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IR35 rule changes mean public sector contractor costs could rise by 23%

IR35 public sector changes arising from the Government’s latest measure to tackle ‘tax avoidance’ could mean a rise in contractor costs for the public sector - to the tune of 23%.

Last week’s Budget announcement that the responsibility for determining the IR35 status of contractors in the public sector will soon rest with their clients marks the latest in a long line of poorly considered policies that look likely to backfire for the Government.

That being said, are we all that surprised? Maths hasn’t exactly been a strong point for tax policymakers over recent years, nor for the media for that matter. Media reports prior to the Budget, for example, warned of the impending policy, but the figures provided didn’t quite add up.

The Press Association reports, as do many other sources that received the Treasury leak on this topic days before the Budget 2016, that there are around 20,000 workers in the public sector working through ‘personal service companies’ (PSCs) in order to avoid an average of £3,500 in tax per year.

This is supposedly meant to amount to that £400m figure that we’re all so familiar with, but by our reckoning 20,000 x £3,500 = £70m. Where does the remaining £330m come from?

Not only are these calculations a long way off, they also fail to take everything into account. Reporters are happy to acknowledge the income tax and National Insurance Contributions (NICs) that limited company contractors don’t pay. However, what seems to have slipped under the radar is the dividend tax, which is set to rise in a matter of days.

Based on the Press Association’s curious calculations, we can assume that the average annual earnings of public sector PSC users are somewhere in the region of £35,000. This marks the point where the difference in taxes paid between contracts inside and outside of IR35 is £3,500.

Assuming company running costs paid to external suppliers of £3,000 per year, a limited company contractor on a £35,000 contract outside of IR35 would take home £26,360 after paying the Government £5,640 in taxes. This means that, in essence, the Government pays £29,360 per year for the contractor.

For a contractor on the same contract but inside IR35, take home pay is £22,947, costing the Government £25,947 because more taxes have been paid.

Interestingly, a public sector employee at a total cost to the Government of £35,000 would take home £24,750 per year after employer’s NI and taxes, meaning they pay less in taxes than ‘disguised employees’, whilst still being able to enjoy their employment benefits.

All of this begs the question: Why would contractors take this hit?

In the same way that it expected the figures it plucked from thin air to go unquestioned, the Government displays naivety in expecting contractors to simply roll over and accept its public sector reforms.

If HMRC believes the contractor workforce is so savvy and conniving as to engage in such means of ‘tax avoidance’, does it not think contractors might just have the nous to increase their rates when faced with higher taxes?

From this policy we can only see one outcome. Contractors operating in the public sector will quote two different rates. One for contracts deemed inside IR35 and one for contracts outside.

A contractor who is told a public sector role normally paying £35,000 is inside IR35 would increase their rate by 23% to £40,700 per year to bring in the same net income after taxes. Clearly, taxes would also rise considerably, whilst the net cost to the Government would be £29,360 – the same as it would be for a contractor on £35,000 outside of IR35.

With or without this policy, the cost to the Government will remain exactly the same. The only difference would be the heaps of unnecessary paperwork for public sector departments.

It doesn’t matter if the Government’s expected tax yield from this policy is £400m or £4m. It seems doomed to failure either way.

Published: 22 March 2016

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