In 1999 Chancellor Gordon Brown was fairly new to his role. As well as cutting Corporation Tax to “the lowest rate amongst major industrialised countries” of 30%, he also undertook to “introduce rules to prevent individuals avoiding income tax by providing personal services through intermediaries, such as service companies”.
These rules became known as IR35.
Almost 20 years later and corporation tax is set to drop to 17%, and we are still talking about IR35, originally introduced to tackle the problem of “disguised employment” through an intermediary company.
The press release itself identifies the problem of an individual engaged as an employee on Friday, returning on Monday to perform the same role through a limited company, and less tax/NI being paid as a result. 18 years on from when the rules were introduced, there still seem to be lots of one man service companies operating in what could be considered to be grey areas in terms of IR35 compliance. How did this happen, and what is the likely resolution?
Principal Limited is a limited company. Sue wants to provide services to Principal. If Sue engages with the company, the company will have to decide whether or not the relationship is one of employment for tax purposes, and therefore whether or not PAYE should apply to payments made to Sue.
However, if Sue provides her services to Principal Limited via an engagement with Sue Limited, then Principal Limited do not have to consider whether or not Sue is an employee. The tax analysis is pushed back on to Sue/Sue Limited in terms of whether or not IR35 applies.
The difficulty of this for HMRC is that there are thousands of Sues, and that having the resources to police IR35 then becomes challenging, as the amount of tax at stake in each case is relatively small, but each is particular to its own facts and circumstances, and so there can’t be a single decision at tribunal which helps HMRC establish a firm basis for dealing with what they consider to be non-compliant contractors.
This changed in the public sector from April 2017. In the example above, if Principal Limited was a public sector body, it would be required to consider whether or not there was effectively an employment relationship – Sue Limited can no longer be used by it as a shield.
Public sector bodies have interpreted the rules cautiously and often prefer to apply PAYE (sometimes on a blanket basis where it should not actually be due). The online tools provided by HMRC to help guide compliance are too crude to function effectively. There is anecdotal evidence that this has led to contractors who have the option of working in the private sector of seeking the same “net” pay, and therefore either making it more difficult for the public sector to obtain the best people or increasing costs, such that any extra tax take is in effect lost.
However, HMRC/the Treasury wish to introduce something similar in the private sector, and issued a consultation document (Off-payroll working in the private sector) in May 2018, with intention to legislate from April 2020.
It is clear that IR35 has not been effective in solving the problem which it sought to address, as non-compliance rates are estimated at 90%, and instead simply acts as something which creates uncertainty. HMRC effectively acknowledge that they are unable to effectively police the system, hence the wish to bring in something akin to what they have in the public sector whereby the burden of compliance will in effect fall on the engaging company, leaving HMRC with fewer customers/targets to check the compliance position of.
As many respondents to the consultation have pointed out, this is an unfair burden on businesses, particularly at a time where the status of employees and the self-employed is increasingly complicated. The courts recognise there is now something called a “worker” for employment law purposes which is not however recognised by the tax system.
There is likely to be an adverse impact on cash flow, and also a risk of a competitive disadvantage against other businesses which apply a more “liberal” interpretation of the new rules.
The correct answer is surely to increase HMRC resource in order to properly monitor a new, more transparent system. However, it is more likely that we will end up with something similar to the public sector rules moving into the private sector in 2020.
Construction Industry Scheme
Of course, those in the construction sector already have a similar set of rules in terms of the Construction Industry Scheme (CIS). CIS broadly applies where a business spends more than £1m a year on construction operations in furtherance of a business. Construction operations is widely defined, and so the rules will have to be applied to most payments made.
Payments must be made net of tax (at 20%) unless the sub-contractor is registered with HMRC and has gross payment status. The aim of the rules is to prevent payments disappearing into the black economy. Taxpayers can be both contractors and sub-contractors in respect of a project, if for example they are paid by the developer and then pay sub-contractors in turn.
Loss of gross payment status can have significant cash flow impact, and care must in turn be taken by any contractors that they operate the scheme correctly to ensure they do not face penalties or lose their own gross payment status.
Anyone operating in construction should ensure they are therefore aware of and complying with their requirements under CIS, whether they are contractors, sub-contractors or both.
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The information in this blog should not be regarded as financial advice. This is based on our understanding in December 2018. Laws and tax rules may change in the future.