Tax experts have blasted the government’s proposal to make client organisations in the public sector responsible for deciding employment status and applying the IR35 tax rules
This article was first published in the September 2016 UK edition of Accounting and Business magazine.
Abolition of the controversial IR35 tax regime for personal service companies is not an option, the government declared in a July 2015 discussion paper. Instead it decided to try to make the legislation more effective without widening its scope.
It did so in this year’s Budget, announcing that public sector organisations will have a new duty to ‘ensure that those working for them pay the correct tax rather than giving a tax advantage to those who choose to contract their work through personal service companies’.
IR35 specialists have criticised the reform. Andrew Chamberlain, deputy director of policy at the Association of Independent Professionals and the Self Employed (IPSE), says it is ‘only likely to create a lose-lose situation’.
In a technical note issued with the Budget, HMRC admits there is widespread non-compliance with the rules set out in sections 48-61 of Income Tax (Earnings and Pensions) Act 2003, and confusion about what they are.
Until the new public sector obligation kicks in, those rules are as follows: IR35 applies when a worker provides services to a client via a personal services company or partnership, and the circumstances are such that, if the services were provided directly to the client, the worker would be treated as an employee of the client for income tax purposes. It is the personal services company’s responsibility to determine whether IR35 applies and, if it does, to account for any income tax and national insurance liabilities arising.
According to HMRC guidance, the facts of each engagement determine whether IR35 applies: ‘You need to assess what that relationship would be if there were no intermediary involved.’
Readers are directed to HMRC’s employment status manual for detailed guidance. There is an employment status indicator tool on the HMRC website, but the tool does not itself determine whether an engagement falls under IR35.
An HMRC consultation that began on 26 May invited comments on the impact of the major change intended to improve IR35’s effectiveness for engagements in the public sector. Stakeholders were invited to work with HMRC to develop a new digital tool that would be able to determine whether an engagement is within IR35.
From April 2017, a public sector organisation engaging a worker via a personal services company will be responsible for operating the IR35 tax rules if the engagement comes under IR35, and will have to account for any income tax and national insurance contributions.
A new gateway process ‘will allow anyone engaging a worker through a personal services company to quickly decide whether the rules need to be considered’, HMRC says.
The first part of this gateway process will eliminate engagements, such as some building contracts, where 20% or more of the contract is for ‘materials consumed in the service’, as well as contracts where a worker does not own their own company.
The second part of the process concerns whether the worker (rather than a substitute) is required to do the work, and if the engager has the right to decide how the work should be done.
If the IR35 question is not determined by this two-part process, the public sector organisation will need to consult the new digital tool. ‘The tool will be the main way HMRC will give customers certainty about their situation. If the tool has been completed accurately, reflecting the true facts, and the engager keeps the results, HMRC will stand by that outcome,’ HMRC says.
Chamberlain says: ‘Clients will want to play it safe and minimise any risks, so they’ll just assume all their relationships with contractors are considered to be under IR35. This means the contractors will be taxed as employees but won’t receive employment benefits, making legal challenges more likely as the boundaries are blurred between employment rights and tax status.’
Many contractors will respond by hiking their rates, Chamberlain warns, so ‘the government itself will likely pick up the bill, reducing the efficacy of the entire proposal’. Some contractors will simply avoid public sector work altogether, he says, ‘damaging the public sector’s ability to deliver vital projects’.
He adds: ‘On top of that, HMRC’s new online tool to determine when IR35 applies is unlikely to work in practice. IR35 is so complex that it’s impossible to imagine a tool that will be 100% accurate, meaning some contractors could lose out severely.’
Matt Fryer, senior compliance manager at Warrington-based IR35 specialist Brookson, says he does not think abuse of the existing rules is as widespread as HMRC suspects. ‘The issue is that HMRC does not have sufficient resources to police the existing IR35 legislation, which I think is fit for purpose,’ he says. ‘Shifting the liability, and the risk associated with getting employment status wrong from the personal services company to the client will cause distortions in the market as risk-averse hirers will take a prudent approach and apply the IR35 rules to all off-payroll workers.’
He warns that this could result in ‘significant reductions in pay’ for genuine career contractors who offer a valuable flexible resource to the public sector. ‘This is not proportionate, nor is it a fair outcome, so it goes against two of the key objectives for policy change. It may also result in skills shortages in key public sector services such as education and the NHS, as highly skilled flexible resource moves into the private sector.’
The government does not intend to change the rules for private sector engagements. ‘Public sector’ will be defined by freedom of information legislation for this purpose. The list of relevant organisations occupies 40 pages of the consultation document.
The personal services company will continue to account for VAT if registered, and the engager will treat the VAT-exclusive fee (less a 5% allowance) as taxable earnings, deducting income tax and national insurance as appropriate.
A credit will be given against the worker’s tax liability on earnings and dividends drawn from the personal services company to avoid double taxation.
Reconsider or scrap
Chas Roy-Chowdhury, head of taxation at ACCA, says the problem in treating public sector engagements differently is not just the complexity, but how to define the public sector. ‘We can have public/private partnerships, we can have joint ventures, and we can have outsourcing. The public sector is not homogenous and should not be treated as such.’ He says the consultation was not well formulated, and the government should either reconsider and re-issue it or scrap IR35.
Chamberlain also urges the government to reconsider. ‘In times of such uncertainty around our exit from the EU, the government should be doing everything they can to reassure microbusinesses that the future still looks positive. Threatening them with such damaging proposals is not the way.’
Fryer suggests better enforcement of the existing regime, with penalties for public sector bodies that do not adopt suitable processes to ensure that contractors are paying the right tax. The consultation was set to close on 18 August.
Andrew Goodall, tax journalist
"It may result in skills shortages in key services such as education and the NHS, as highly skilled flexible resource moves to the private sector."