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IR35 Reform: IR35 is no longer relevant to contracting

Contractors could be forgiven for feeling a sense of déjà vu, as HMRC is conducting yet another review into why IR35 is not delivering the tax the taxman thinks it should. HMRC’s Intermediaries Legislation (IR35) discussion document shows that they are right out of ideas.

But the Treasury has been promised £430m a year in IR35 taxes, alongside £520m HMRC believes is generated by the deterrent effect. Neither of these figures has been sufficiently substantiated by HMRC, so perhaps the flaw with IR35 is that there are not the tens of thousands of disguised employees out there that the taxman believes should be paying the tax. If there were, why hasn't their ramped up IR35 taskforce caught them?

In this first of a series of three articles summarising ContractorCalculator’s response to HMRC’s IR35 discussion document, we explain that the world of contracting has changed during the last 15 years, which is why IR35 is no longer relevant or fit for purpose, and why it is raising so little tax.

Why HMRC published its IR35 discussion document

The origins of the latest review of IR35 superficially appear to lie in the Chancellor George Osborne’s Summer Budget 2015. In the Summer Budget 2015 document (section 1.180 page 44, and section 2.183 page 96), a commitment was made to engage with business to determine how IR35 could be made to work.

In reality, through a succession of Budgets and Parliaments, HMRC has been claiming that IR35 already secures half a billion pounds worth of tax through the deterrent effect, and has the potential to generate almost as much again if implemented properly.

What has most likely happened is that the Chancellor and the Treasury has said to HMRC: “So where is all this extra tax you promised? You’ve got one last chance to find it.” And so we have HMRC’s Intermediaries Legislation (IR35) Discussion document.

What HMRC is seeking from the consultation

The document says very little that is new in its 11 pages apart and contains some overly simplistic ideas about using different tests and making clients responsible for enforcement. It has asked for market intelligence on what other types of intermediaries could be subject to IR35 and requests ‘evidence’ about how contractors currently operate IR35.

HMRC is also seeking tangible ideas about how IR35 could better achieve the policy objectives, which are to meet the £430m target of extra tax revenue each year and protect the £520m of tax receipts that the deterrent effect allegedly generates.

The document smacks of HMRC’s desperation and its evidence base and proposals are weak. This is mainly because there is insufficient substantiation for the tax yield claims which appear to be the driving force behind retaining the legislation. Until these numbers are explained, and until further detailed research is conducted to understand if there is still a problem, the entire process is flawed.

How contracting has changed over 15 years

One of the principal reasons that IR35 is no longer fit for purpose and irrelevant is that the problem it was designed to address has largely gone away. Market forces in the mid- to late-nineties and early noughties led to many employers facilitating the conversion of their employees into contractors so that they could retain their employees’ skills, and avoid them handing in their notices and moving to more lucrative opportunities in the contract market. The vast majority of IT workers in the late 1990's went contracting because the rewards were huge.

An employee would leave work on a Friday night and return on a Monday morning to the same desk and same job, only to have become an independent contractor trading via a limited company. The new ‘contractor’ was also distinctive, and gained so much attention from policymakers and HMRC, because contractors are thought to may much less tax than employees.

In HMRC's view many of these workers really should have stayed employed, and this ‘Friday to Monday’ phenomenon was a huge source of disguised employment. IR35 was created to address the issue, and although it was poorly thought through, too complex and largely unworkable when it was first launched, it did attempt to tackle a perceived problem.

There are few disguised employees masquerading as contractors

But that has all now changed. The market dynamics are very different, and the shortage of IT skills that was the main driver of this behaviour has largely disappeared. The fact that IT contractor rates have remained largely static for the last 15 years proves that the problem has gone away.

This means the hordes of disguised employees that HMRC believes exist are simply not there to pay any extra tax. Plus the assumption that contractors pay much less tax than employees is just not true.

Market forces mean that a contractor in a similar role to an employee will be charging the client/employer significantly more than what the employee is costing. When the numbers are run, the contractor’s marginal rate of tax might be lower, but they are paying at least as much if not more in tax than the employee.

There may be some disguised employment at the bottom end of contracting where firms insist on hiring only contractors. But in the core contracting sector, and by this we mean mid- and top-end IT, engineering, construction, energy/oil & gas, finance, marketing, media and management contractors and interims, it just isn’t there.

The dividend tax changes are a game changer

The changing demographics of the contracting sector largely removed the major problem of disguised employment years ago, making IR35 largely irrelevant. And the dividend changes due to come into force in April 2015 render IR35 completely obsolete.

Once the dividend tax changes take effect, the differential between the tax that employees pay and that paid by contractors will shrink considerably.

Yes, contractors will continue to pay less National Insurance Contributions (NICs) than employees, but overall a person who chooses to operate as a contractor will pay close to the same amount of tax they would do if they choose to be in permanent employment.

However, the elephant in the room remains, as it has always been, employers’ NICs. Under IR35, this payroll tax is paid for by the worker, not the engager. This breathtaking unfairness is one reason by the UK’s flexible workforce has rejected IR35. This is also a contributing factor to why HMRC has got its sums so badly wrong when estimating the expected tax yield of IR35. They originally thought contractors would roll over and pay up. But due to the unfairness they decided to fight it, and have won that fight as evidenced by the IR35 tax collection figures.

The problem that IR35 was designed to tackle has largely disappeared – disguised employment and tax differentials between employees and contractors no longer exist. As a result, IR35 simply not fit for purpose, is targeting the wrong part of the labour market and has become irrelevant.

The next part of ContractorCalculator’s response to HMRC’s IR35 Discussion document highlights why IR35 is unenforceable, and will provide an analysis of HMRC’s policy objectives and explain why they are fundamentally flawed.

Published: 07 October 2015

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