Contractors pay more tax than employees. HMRC’s calculations in its Intermediaries Legislation (IR35) discussion document try and prove that employees pay much more tax than contractors, when in fact they don’t – the opposite is true.
On page three of the discussion document, HMRC provides a worked example of two lawyers, with one engaged as a contractor and the other as an employee. You could be forgiven for thinking that HMRC is deliberately trying to distort the situation, as the case study could not be more wrong.
The first and fundamental mistake the taxman makes is assuming that the contractor and employee are paid the same and cost the client the same in gross payments. HMRC compares a £70,000 salary with £70,000 limited company fee income.
This is an incredibly unlikely scenario. Contractors always cost more than employees. That’s just how the market works.
Then HMRC claims that when the worker is employed, more tax is gained because the client pays employers National Insurance Contributions (NICs). What the example fails to say about the limited company contractor example is that the employer’s NICs that were paid by the client when employing someone now hits the firms bottom line if using a contractor.
This client’s profit is then taxed at 20% corporation tax and then taxed again when the client’s shareholders take dividends/profit out of the company. Or it is reinvested by the client organisation, and spent elsewhere, perhaps on employees, generating more tax or buying products/services and generating VAT.
Let’s look at a more realistic example. A decent software developer who is employed will earn around £60,000. The equivalent market rate for an IT contractor developer is around £400 per day.
The employee earns £60,000 per year, which actually costs the client £67,160 when you add employer’s NICs. Using our Permanent Employee Financial Profile Calculator, we work out that the tax paid by the employee is £24,990, leaving them with net, take home pay of £42,170.
In contrast, the contractor costs the client £92,000 per year. This is assuming they work a typical contracting work pattern of five days per week for 46 weeks. Say they take £8,000 salary and the rest as dividends. The total tax paid, which includes corporation tax paid by the contractor’s company and income tax paid on the dividend, is £26,015. Net pay is £62,985.
We can already show that a) HMRC’s two lawyer model is flawed in its basic assumptions and ignores the reality of the contracting marketplace and b) contractors do actually pay more tax. This excludes the VAT the contractor’s company collects and pays to HMRC, which would add even more tax if the client cannot reclaim VAT.
It gets better, or worse, depending on your point of view, if the contractor is caught by IR35. In this case, the contractor is paid £92,000 a year and actually pays £34,714, with net pay of £52,585.
And of course all this extra tax a contractor has to pay for being judged to be a disguised employee and taxed like one won’t buy them employment rights, according to the current and proposed framework.
The above more realistic and factually accurate numbers paint a very different picture to what HMRC was trying to prove in its discussion document.It is exactly these kinds of misleading examples that result in governments introducing sub-standard legislation that is not fit for purpose.
And it is how contractors end up actually making a greater contribution to the Exchequer than if they were employed.