Highly skilled and experienced contractors who are on the highest of day rates and right at the top of the value chain, will almost always be left ‘unharmed by the key tests of employment applied to determine whether a contractor is inside IR35. That’s because one of the key tests of employment is whether the contractor is controlled by the client, and highly skilled contractors rarely get told what to do, and even more rarely how to do them. That means they are very unlikely to be classed as ‘disguised employees’, and so stay firmly outside IR35.
However, it’s a very different story at the other end of the scale. Contractors with lower skills and less experience who are on more modest hourly rates are frequently controlled by the client. As such, they tend to not only fail the ‘control’ test, but also other key tests, such as ‘mutuality of obligation’ and ‘substitution’. That means they are likely to be classed as ‘disguised employees’, putting them firmly inside IR35.
The awesomely complex tests of employment used to determine whether a contractor is in fact a disguised employee and caught by the IR35 legislation require such a high level of expertise that only employment law experts and judges can possibly understand and apply the rules. Certainly contractors and most accountants aren’t in a position to accurately make these judgements themselves.
As an indication of how complex these rules are, to design the ContractorCalculator Online IR35 test we worked closely with IR35 experts Qdos Consulting and conducted extensive research, speaking to experts in employment law, contract law, taxation and IR35. We also drew on over ten years of monitoring IR35 and related legislation since April 2000. The resulting algorithm takes into account case law and the relative importance of IR35 factors like substitution and control.
The corresponding costs to HMRC for enforcing the legislation, particularly when the contractor employs an IR35 expert to conduct a defence, means that only those contractors likely to provide a high yield in extra tax, National Insurance Contributions, interest and penalties will be targeted.
But, as we’ve seen, high-earning contractors are much more likely to be outside IR35 than their low-earning colleagues. So the expense for HMRC to investigate and pursue the higher-earning contractors is likely to be greater than the revenue generated. At the other end of the scale the taxman is likely to be more successful finding lower-paid contractors inside IR35. But at what cost? Again, the expense is likely to outweigh money it brings in or, at best, the ‘positive yield’ will be so low as to be negligible.
So, we’ve looked at both ends of the scale; what about those contractors left somewhere in the middle, both in terms of earnings and IR35 status. They’re clearly in a grey area where any HMRC investigations are likely to be complex and any claims for back-taxes open to appeal. And, as many of the contractors in this grey area are likely to have tax insurance to cover an investigation, chances are HMRC will find itself in an expensive legal tussle that they might not win.
Since the introduction of IR35 in 2000, when it was forecast to yield the Exchequer an additional £200m a year, the regulatory landscape has changed. IR35 itself drove many contractors into umbrella companies, and this trend was accelerated by the introduction of the Managed Services Companies legislation, forcing contractors out of composite limited companies. So before embarking on designing an updated and improved net that will catch high-yield disguised employees, it might be appropriate to determine how big the contractor catch might be and whether it is even worth bothering to try and fish them out.
We have tried the complex route, in the shape of IR35, and the result has been that few contractors ended up being caught. Introducing simpler rules could result in an even lower yield catch for HMRC, because the rules could be too easy to avoid. And with very simple rules, not only would no one be caught, but contractors knowingly inside IR35 and currently using solutions such as umbrella companies might leap back into the pond. Overall, that would result in a massive drop in tax revenues, because through their PAYE and National Insurance payments, umbrella companies are very effective ‘tax collectors’ for HMRC.
What this all demonstrates only too clearly is that the existing tests to determine IR35 status are catching neither fish nor fowl at either end of the food chain, and those few that it does catch are likely to be ‘sprats’ not worth the effort involved. Finding out how many disguised employees are out there in the contracting pond should ultimately drive any new rules or IR35 replacement designed to catch them and tax them like the employees they are.