HMRC, who did not point out the key differences between Chapter 8 and Chapter 10 - the main one being (to reinforce the point again) that employment taxes are now paid on top of contractors fees, and not taken from them. What this means in a practical sense, is that if you want to maintain budgets and the same workforce, and put all contractors on payroll, you would have to try renegotiating a 20-25% rate cut with every contractor on your books. Not surprisingly, this is unlikely to work, so you need to have a realistic plan.

Be warned, many contractors will sooner terminate the engagement than be processed as ‘inside IR35’ because it opens them up to historic tax risk. Identifying such instances well in advance gives you more time to make arrangements for the loss of talent.

Off-Payroll reforms: prepare now to avoid the panic

Where possible, the favourable and cheapest option is to continue engaging contractors outside of IR35. This requires the tax risk to be managed, meaning full assessments and a due diligence paper trail must be kept. To get further peace of mind, in case of a knock on the door from HMRC, tax investigation insurance should be considered, the cost of which is insignificant compared to putting all the contractors on payroll and paying all the extra employment taxes.

Implementing compliance practices while juggling the behavioural fallout from the Off-Payroll rules doesn't have to be arduous. The chaos that ensued in the public sector following the April 2017 reform was largely due to a lack of planning, which is why the private sector were given more time to prepare. A cohesive compliance plan devised well in advance is an essential requirement for any hiring firm.

Ignoring the issue until a later date will only amplify the strain felt when things come to a head. Hirers are advised to have a plan ready to implement prior to October 2019, to ensure that they don’t get caught up in the panic. Firms and contractors shouldn’t fear the Off-Payroll reforms – simply prepare for them.

Published: 24 June 2019

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