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Public sector IR35 reforms are ‘a departure from reality’, warn experts

Imminent reforms to how IR35 is enforced in the public sector are ‘hopelessly uneconomic’ for contractors, clients and agencies, and will bring the Exchequer back to square one.

These are the conclusions of IR35 legal experts after the publication of HMRC’s draft legislation and accompanying documents revealed a stark departure from reality by the taxman that will mean big problems for the public sector.

If you’re a public sector contractor, you need to act fast to ensure you don’t feel the effects of these reforms. Start by taking our online IR35 test. Then secure an independent contract review and speak to your public sector client to find out their plans for checking for IR35 following April 2017.

IR35 reforms will prove ‘totally disruptive’

Within the draft legislation itself, the major surprise was that public sector clients are to assume responsibility for checking IR35 status in all instances, whilst agencies will be responsible for operating PAYE (Pay As You Earn) and paying employer’s National Insurance (NI) and the apprenticeship levy in any contractual chain they are involved in.

As Roger Sinclair of contractor law firm Egos explains, the requirement for agencies and, in some cases, clients to make employer’s NI payments will cause chaos in the public sector:

“The impact of employer’s NI is going to have a totally disruptive effect on the marketplace. If you have a public sector direct engagement inside IR35, the engager is going to have to bear the cost of this and the apprenticeship levy. Where an agency is involved, their margins simply aren’t enough to be able to absorb the NI burden.”

NI changes to cut contractor agency margins to 4%

Sinclair notes that the arrangement will prove hopelessly uneconomic, and foresees a combination of three potential outcomes:

  1. Contract rates will need to be renegotiated with clients paying more to cover the cost of employer’s NI
  2. Contractors will have to accept lower rates to allow agencies to make the necessary payments
  3. Agencies will have to absorb employer’s NI into their own margins

“However, if you take into account the fact that employer’s NI and the apprenticeship levy will probably account for roughly 11% of what is paid to the contractor, a typical agency operating a margin of 15% suddenly finds it cut to 4%. That simply isn’t going to work.”

Sinclair adds: “The likely end result is rates will be pushed up for public sector clients. They’re going to have to spend more for the services they want, and that ends up costing the Exchequer just as much as it receives from the tax gained. So it’ll wipe out at least the majority of the anticipated advantage.”

HMRC oblivious to damaging impact of reforms

This is the devastating fallout - completely overlooked by HMRC in its recent publications -that Sinclair claims demonstrate a severe departure from reality, exemplified in one of the case study examples used in its technical note:

  • Workers 4 U Ltd is an agency contracted to supply mental health nurse Mikael to an NHS Trust for a year
  • The contract is worth £36,000 plus VAT and IR35 applies
  • Mikael invoices the agency for £2,200 per month, or £26,400 per year
  • This leaves the agency with £9,600, a margin of 27%.

“Out of this margin, £2,400 needs to be paid to HMRC as employer’s NI. This seems feasible only because the hypothetical agency margin is so high at 27%,” comments Sinclair. “That’s not the way it works in the real world.”

IR35 a ‘different species of employment law’

Another potentially disastrous pitfall concerns IR35 checking and the capabilities of those responsible. A notable omission from the draft legislation and its accompanying documents is an explanation as to exactly which public sector employee will take on this responsibility.

The case studies included in the technical note suggests the public sector clients will be ‘experienced’ in determining IR35 thanks to having carried out HMRC’s ‘assurance process’. However, for Martyn Valentine, director of The Law Place, this represents a naïve simplification of IR35:

“IR35 is an entirely different species of employment law and the depth of knowledge required to navigate it successfully exceeds both what is understood by professionals and what is conveyed through the assurance process.”

Will IR35 reforms prove more costly for public sector clients?

Beyond this, there’s no certainty that the public sector client employees will have experience of the contractor’s day-to-day working arrangement. The likely outcome is insufficiently experienced HR professionals making misinformed decisions on IR35 status.

The alternative option, as Valentine points out, will have an adverse effect on HMRC’s money saving objective for the public sector:

“What we could see is the recruitment of more lawyers to public sector organisations or more costs incurred training existing staff to help effectively manage this compliance burden. Either way, it would likely offset any savings on tax.”

IR35 reform draft legislation – what else is missing?

There are several more omissions from HMRC’s published documents that are bound to compound uncertainty amongst public sector clients, including:

  • Apportion of liability where an incorrect judgement has been made
  • Provisions for appeals against judgements
  • Acknowledgement of IR35 testing options other than the Employment Status Service (ESS) tool

A major concern for contractors is that clients will be reluctant to independently test contractors in case the outcome disagrees with HMRC’s verdict, resulting in an additional administrative burden.

“That may well be the case,” comments Valentine. “That is until contractors realise that they might get a different answer if they take independent advice. Then all of a sudden, public sector clients who don’t allow independent assessments suddenly become far less attractive to the contractor and may consider reviewing their operations.”

HMRC IR35 tool isn’t legally binding

“I don’t think HMRC is contemplating the possibility that the tool might be wrong or, more to the point, that anyone would argue with what it says,” adds Sinclair. “It’s encouraging an over-cautious approach that will inevitably see many legitimate contractors taxed an unfair amount should they choose to accept it.”

It waits to be seen whether HMRC will provide clarity over these issues. However, for Valentine, there’s an evident incentive for the taxman to leave public sector organisations in limbo:

“There’s always the motivation there for HMRC as ensuring the tool is used seems a sure fire way to achieve higher tax revenues whilst reducing administration costs. One of the main problems, though, is HMRC is giving off the impression that the tool is legally binding when it isn’t.”

Public sector clients need to seek independent reviews

Having already claimed it itself would be bound by its outcome, HMRC is strongly encouraging use of its tool by public sector clients, who will see it as a risk-free solution. However, for Sinclair, it’s a disaster waiting to happen:

“There are factors related to the worker’s own situation that can influence their IR35 status which the tool won’t be able take into account. It’s all too grey. We’re going to end up where a decision is taken based on only a portion of the relevant information, and countless incorrect judgements will be made.”

Valentine adds that a policy statement by HMRC is not legally binding, and urges clients to consider alternative solutions, adding that the tool will lead to complications further down the line:

“The Law Place has needed to amend 100’s of contracts that were previously assessed using the failed Employment Status Indicator (ESI) tool and other tools mainly because of confusion as to the interpretations of judgements in respect of mutuality of obligation.

“The best option for public sector clients is to either use their own internal legal departments or get external, independent advice. There’s more to be considered when determining IR35 status than what is simply written in the contract, so it often requires a more careful analysis that HMRC can’t provide.”

Public sector contractors – take action now!

“The headline rate in the public sector is now going to be of less value to the contractor, so where a contractor has a choice they will take that into account and may well be tempted by a lower rate in the private sector,” concludes Sinclair.

Sinclair adds that the private sector may not be an available option for all contractors, some of whom may have to take what’s available in a diminished public sector talent pool.

“If a contractor has a choice, they need to be voting with their feet and trying to find more attractive engagements in the private sector. But whatever they do, they need to decide fast.”

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These changes will severely impact public sector contractors as well as the public sector as a whole, with experts predicting the measures will be rolled out to the private sector in due course.

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Updated: 24 February 2020

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