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Preparing for the Off-Payroll rules: what HMRC failed to warn hiring firms about

Businesses engaging contractors could experience major disruption when the Off-Payroll working rules are extended to the private sector in April 2020, unless they immediately begin to prepare for the practical realities of the proposals.

Tax liability changes will significantly increase the cost of hiring contingent workers caught by the rules. Inevitable attempts by companies to mitigate their impact risk could cause project delays, struggles to source talent, and reduced workforce mobility.

  • Clients must consider contractors’ IR35 status before April 2020 to avoid disruption
  • Off-Payroll rules impose a new tax bill on firms engaging ‘deemed employees’
  • Contracts with affected contractors will need to be renegotiated
  • HMRC and Treasury Off-Payroll assumptions ignore the behavioural impact
  • Failure by firms to address this issue risks spiralling costs and damage to projects

These factors have been overlooked by HMRC and the Treasury, and thus not conveyed to the soon-to-be affected businesses. This is in spite of warnings from the Office for Budget Responsibility (OBR) that behavioural uncertainty poses the biggest threat to the anticipated tax yield from the proposals.

Rather than accepting HMRC’s simplistic assumption that the Off-Payroll rules will be adopted seamlessly, a closer examination of the proposals can provide some foresight, helping companies to prepare for April 2020.

Off-Payroll and IR35: the key differences

The Off-Payroll working rules introduce significant differences to the way IR35 is currently applied in the private sector. Historically, the contractor has been responsible for determining their employment status, and liable for all tax if deemed by HMRC to have arrived at the wrong conclusion.

The Off-Payroll rules require that the end-client assesses the contractor’s status, and the fee-payer – the party above the contractor in the supply chain – assumes the tax risk.

Arguably the most significant difference concerns employer’s National Insurance (NI). Currently, where an individual is deemed caught by IR35, employer’s NI is deducted from their fees. However, under the Off-Payroll rules, this tax – along with the Apprenticeship Levy – is to be paid on top of the individual’s earnings by the fee-payer.

Though a recruitment agency will often qualify as the fee-payer, this cost would cause most agencies to fold if they genuinely had to contend with it. Realistically, the hiring firm will have no choice but to cover this cost.

Rather than clarify the employer’s NI requirement sufficiently, HMRC and the Treasury have in fact obscured matters through the false reiteration that ‘the reform does not introduce a new liability, or extra tax’.

In truth, this new liability increases the cost of hiring ‘deemed employees’ – contractors assessed as ‘inside IR35’ – by 13.8% for employers NI and 0.5% for the Apprenticeship Levy.

The rules also prevent affected contractors from claiming tax relief on expenses, a withdrawal that will prove costly for those who travel and stay overnight for work. Affected contractors will typically seek to offset this by negotiating increased contract rates, contrary to the client’s wish to reduce fees to cover some of their new tax costs. Either way, renegotiation is inevitable.

Can we trust HMRC’s Off-Payroll assumptions?

HMRC’s IR35 claims are dubious at best. In its latest Off-Payroll consultation, the taxman estimates that the cost of non-compliance with IR35 in the private sector will reach £1.3bn by 2023/24.

ContractorCalculator queried this figure via a Freedom of Information (FOI) request, observing the OBR forecast that the Off-Payroll rules will net the Exchequer roughly £725m in 2023/24. This is £575m short of HMRC’s non-compliance estimate, a sum which it presumably doesn’t believe the Off-Payroll rules will account for.

FOI requests to both HMRC and the Treasury for details underpinning the £1.3bn claim have been rebutted. HMRC has since stated that its £1.3bn estimate is ‘underpinned by data and analysis across several sources’, yet has provided no tangible evidence.

Until HMRC does so, questions will remain over its perception of non-compliance. Similarly, its refusal to acknowledge the behavioural impact of the Off-Payroll rules means its assumptions as to the likely effectiveness of the rules aren’t credible.

Evaluating the anticipated fiscal impact of the Off-Payroll rules, the OBR gave its forecast its highest possible uncertainty rating of ‘very high’. This was largely the result of a very high level of behavioural uncertainty, the factor deemed of greatest importance by the OBR, due to its admission that there was ‘no information on potential behaviour’ available.

Staggeringly, Government has decided to overlook this admission. Published HMRC guidance has at least conceded that ‘they [fee-payers] are likely to wish to renegotiate the fee with the intermediary’, yet the Treasury has sent contrasting messages, with Financial Secretary to the Treasury Mel Stride recently stating in a letter to an MP: ‘It is not the case that the reform of Off-Payroll working rules requires renegotiation of contracts’.

The behavioural impact of the Off-Payroll rules

The behavioural effects of the proposals are wide-ranging and unpredictable. While employer’s NI adds an initial 13.8% onto the cost of hiring a ‘deemed employee’, there will be further hurdles to overcome for companies.

While clients will be eager to negotiate lower contract rates, contractors will seek to counter their own tax hit, suffered as a result of their ‘deemed employee’ status, by increasing their rate. The withdrawal of tax relief on expenses for ‘deemed employees’ will also bear a considerable cost, which in-demand contractors travelling long distances in particular will wish to offset.

For firms to retain their services, these individuals will want reimbursement for their costs factored into a renegotiated contract rate. Our calculations show that, for a contractor to receive the same take-home pay as before, the cost of hiring for the client could increase by up to 43%. In contrast, a client would need to reduce the contract rate by roughly 20% to ensure the same cost of hiring.

An alternative solution might be for clients to downsize their contingent workforce, using the sums saved to pay the tax bills due on fees paid to the remaining contractors. This is essentially damage limitation, enabling firms to retain some access to necessary skills without spiralling costs.

The gravity of the situation is illustrated by measures that some organisations in the public sector have reportedly taken. There have been widespread reports of organisations engaging contractors via umbrella companies, with contracts being advertised to contractors at the rate that the umbrella company is paid.

Employer’s NI is funded from the sum paid to the umbrella company, leaving the contractor effectively funding the client’s employment costs. Any company considering this approach is warned that it could be construed as legal misrepresentation. Being completely transparent with workers is essential to avoid later complications.

Off-Payroll contract renegotiation in practice

Taking the example of a contractor on £400 per day, we can better understand the financial fallout of an ‘inside IR35’ assessment. The contractor works 230 days during a 12-month contract. Under the current IR35 rules, the annual cost to the client is £92,000.

The client identifies the contractor as a ‘deemed employee’ under the Off-Payroll rules. With employer’s NI and the Apprenticeship Levy accounted for, on top of the contract rate, the cost of hiring the contractor increases by 13% to £103,965.

The client can’t afford to pay an additional £11,965 for each ‘deemed employee’ on its books, so it needs to explore alternative options. Ideally, the client would like to retain the contractor’s services for the same £92,000 annual cost. This would mean that:

  • The contractor’s annual pre-tax fees are reduced to £81,532
  • The remaining £11,468 accounts for employer’s NI and the App Levy
  • The contractor’s day rate is reduced to £354

However, having operated outside of IR35 prior to the Off-Payroll rules, the contractor’s new ‘deemed employee’ status has already caused them a tax increase of roughly £3,085 over the course of the contract, even when retaining their £400 day rate.

Instead, the contractor is seeking to negotiate an increased rate to ensure that they receive the same amount of take-home pay as before. This would mean that:

  • The contractor’s day rate increases to £423 per day
  • Employer’s NI and App Levy liability are £12,725 combined
  • Annual costs for the client amount to £110,043 (or £478 per day)

The difference between the contractor’s preferred day rate and the client’s is now £69.

This disparity could be significantly greater where the contractor is also seeking compensation for lost travel expenses. The same contractor spends £300 per week on travel and accommodation, which will no longer be tax deductible. If they seek to increase their rate so their income does not drop, this would mean:

  • The contractor’s day rate would need to be £446 per day.
  • The annual cost to the client would be £116,315 (or £505 per day)
  • The total cost for the contractor will increase by 26%.

Many firms will be faced with these dilemmas for each member of their contingent workforce, which is why the matter requires urgent attention.

Why firms need to address and renegotiate contracts now

Because firms don’t have a magic money tree ready to pay this new tax liability, they are likely to experience clashes over contract rates, and a considerable slump in productivity and profits due to a shrinking flexible workforce and rising costs.

The fallout from these difficulties is the exact reason why the changes will fail to meet HMRC’s expected tax yield. Likely outcomes include:

  • Failed contract renegotiations causing contractors to walk out
  • Cuts by clients, reducing the number of engagements
  • Significantly increased costs of hire for firms in remote locations
  • Reduced taxable revenue from contractors, as less viable work is available
  • Contractors returning to lower-paid, lower-taxed, permanent work

Once such factors are taken into consideration, it’s understandable why the OBR’s prediction that the Off-Payroll rules will yield the Exchequer £595m in 2021/22 is considered highly uncertain.

This new tax liability is less than a year away. Companies must prepare now by assessing their situation to gauge the size of the challenge they are facing. They need a workable plan, ready to implement should the Chancellor choose not to cancel or delay the proposals in the November Budget. Early action will enable firms to:

  • Retain access to existing key skills and workforce flexibility
  • Avoid spiralling and unmanageable costs
  • Protect existing projects and budgets
  • Prevent a cliff-edge effect and contractor walkouts closer to April 2020

Whilst Government’s figures and proposals are highly questionable, it is important that companies prepare a plan ready to execute by the end of this year.

This article first appeared in Taxation Magazine, issue 27th June 2019.

Published: 09 July 2019

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IR35 and Off-Payroll Explained