Contractors and the contracting sector can still influence the outcome of IR35 reform, with the body looking into it – the Office of Tax Simplification (OTS) – already having shown that it is very much in ‘listening mode’ in its review of IR35.
The OTS’s interim report on the Small Business Tax Simplification Review, which has been presented to Chancellor George Osborne in advance of the Budget on 23rd March 2011, suggests three main options for IR35’s future:
- IR35 could be suspended prior to abolition
- It could be enforced more effectively by HMRC
- It could be left ‘as is’, but with the addition of an objective ‘in business’ test aimed at eliminating over 90% of genuine contractors from IR35’s scope.
Significantly, the OTS sees these as holding measures until IR35 is made irrelevant by structural reform and simplification of the UK’s tax system. But OTS Tax Director John Whiting is keen to point out that these are only interim suggestions, and is inviting feedback from anyone with an interest: “...whether you agree with us or not, we are keen to hear your views to help us develop our final report to the Chancellor later in the year.”
Option 1: suspend IR35 in advance of its abolition
According to OTS, abolishing IR35 would deliver the greatest improvement from a simplification standpoint, and removing the legislation would offer contractors certainty over their tax status. As an interim measure, if this route were chosen, OTS recommends suspending IR35 whilst awaiting the merging of income tax and National Insurance contributions (NICs) – a major structural reform that would render IR35 irrelevant.
However, OTS has identified that there is a significant risk to the Exchequer’s revenues of contractors opting wholesale for the limited company route – this would reduce contractors’ income tax and National Insurance liabilities, and therefore the amount collected by HMRC. It would also make collection of revenues relatively more expensive, as contractors working as PAYE employees of umbrella companies provide an assured and cost-effective method of tax collection for HMRC.
So, when a possible suspension of IR35 is coupled with additional pressure resulting from the introduction of the Agency Workers Regulations, the loss to the Exchequer could be considerable.
OTS says the risk of tax revenue loss is further exacerbated by “the aggressive marketing strategies used in the IR35 industry to encourage individuals to incorporate”. And added to these risks is the difficulty of actually measuring the potential impact of suspension and resulting moves from employment and umbrella companies into limited companies.
Despite these risks, OTS acknowledges that if the government were to commit to structural reform and there was a trigger mechanism to ‘un-suspend’ IR35 if wholesale avoidance occurred, it would mitigate those possible losses to the Exchequer.
Whether you agree with us or not, we are keen to hear your views to help us develop our final report to the Chancellor later in the year
John Whiting, OTS
But suspension on a temporary basis with a trigger for un-suspension may actually contribute to uncertainty, and significantly more data will be required between now and the final report in June before this option can be properly considered.
Option 2: Retain IR35 in its current form with more effective enforcement by HMRC
OTS’s second possible option for IR35 reform is to retain the IR35 legislation in its current form but “with explicit commitments from HMRC to make specified changes to the enforcement of the legislation.” These would include measures such as:
- Encouraging the use of HMRC’s Employment Status Indicator
- Creating and publishing new IR35 guidance on contractor and government websites
- Publishing a list of genuine business criteria contractors could use to self-certify
- Setting a maximum investigation timetable of 12 months
- Creating preferred supplier lists of IR35 contract reviewers whose opinion would be accepted by HMRC inspectors in status cases
- Introducing an independent mediation partner, a parallel to the role ACAS plays in employment tribunals or Alternative Dispute Resolutions.
The objective of this approach is that it would “enable individuals to self-certify their IR35 status with certainty, saving time and costs”, notes the report. It would also “address the lack of consistency by HMRC in handling IR35 cases,” giving 90+% of contractors greater certainty that they are in the clear.
This would leave those at greatest risk of being inside IR35 as the biggest potential losers from this scenario. From an employee’s perspective, this would seem fairer than the current scenario where many ‘disguised employees’ simply ignore IR35.
To assist HMRC with improved targeting, it is clear that more data is required about both genuine contractor and ‘disguised employee’ behaviour, and existing tools such as the Employment Status Indicator would have to be developed further to meet the needs of modern working patterns.
Option 3: ‘Use a genuine business test to exempt certain individuals’
OTS’s third option would be to maintain IR35 and its current tests, but with the addition of an ‘objective business test’. Such a test would be designed to exclude 90% of genuine businesses from IR35 completely, allowing HMRC to apply IR35 as it stands to the remaining 10%.
Although this measure would add an additional layer of administrative complexity, an objective test would provide certainty to the vast majority of contractors. However, the OTS admits that during its initial consultation process it received strong arguments against such an approach. As explained in the report, the “key problem would be how the tests were defined”. Absolute and objective tests, such as those used in Australia and examined in greater detail in ContractorCalculator’s white paper on the solution to IR35, often suffer from the ‘law of unintended consequences’.
Potential criteria for an ‘objective business test’, suggested by OTS for consideration, include:
- Having multiple clients and agreeing fixed fees for specific projects
- Capital investment in the business and having separate business premises
- Dividend frequency and minimum PAYE salary
- Providing equipment, expenditure on marketing and having tangible assets
- VAT registration, business insurances, industry/professional accreditations
- Exit strategies, business plans, retained profits, management accounts.
The OTS is emphatic that “rigorous analysis and consultation on the criteria to be used in a possible test” would be vital before it was implemented. And the analysis of this approach already completed in ContractorCalculator’s white paper suggests the chances of successfully defining and implementing an objective business test are remote.
IR35 reform options dropped by the OTS
Two key IR35 reform options were dropped by the OTS:
- “Place onus on engager to establish IR35 status at the outset”
- “Minimum salary at the rate of National Minimum Wage for company directors”.
Part of the original IR35 legislation created in 1999 included proposals to place the burden of employee classification on the end-user client. This is used in the USA, where employers can face serious penalties and back taxes for incorrectly classifying employees as contractors.
However, the option to require clients to determine IR35 status was rejected by the OTS on the grounds that genuine contractors would be constrained if seeking assignments with employment characteristics. In addition, the cost of administration was likely to be too high.
A director’s minimum salary was deemed unworkable, because the implications would be felt by all businesses, not just contractors. OTS felt the measure would ultimately become unenforceable, as there would be so many loopholes that could be exploited.
Contractors and contracting organisations that wish to provide feedback and submissions to the interim report can email the OTS directly – firstname.lastname@example.org.