There’s something rather unpopular and controversial afoot and it’s something freelancers, consultants and interims can’t ignore. If you are one of the estimated 900,000 limited company contractors in the UK, or a business that uses them, the IR35 regulations, or off- payroll working rules, as they are also known, will affect you.
In his autumn 2018 budget, chancellor Philip Hammond announced plans to extend the ‘off-payroll’ tax to the private sector in April 2020.
For many, this is an unpopular move, forcing contractors into false employment without full employment rights, yet paying the taxes of a fully employed person. Contractors can lose up to 30% of their take home pay and hiring businesses have seen costs rise as they seek to retain the talent they need.
A bit of background
IR35 rules were introduced back in 2000, by then chancellor Gordon Brown, in an attempt to put an end to ‘disguised employment’ where contractors worked through their own limited company (outside of IR35) to avoid paying tax; basically to stop someone leaving their permanent job on a Friday and then returning as a contractor on Monday to perform their old role but without paying tax and National Insurance at the higher rates. In reality, their working arrangements still reflected employment and in fairness to HMRC, this was a loop hole that they were probably justified in closing.
HM Treasury thinks there is £1.2bn missing each year as a direct result of individuals operating outside IR35 when their contract amounts to employment. The majority of the perceived tax avoidance here is the employer’s NICs, which would have been paid by the ‘engager’ – the hiring organisation – that the contractor is working for. The government has tried to justify IR35 reform by claiming that 90% of the contractors working outside the rules are doing so non-compliantly. This claim is vehemently refuted by freelancers and contractors, and the organisations that champion them, perhaps backed up by the fact the HMRC have only won three out of their last ten cases in court!
In or out?
When working outside the scope of IR35, a contractor can pay themselves through their limited company (sometimes referred to as a PSC, Personal Service Company) taking advantage of the personal allowances and a dividend model to pay themselves, which is (marginally) more tax efficient. When working inside IR35, a contractor is deemed ‘employed for tax purposes’ and has to pay income tax and national insurance contributions just as any PAYE employee would.
What is changing?
From April 2020, every medium and large private sector business in the UK (those with a net turnover of more than £10.2m, a balance sheet total greater than £5.1m or more than 50 employees) will become responsible for setting the IR35 tax status of any contract worker they use. This will mean that the liability for incorrect assessment of IR35 status will be carried by the hiring organisation or agency ‘fee-payer’ and not the individual contractor, as is currently the case. The costs of getting it wrong can be high.
This is not entirely new legislation – these rules already apply to all public sector organisations following changes introduced in April 2017.
Why is it so unpopular?
Firstly, it’s important to point out that the off-payroll working rules are unpopular with both the hiring organisations and the contractors. One of the problems that contractors highlight is that when working inside IR35, and thus classed as an employee in law, they should be treated as one for both rights and tax. As things stand, they are classed as an employee for tax purposes, but receive no employment rights. Contractors are understandably asking how this is fair? Alone, this is pretty hard to ignore, but also for the end-user clients there is significant extra cost and administrative burden. And risk.
Dave Chaplin, founder and CEO of contractorcalculator.co.uk is a champion and active IR35 lobbyist. He told us: “Essentially the new rules correct what was an unfair anomaly in the previous rules, whereby the individual who is classed as a “deemed employee” has to pick up the hirer’s tax bill (Employers NI). The new rules correctly ensure that the right party pays the right amount of tax based on the contract fees being treated as salary.
“For example: If a salaried position is advertised for £50,000 per year, that’s how much the employee is expecting to be paid. As a ‘deemed employee’ that individual is expected to pay their own employment taxes on top of that – which are £5,737. That money is not deducted from the employee of course. But that’s how the existing rules in the private sector work. This means the individual would first pay the employer’s NI tax bill out of their earnings, and then their own taxes, and still not get any employment rights to boot.
“For the new rules, the ‘deemed employer’ has to pay employer’s NI (and the Apprenticeship Levy) on top of the earnings paid to the individual. These taxes are 13.8% and 0.5% respectively. When allowances are taken into account, we are looking at an extra 12% tax payable by the hiring firm.
“In fact, the vast majority of the extra tax payable under the new rules is payable by the hiring firm. Business that are looking to do one-off projects to facilitate growth will now have to pay 12% more for the same skilled people. It’s essentially a 12% tax on growing businesses.”
What has been learnt from the public sector reforms?
If the reforms in the public sector are a pilot for the private sector roll out, it is hard to see them as a success. Yes, the government has raised additional tax revenue (an estimated £550m so far) but this is their only measure of success. Much of the confusion lies in the assessment of tax status – and this is woefully haphazard it seems. Several public sector organisations have made blanket IR35 determinations, resulting in all contractors being taxed as employees. The rules do state however, that each contract must be assessed on its own merits. The result has been a significant talent drain from the public sector as disenchanted contractors have taken their skills to the private sector leaving skills gaps and project delays in their wake. Such decisions present significant financial risk to the hiring organisations too.
Human cost of chaos
To bring this to life with a real case example, this is the experience of a contractor, (who for these purposes we will call Matthew), told to us by his accountant, Michael Lee-Brown of Chartered Certified Accountants, Braywood Ltd: “Matthew had been engaged in late 2016, via his personal service company, to carry out a specific short-term project for an NHS Trust. When we first met him, we discussed IR35 and, after taking consultation from our firm’s network connections with one of the leading IR35 advisory agencies, Matthew considered the project to fall outside IR35 but we flagged up the changes that were scheduled to arrive following the Chancellor’s Autumn Statement in 2016.
“In April 2017, as the new “off- payroll working in the public sector” regulations came into force, Matthew was contacted by a senior member of the NHS payroll team to say that they considered his company would be caught by the new regulation and he was asked for his National Insurance number so that they could operate PAYE on future payments. Matthew refused – knowing full well that he would not be paid but that if he handed over his NI number the NHS would close their file and consider the argument finished.
“Matthew completed an online Check Employment Status for Tax (the notorious “CEST” tool) assessment and this indicated that the contract would fall outside the new rules. NHS HR disagreed and ran their own version of the CEST. At this point, the argument was escalated to the head of that NHS Trust HR and, in parallel, we were running the details back through our IR35 consultants and discussing the outline of the case with several of the leading IR35 experts.
“The NHS team, in conversation, stated that they had all recently been on an in-house course run for NHS by HMRC at which the HMRC officer allegedly stated that they would not expect any contractors working for the entire NHS to fall outside these new rules – and the NHS team took this fully on board.
“There were multiple arguments supporting Matthew’s case – in particular, that his PSC was actually employing another staff member (actual substitution, way beyond the usual arguments about theoretical substitution) and the NHS department Head to whom Matthew’s contract was being delivered stated that, having looked at the CEST tool results from Matthew’s version, he also considered the contract to fall outside the new rules. However, the NHS HR position became entrenched.
“The following months were particularly hard: Matthew, the sole breadwinner in his young family, stopped receiving any income – their mortgage fell into arrears, permanently damaging their credit rating, his company was paying the other staff member so that the NHS project could still be delivered despite not being paid by the NHS, and this meant that other creditors were not being paid, putting at risk the liability protection offered by a limited company so that their home could be at risk. It was only Matthew’s sheer grit that saw them through and by December 2017 they had run out of funds, facing a bleak Christmas despite being owed tens of thousands of pounds by NHS.
“Eventually, when Matthew threatened to walk away from the project and the Trust board realised that the entire project was about to collapse, the HR department decision was overturned and the full payments made, a few days before Christmas – nearly nine months after they had last seen any income.”
He goes on to explain: “The human issues are these: there was no right of appeal against the NHS’s status assessment; it appears that HMRC has been delivering lectures to public sector bodies where their guidance is being presented as if it has the full force of law; establishing someone’s status (employed or self-employed) is a decades-old morass of statute and case law so that it is anything but clear cut and yet the contracting parties are being pushed into using the highly simplistic CEST tool. The results in Matthew’s case were horrible – but what will happen when, from April 2020, these decisions are being made by private sector companies without any kind of experience or expertise in making these assessments? Yes, IR35 was brought in ostensibly to put a stop to abuse but the law isn’t always clean & tidy, and this will lead to real hardship again.”
Scrutinise your contracts
Sadly, stories like Matthew’s are rife, and blanket determinations are clearly not fair. If you believe your contract to be genuinely outside IR35, it is vital that you check it in detail. The contract is the first place HMRC will look should they choose to inspect you so whether a contractor or a hiring client, it pays to have your house in order and that includes having your contract documentation checked by an appropriate legal expert. Here are ten essential points to help you determine whether or not your contract would pass IR35.
As a professional contractor, getting a confirmation of terms letter from the client could save you endless trouble and expense if you need to prove that you are outside IR35. Dave Chaplin again: “If you are a genuine professional contractor, freelancer, interim or consultant who is in business on your own account, you should have nothing to fear from IR35. This is so long as you take the time to understand how the legislation works and apply best practice to ensure it does not apply to you, and have a defence prepared if investigated by HMRC. Making sure that your contracts correctly reflect your working arrangements is essential and a thorough review and renegotiation of your contracts may be necessary.”
If you are not safely outside IR35, then there are other options to consider including working via an umbrella company – insisted upon by certain hiring clients and their agencies – or going onto payroll.
What about umbrella companies?
Umbrella companies have got themselves a poor reputation in some quarters, but a compliant umbrella company is still a good option for many contractors. We asked Julia Kermode, CEO of The Freelancer & Contractor Services Association (FCSA), the independent trade association whose members provide umbrella and accountancy services to contractors and freelancers, to explain what to look out for.
“There are five key benefits of umbrella employment to the contractor and a compliant umbrella firm will:
- Employ you
- Give you all statutory rights & benefits of employment (holiday pay, sick pay, pension etc)
- Give you the flexibility for numerous different end-hirers
- Consolidate your pay from numerous hirers into one pay packet
- Process the full amount of your gross pay through PAYE
Beware of ‘work arounds’
But Julia Kermode had word of caution: “There are now a number of schemes that are aggressively targeting professional contractors to sell their ‘product’ of higher take-home pay. They “work” by paying a small portion of your earnings via PAYE and then disguising the remaining larger part of your income as something else, often an offshore loan. Most of these schemes are illegal.
“Although these companies are suggesting they can reduce your tax and NICs, in reality you are still liable to pay those. By using such a scheme, you put yourself at significant personal financial risk. HMRC will usually backdate any charge for unpaid taxes to the date that you signed up to the scheme, and once fines and interest is added then your total tax bill will be extremely large.
“Sometimes these schemes label themselves as “umbrella”, but they are not umbrellas at all, and they are bringing the sector into disrepute. A true umbrella employs the worker whilst giving them flexibility to work for numerous end-hirers – so the worker has an umbrella of employment benefits and rights that they take with them wherever they work. Crucially, an umbrella will always pay 100% of your gross pay through RTI payroll.”
Is it still worth working via a Ltd company?
Michael Lee-Brown has a point of view: “If a contract falls within the (current) Public Sector IR35 rules (which are planned to roll out to private sector in 2020) then my view is that in most cases the worker would be better off going onto the client’s payroll or working through a compliant umbrella company – the net funds they’d receive will be broadly the same (as it’ll all be taxed under PAYE whichever route it goes) but with a Ltd company they’ll need to pay for the admin of the Ltd company on top. Where the contract is not deemed to fall within IR35, then the Ltd company is still a valid structure. The real difficulty is (as seen in Matthew’s story above) that the decisions around whether or not contracts are caught within IR35 have been questionable within the public sector. Now the net is closing in on the private sector…… it’ll be interesting to see how they respond.”
Recruitment agencies also have a role to play in all of this. Dave Chaplin adds: “They are the middlemen, and often the referees of the debacle. If the clients and agencies want to hire the best people, they need to take on tax risk, and if they don’t want the tax risk, they won’t attract the best talent, or have to pay more for it. Contractors are being oppressed, and it’s a renegotiation – those that can least afford it are worst affected.”
When handling payments on behalf of the end client, it is widely expected agencies will carry the IR35 liability, despite the fact the hiring organisation remains responsible for making the decision. Comma’s Virginia Hicks, who places interim communications, change and coaching professionals adds: “The choice of switching to an umbrella company (and closing their limited company) or going on to PAYE and paying more tax is not a palatable one for interims. Already some interims are avoiding public sector opportunities due to blanket assessments unless their day rate is adjusted to compensate for the higher taxation they incur. The private sector relies on talented interims to resource vacancies, cover maternity and support critical business change so the market will have to adapt quickly to ensure contractors are still attracted to this way of working.”
Government has yet to publish draft legislation for extending the off-payroll working rules to the private sector and many MPs in the currently low-majority Government do not wish the reforms to proceed. So, it’s by no means a done deal. The current consultation period continues through February before legislation is drafted in the summer ahead of an announcement in the November 2019 budget. Clients, agencies and professional contractors are urged to have their say.
Julia Kermode sums up: “In recent times, we have seen a number of tax policy changes introduced which have simply served to penalise the contingent workforce and the businesses that support them, leaving them financially worse off and under-valued by a Government that claims to recognise the economic importance of the flexible workforce. It would be simply malicious and wrong to punish these workers and the businesses that have been the financial backbone of the UK economy in recent years by imposing these reforms on them.”
For more information, download the IR35 Factsheet here.