IR35 Solutions – Part 2: The evolving context of IR35

In this second of our IR35 solutions series analysing potential solutions to IR35, and the challenges facing the Office of Tax Simplification (OTS) as it reviews the IR35 legislation with a view to recommending an alternative, the sweeping changes of context are identified across the market, political, economic and legislative spectrum.

Contracting in 2000, when IR35 was first introduced, was in many ways done in a very different industry and within a vastly different context. Yet, in other ways, contractors and contracting have not changed all that much.

Certainly the context in which the Office of Tax Simplification (OTS) is completing its current review of IR35 will have some marked differences from the 1998-2000 period when the Treasury and the then Inland Revenue were laying the foundations of what was to become the IR35 legislation that is still in force today.

But whether that context is more or less favourable as a base from which to create and launch new tax legislation to succeed IR35 has yet to be determined. Certainly, the change in government from Labour to a Conservative-Liberal coalition may result in a positive outcome for contractors, although that has been far from proved. What is certain, though, is that the economic, fiscal and market landscape is rather bleak.

Changed political ideology

Although the coalition government has yet to prove its pro-small-business and pro-contracting credentials, it does not appear to view contractors with the same degree of suspicion as many industry commentators would argue the previous Labour administration did.

Where the Labour government seemed neither to understand the mechanics and dynamics of the flexible knowledge based workforce nor the benefits it could bring to UK plc, the Coalition appears to have. Fair evidence of this can be seen in the creation of OTS and the review of small business taxation and IR35.

However, we are in the very early days of a potentially five-year administration. So, whilst historically the Conservative majority of the ‘ConLib’ Coalition has a reputation for favouring business, the business it has favoured tends to be ‘big’ and, despite all the rhetoric we have so far heard, small to medium sized enterprises (SMEs) haven’t yet seen any real action.

Contractors are good for the economy

According to its terms of reference, the key economic issue OTS must consider in its recommendations are that any changes to tax legislation should be ‘revenue neutral’, meaning no loss of tax yields to the Exchequer. Clearly a buoyant economy means greater tax yields, and a thriving and less regulated flexible workforce should be good for the economy both in itself and through greater tax receipts.

And, in theory at least, the flexible knowledge-based workforce is exactly what the economy needs to accelerate the economic recovery. PCG’s ‘Freeing Up Potential’ theme for its 2010 National Freelancers Day is potentially what the coalition government could do simply by leaving contractors to get on, unfettered, with supporting UK enterprises.

But looming legislation in the form of the Agency Workers Regulations coming into force in October 2011 could derail the efforts of a significant chunk of the flexible workforce, umbrella company contractors and those on agency payrolls, by effectively increasing costs and reducing the very flexibility that makes contractors so attractive to end users.

Evolving market dynamics

PCG research published in 2008 estimates that there are 1.4m flexible workers in the UK, comprised of contractors, freelancers, consultants, interims and other kinds of flexible workers, a figure that is said to have increased by 10% from 1998.

But indirect evidence suggests that, compared to ten years ago, contracting is in a relative slump. According to data from, there were 197,000 IT jobs being advertised in the first quarter of 2000 compared to 80,921 being advertised in the third quarter of 2010.

This does not confirm the absolute number of contractors, but does suggest there are fewer opportunities now in one of contracting’s largest segments compared to when IR35 was being formulated. Will this possible reduction of potential have a bearing on OTS choices during its review? Would a more benign tax regime help reverse this decline?

Managed Services Companies Legislation: the rise and fall of the composite company

IR35 caused turmoil in the contracting sector, but it is debatable as to whether it had as big an impact as the Managed Services Companies (MSC) legislation introduced in 2007. This led a significant number of contractors to drop the limited company model and fuelled the growth in umbrella companies and offshore solutions, such as employee benefit trusts (EBTs).

The Labour government seemed neither to understand the mechanics and dynamics of the flexible knowledge based workforce nor the benefits it could bring to UK plc

The movement of contractors into EBTs, which HMRC has firmly in its sights for future legislation and anti-avoidance targeting, and the much greater migration, in volume terms, of contractors into umbrella companies may have slashed the perceived avoidance problem IR35 was introduced to combat at a stoke.

EBTs and other offshore solutions contribute little to the Exchequer, but the number of contractors adopting these trading models is likely to be small. However, umbrella companies have become a major contributor to the Exchequer’s coffers. Just taking the top five umbrella companies, which between them employ about 50,000 contractors, it is reasonable to assume they collect over half a billion pounds in income tax and National Insurance Contributions (NICs) each year. And, because they do so through pay as you earn schemes, the cost of collecting this tax is negligible to HMRC.

Wholesale movement of contractors across different trading models, and particularly into those outside of IR35’s scope, is nearly impossible to track and highlights a serious knowledge gap. The scale of the IR35 ‘problem’, suspected avoidance through disguised employment, has only ever been estimated. HMRC is no closer to understanding the scale of the problem now, as it was in 1999.

Contracting is maturing as an industry sector

There is no doubt that, as an industry sector, contracting is maturing. It has a thriving service industry that has grown significantly in ten years. Witness, for example, the growth and decline in composite companies, and subsequent mushrooming of the umbrella company sector and the substantial tax revenues umbrella companies collect on behalf of HMRC.

IR35 has spawned an entire services industry that will no doubt morph into catering to contractors’ needs to manage the implications of IR35’s successor. There are membership organisations such as PCG for contractors and ‘trade bodies’ such as the Freelance and Contractor Services Association (FCSA) for service providers. In addition, contractor accountancy is informally recognised, and formally marketed, as an accounting sector specialism.

Although the state of the contracting sector may well have no direct bearing on the choices made by OTS, contracting now has a much stronger, influential and probably more professional lobbying voice than a decade ago. And it is possible that the quality of information about the scale of any avoidance problem within the sector could be improved on that available in 1999.

The context in which OTS is reviewing IR35 is very different and potentially more positive for contractors than that of a little over ten years ago, when the Treasury was engaged in the task of creating IR35. Following the MSC legislation and the growth in compliant umbrella companies, the scale of the problem may be much less than in 1999.

At the very least, OTS appears to be much more receptive to the views of stakeholders than the Treasury was in 1999, which could bode well for contractors in the creation of what will hopefully be a less destructive replacement for IR35.

Part 3 of ContractorCalculator’s IR35 Solutions series provides a detailed analysis of the key tests of employment currently applied to determine IR35 status, and why using such a test in a tax context is wholly inappropriate.

Updated: Thursday, January 13, 2011

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