Business entity tests: Details and reactions

As we speak, I imagine there are all sorts of creative types coming up with business directories that cost £1,201 to list in (and offer surprisingly generous free gifts & other incentives) and we will no doubt hear of 3 bed semis that 500 workers have rented work space in (at the same time) and there will be "IR35 Compliant/Proof Business Plans" that will have HMRC officers experiencing the strangest feelings of de ja vu.

That's 13 points already and into the medium risk category.

I cannot understand the reasoning behind some of these business entity tests.

 For example why is it 'bad' to:

• run a business from your own home - my home contains two full time businesses
• run the entire business on your own - much can be achieved with a bank of computers and one person
• not pay to advertise - I never advertise all my work comes from contacts
• never have bad debts - this is surely an example of good business management
• not have a business plan - a business plan is only needed to demonstrate the health of the business to someone else, such as a lender.

I can't believe HMRC think you have to have 10% bad debts to demonstrate that you are self employed.

If any of my clients had 10% bad debts I would be sending them back to school or telling them to get a job.

1% seems like a more reasonable figure.

QUESTION: Will HMG's 2,000 alleged NPWs [Non Payroll Workers] as reported in the media as being identified by Danny Alexander be"part and parcel" of ‘the test and learn phase’ of HMRC?

We should be told, for example via the HMRC's IR35 Forum, and via its publicly available Minutes!

dsticki:I completely agree with you, the publication of that letter  has been followed by a mysterious silence.........a case of 'do as I say not as I do' ?!

If you think of the tests as a quick way to know that a given client is 100 miles outside of IR35 so you can avoid spending any more time thinking about IR35 they have value.

However I don’t see how they help with most contractors/freelancers as they all mostly still in the grey area.

ringi: a quick check of my clients tells me that NONE of them are offerred any assistance by these tests.This is a group of people who,speaking generally,work from home,do not advertise,work without dependence on assistants etc etc .....are they now to be considered more high risk under existing case law than this time last week? Hardly I would say !

As I pointed out in an earlier thread on AW, the business entity tests are fundamentally flawed. The original thinking was that they might be used to sift out those contractors who are outside IR35.

However, the net has been cast so wide, that anyone who is providing personal services by a limited company is considered medium or high risk. They could just replace all the tests with one question: Are you a service company? If yes, then you are potentially at risk.

The flaw in the tests is that (a) the questions are not based on the most important aspects of IR35 case law, but yet they are drawing a conclusion about IR35 risk. and (b) they are implying that anyone who isn't in the low category is at risk of IR35. This isn't true, and is a bit like trying to locate people in Europe by considering anyone who doesn't live in China.

If you look at the scenarios, they are fairly useful for newbies, but seasoned IR35 observers will spot that most contractors will be in the borderline case. So they don't help either.

So, what's the difference between pre-OTS review + Forum and now?

(1) More unnecessary complexity and confusion.

(2) Many more time wasting IR35 investigations.

Progress? Don't think so!

Hi John Stokdyk!    May I politely request - when you [or any other AWEB reader] next contact John Whiting, etc - that (to ameliorate political fallout of granny tax, etc) you please ask him (etc) to consider an additional / new IR35 Business Entity Test question, to those already published, of the form:

*   "Contractor's Age test - Is the contractor aged greater than State Pension Age? (999 points if yes)".

Of course, if HMRC's proposed system can only deal with two digits, then score 99 points (if yes); as, for your easy reference, I previously set out in this AWEB link:-

 http://www.accountingweb.co.uk/anyanswers/question/ir35-2#comment-558692

Here are some rationales to support a "Contractor's Age test", for consideration:

(1) IF HMRC really does support the Chancellor's Budget 2012 for growth, THEN surely it's better that people over State Pension Age (SPA) are in work, creating economic activity for the UK's economy, rather than on the street or buses, or causing extra public expenditure through pre-mature dementia/altsheimers/etc and associated NHS or care home costs.

(2) Haven't the necessary contributions needed by the state already been paid by and for such OAP workers, through the NIC records?

(3) Don't the advances in computerisation since the post WW2 introduction of the NIC scheme mean that employers can now efficiently distinguish between workers aged below and above SPA?

(4) With the intellectual/skills capital of workers > SPA, isn't it sensible to unleash same, especially as an ageing population demands sufficient workers, and immigration is now discouraged by HMG due to the costs of congestion, etc?

[later edit, this cross refers from http://www.accountingweb.co.uk/article/business-entity-tests-what-you-ne... which shows:

The proposed Contractor's Age test criterion is to draw a line whether, or not, the contractor is over or under 65, or whatever SPA (UK State Pension Age) evolves to, and so it should be easy to apply by HMRC, and be seen to apply. .

As HMRC has had a court/tribunal ruling that a contract - or a series of contracts - may be part-inside IR35 and part-outside IR35, then the revised IR35 "Age test" condition would be to apply (or not apply) IR35 accordingly. ]

IR35  is all about the payment+ collections of tax + ni, 

So would a better series of tests to determine risk be  

salary+nic + pension + p11d etc   >=  say80% of turnover = NO RISK

or

div > turnover  [ some risk, given that most dividends are out of 'current  year ' turnover and not from Company CT  taxed Reserves.. ]

HIGH  RISK - current year      LOW RISK= Div from reserves

PCG and alike how much are they a party to these new checklists! Any point in lobby groups then.........with HMRC

It might not find favour with many but why not have a rule restricting the amount which can be distributed by close companies. e.g. no more than 50% of distributable reserves (accumulated plus profit for the year) can be distributed in any financial year. Any excess is treated as salary subject to PAYE and NI.

We need clarity and certainty.

re Mallock-   these RESERVES  have already historically been taxed from current CT rates possibly up to near 30%+ some reserves value may even predate IR35.  So do you really advocate a  :   PAYE +Ni  - on- CorpTax[paid] reserves/profit ?  ie taxation  on alreadytaxpaid rev ?  

surely you would mean to exclude  'accumulated' from your 50% levy? which would bring you back inline with IR35.. ie the name of the game?

This is all about revenue collection so the Salary + DEEMED payment versus high dividends and small salary when compared to turnover is already in place.     So the at MAJOR RISK business from an HMRC risk assessment would surely be high dividend versus turnover ratio. Case law is available we dont need awhole new decade of reinventing the wheel, unless they just quash ir35

the lobby groups really seem to have lost sight of the end game and exist as self perpetuating  means to stay in existance themselves

dsticki - agree re NI, OTS should really have a look. Ask Vince?

A recent documentary showed how HMRC made deals with companies that were operating via Luxembourg, to collect a bit of tax rather than almost none at all.
However the last government effectively abolished managed service companies (such as those via JSA) under which numerous small one-man consultancies and the like were pushed out of a compliant tax regime into the DIY world of corporate tax.
I wonder how much steady tax revenue was dissipated in this change ? It does seem to reflect the opposite view to the first point in terms of pragmatism.

It would be wonderful to think that HMRC might drop IR35 completely but I really doubt it.

I agree that companies with a high dividend to turnover ratio are the types of business HMRC believes are trying to avoid NI and are therefore high risk but very little in the new rules provides any kind of certainty: high risk does not necessarily mean you are caught by IR35 and low risk doesn't mean you are outside IR35. How is someone (probably with modest savings and high outgoings) supposed to organise their affairs so that they can pay up when HMRC state that IR35 applies to them 4 or 5 years down the road - these individuals will probably face bankruptcy. This is not acceptable in my opinion and taxpayers deserve certainty.

My 50% figure was merely an attempt to demonstrate that HMRC/The Government could achieve largely what they want by a simple test which provide certainty. The reason I suggested that the figure should be based on accumulated profits plus current profits is that it would prevent further manipulation. I accept your point that the profits in accumulated reserves have already been taxed but my suggestions merely restrict the amounts which can be withdrawn by dividend and don't lead to any additional tax/NI payments unless the 50% total is breached.

Let's face it, HMRC are not going to forget IR35 and the Government are not going to do what they should and amalgamate tax and NI, so some workeable solution needs to be found.

I was merely looking for a simple formulaic solution which would provide certainty and simplicity. 

Hi kiwilondon99!   Thanks; I assume that you also agree that there should be NO IR35 employER National Insurance Contributions IF a contractor is aged >SPA (State Pension Age), currently 65 years old.   To neutralise OAPs' IR35 - analogous to what Kier Starmer did with new rules for assisted suicide - I think we need an additional / new IR35 Business Entity Test question, to those already published, of the form:

*   "Contractor's Age test - Is the contractor aged greater than State Pension Age? (999 points if yes)".

Of course, if HMRC's proposed system can only deal with two digits, then score 99 points (if yes).

I'll compose something for Vince Cable to pass on to Treasury Ministers/OTS when I can, especially as it was alleged that he had problems with VAT registration AND HMRC's IR35 practices are far more incomprehensible, especially for those of advanced years who can still contribute to UK's economic growth!

" these individuals will probably face bankruptcy " - surely if they have not been negligent and had reasonable reasons for their stance at the time, all they would face is the company being wound up ?

And I would still hold that there must be some quid pro quo for the 'disguised employee' on being deemed as such and being expected to pay through the nose for it.

Unfortunately, HMRC have the power to pursue a director where PAYE or NI is outstanding on monies that he/she has withdrawn from the company. In other words the full IR35 liability could fall on the individual even if the company has been liquidated. Whether or not HMRC decide to go down this route will depend to some extent on the quantum of the liability but a larger liability is more likely to be pursued and similarly a large liability will give the individual major problems.

This is why certainty is essential.

Mallock - as was pointed out to you in Shout99, allowing all Ltd Cos to distribute 50% of turnover as dividends is effectively giving anyone that sets up a Ltd Co remuneration scheme a massive tax break. Since the Chancellor's reason for not repealing IR35 was that it would lead to mass incorporation for tax avoidance purposes, your 50% approach would lead to exactly the same problem, only that the reduction on the tax take would be less.

The key thing about IR35 to my mind is that those tested end up polarised at the extremes of the tax system. Either you can do whatever you like, paying dividends and no NI unless you volunteer to pay some, or you end up much worse off than an employee, paying both EE and ER NI. When those under the sole trader regime (Schedule D) are paying around 8-9% NI, what happened to that as a possible outcome of an IR35 case?

This is one reason that I agree with Kiwi: the lobby groups have lost sight of the end game. To aim for the Inside IR35 cases to pay something like Sch D or EE NI would be the fair and achievable outcome. However, it seems as though they've decided that sorting out IR35 would have a negative effect on their membership - the only other possibility seems to be that they're just not very smart.

My over-riding belief is that tax has to be fair and it has to be kept as simple as possible: the more complex it becomes the more loopholes can be found.

Personally I don't really see that there is much difference between someone who is a contractor working through a service company and someone operating, say as a manufacturer's agent, through a company.

The big difference due to IR35 is that the individual operating through a service company may have to pay employee's and employer's NI on 95% of his income and if he brings his wife in as an employee or shareholder there is a distinct possibility that this income will all be taxed on him. His choices are to pay up or take a chance and hope he doesn't get caught. The imposition of IR35 and its excessive tax charge takes no account of the fact that the individual gets no sick, holiday or paternity pay and has no employment rights.

The individual who trades as a manufacturer's agent works on his own but his wife might keep his books and answer the phone for him (in exactly the same way as the wife of the owner of the service company does). However in this case he is quite entitled to pay his wife say £10,000 for her work and also to have her as a shareholder, legitimately receiving NI free dividends and helping to keep the family out of higher rate tax (and keeping child benefit as a result)

It might just be me but I find it slightly distasteful that the manufacturer's agent can arrange his affairs in such a way that he pays considerably less tax and NI than someone who operates through a service company or works as an employee.

My suggestion for a maximum of 50% of distributable reserves would only apply to Close companies i.e. those controlled by 5 or fewer individuals so it would apply to both the companies above and in my eyes would be fairer for all. The 50% would also apply to profit not turnover and normal accounting principles would be applied to determine the expenses which could be deducted under the wholly and exclusively rules.

For some, there will be more tax to pay and for others (those currently caught by IR35) there will be certainty in their tax liabilities whilst retaining  flexibility in their working practices.

I happen to believe that if you give up all the benefits of paid holidays, sick pay, maternity and paternity rights, job security, employee rights etc there should be some compensation in terms of greater take home pay. IR35 completely ignores this and punishes those it catches rather than encourages them. It is flawed unfair legislation.

Unfortunately removing IR35 turns the tables too far the other way as you said, hence my proposal which simplifies everything and makes the playing field a bit more level for everyone.

Mallock

You have written a lot about fairness, unfortunately that is not relevant to the discussion of your idea of 50% dividends - it is a completely separate issue. I'm sure all here agree that IR35 is unfair for the reasons I stated - in fact you are more or less quoting what I said to you as if it somehow justifies your position.

However, the mere fact that IR35 is unfair does not justify one solution over another - what you seem to have ignored is largely... well, all that was said to you about your 50% idea not being workable as a solution because firms will employ people through a Ltd Co to avoid ER NI (prior to 2000 when IR35 was introduced the consensus was that IT work would soon be "100% contract" and we all know what happened to that).

(1) Since the government will lose out by a large chunk of ER NI, they won't do it.

(2) Since there's a popular backlash against any such tax breaks for anyone perceived as remotely better off, they won't do it for political reasons.

(3) Since it's unfair, they won't do it.

(4) Giving out a lot of freebies may seem simple - but it simply doesn't make any sense. If Inside IR35 = Employee then the solution is to have those caught paying the same taxes as employees, no more and no less. And importantly, there is no reason that it cannot be done using the same calculation.

Can I strongly suggest that you drop this idea quickly.

Sorry chEEK but I rellay don't know what your point is.

To make mine quite clearly:

1.  I do not believe that the uncertainty which IR35 brings is fair or reasonable.

2. I don't believe that anyone contracting for the same company for a long period of time should be treated as self employed. There should be a cut off at which point the company would have to employ the individual.

3. I would like to see Tax and National Insurance amalgamated which would largely make the IR35 question redundant since the whole point of the legislation is to stop the loss of NI.

4. We have to retain flexibility in the system which allows people to work in a manner which suits them and those who wish to use their services. i.e. the right to operate through a limited company must be retained.

5. The whole reason we have IR35 is because of too much Government and HMRC involvement and poor legislation. If we had the NI rates from 25 years ago (between 3% and 5%) there would be far less incentive to operate through a limited company. Unfortunately for years the Government increased NI whilst stating it had not increased tax! A tipping point was reached and people quite understandably found ways to avoid the NI. Perhaps we could reduce NI to low levels again and go with a flat rate of tax thereby removing the need for IR35 legislation since there would be little or no difference in the tax paid regardless of which vehicle you traded through. 

6. Keeping IR35 is not the solution, it is the problem.

Mallock

If you really don't understand the point I was making then there's little point in further discussion - the point is clear enough.

Stating a series of known/agreed facts doesn't add up to much of a discussion anyway, but at least I see that you've wisely dropped the concept that they somehow add up to a 50% free-for-all beanfeast.

Although you are largely stating things that are known'agreed (at least, they're agreed outside of the Treasury/HMRC and the political classes) there are still two points where that is not the case.

On your point 6, IR35 or any other piece of legislation will be required to avoid the "no NI" option i.e. a return to pre-2000 dividend levels. Therefore, the key issue is making sure that IR35 (or whatever may be in its place) is fair. Employees should pay employee levels of tax, self-employed should pay self-employed levels of tax.

Unless, of course, you want to become as misguided as the PCG who have lost sight of how this will play out by continuing to bang the repeal drum, refusing to see that it is a dead horse - not only because the Chancellor has said so, but for the simple reason that anything that shifts the balance beyond "fairness" and gives an advantage to the contractor over the employee will never happen.

On your point 3, it's a common mistake, but I'm becoming weary pointing out that "amalgamating NI and Tax" as you call it, by which I assume you mean income tax, is NOT a panacea in any way for IR35. I recently posted to that effect here on this site:

http://www.accountingweb.co.uk/article/business-entity-tests-what-you-need-know/527355#comment-558949

I haven't used the "permalink" facility here before, so if that doesn't work then have a look at this:

 http://www.shout99.com/contractors/showarticle.pl?id=70964

Hope this helps.

I know that employer's NI is the problem which is why I would like to see it reduced or removed altogether.

To return to the "fair" argument I don't think it is fair that a business which employs lots of staff should pay more tax (er's NI) than one which only employs a few staff. Tax should be based on profitability and taxes on employment (or at least excessive taxes like 13.8%) do nothing to help reduce the unemployed or stimulate the economy.

However I accept that the Treasury has become so reliant on the income from Er's NI that it's abolition and the resultant increase in Income Tax and Corporation Tax might be too much to stomach - hence a reduction to a lower level, say 5%, might be more acceptable.

In everything you have said, all you have done is try to pick holes in other's arguments without really saying what you would prefer to see instead.

If I understand you, you want someone who is not caught by IR35 but has to operate through a limited company to be taxed the same as if they were self employed and someone who is caught by IR35 to be taxed as an employee without the Er's NI charge.

To my mind if someone is not caught by IR35 then they should be taxed and treated in the same way as any other limited company, otherwise you require another set of rules to determine if the company is really a service company or not which brings more uncertainty. Your proposals would also require the retention of IR35 which is yet more uncertainty.

The whole tax regime in this country requires an overhaul but in the interim I still don't see what is wrong with having a restriction on the amount which can be paid out as dividend in a close company. Whether it is 50% or more doesn't matter but the principle would work and would be a compromise which should prevent some of the more blatant abuses of the current system.

How can you say: "In everything you have said, all you have done is try to pick holes in other's arguments without really saying what you would prefer to see instead.".

And follow it with:"If I understand you, you want someone who is not caught by IR35 but has to operate through a limited company to be taxed the same as if they were self employed and someone who is caught by IR35 to be taxed as an employee without the Er's NI charge."?

First you say that I don't have a position and then you state my position in the very next sentence. Bizarre. 

I'm not picking holes in your suggestion, I believe I'm driving a truck through it. You seem very unwilling to grasp the fact that any calculation that leads to different outcomes between employees and deemed employees will be doomed to fail, and one which gives an advantage to deemed employees will be political suicide.

Furthermore, the disparity will vary with income/turnover as it does now with the 5% allowance. The concept of increasing the 5% allowance has been discussed in the past - which is a variant on what you're suggesting - but nobody has ever suggested increasing it to 50%!

I believe that EE NI is now a tax and that it is intended that working people should pay it. Therefore it is unavoidable that some form of IR35-like legislation is going to exist - that must be accepted. Replacing IR35 with something more sensible, or adjusting IR35 itself to be more sensible is the same thing.

I also believe that the real injustice of an IR35 case is that the victim is polarised to the extremes of the tax system - either able to pay no NI if they wish, or being the only kind of people in the country who are saddled with both ER and EE NI. If the purpose of the exercise is to determine employed/self-employed then why is it that they are the only tax regimes that are not possible outcomes?

What happened to self-employed (i.e. Schedule D, a la sole trader and employed (as in EE NI only)?

An important thing to realise about Sch D is that in that tax regime no ER NI is due/paid to the government at all. The words of Dawn Primarolo on the subject "Somebody has to pay it" were totally wrong

So yes, I would like to see the outcomes of IR35 adjusted so that the level of tax levied is exactly the same as for the equivalent statuses in other walks of life, as determined via any other route.

I think I was the first to point out that ER NI should be removed since it is a tax on employing British-based workers, something we can ill afford in a competitive global economy. As a business tax on employment, ER NI cannot be merged into income tax as some have rather bizarrely suggested, it has no logical home and therefore it's removal can only be funded by commensurate cuts in public expenditure. Note: hiking the CT rate would be economic suicide.

I have strong feelings about this because I don't want to see another 12 years wasted chasing unachievable goals. The PCG have taken a totally blinkered approach to this, chasing repeal when it was clear from early on that it is not achievable. I've been telling them that since 2001 - I gave up after the OTS debacle and left. So the idea of another non-starter idea gaining traction is... frightening quite honestly.

The only approach to this is to look at what the outcomes should be and then lobby for the law to say that. Anything convoluted and artificial will not fly - it has to be clear, simple and exactly in line with the taxes being paid by other working people in the same boat.

And it has to be justifiable - the public will not wear any kind of tax break for freelancers. The way to win this is to point out the injustice of EE NI + ER NI, win public support and lobby to pay the same taxes as other individuals. Even that will be hard enough - people are jealous of those who earn more than they do and simply don't care if they pay some of their tax for them. So any such campaign would need to be carefully orchestrated - perhaps using the lowest paid contractors as examples, whatever that may be... a recent survey seemed to suggest that might be tech support people in Northern Ireland who probably turn over less than the average UK wage.

We might have more in common than you think but I am afraid that I can't see how your system could work.

My 50% is not an extension of the 5% expense allowance. It is a restriction on the amount which can be paid out as National Insurance free dividend. It was merely a suggestion to make operating through a limited company a bit less attractive to those who exploit the opportunity to the maximum whilst at the same time providing some safeguard to the Treasury and increasing the overall tax take across a much wider group of taxpayers.

I would go back to the example of the manufacturer's agent I provided previously where he earns say £110,000 top line, deducts £15,000 expenses for his car and travel and another £5,000 for other expenses. He then splits the net amount with his wife and pays minimum salary, dividends and sufficient pension contributions to stay out of higher rate tax. The result is that he would be about £15,000 better off than an individual who was a sole trader.

Through a restriction on the amount which can be withdrawn as dividend some of the tax "lost" in the above arrangement would be taxed to PAYE and NI if the individual wanted to draw all the profits out of the company.

We have flogged this one to death but at least we agree that IR35 is inequitous. I happen to agree with your assertions that you should pay the same tax whichever way you are paid but there is more than one way in which this can be achieved e.g a 25% Corporation Tax Rate and Er's Ni reduced.

I didnt't say your 50% things was "an extension of the 55 expense allowance" as you suggest, what I did say was:

"The concept of increasing the 5% allowance has been discussed in the past - which is a variant on what you're suggesting - but nobody has ever suggested increasing it to 50%!".

It has always been clear that we agree that IR35 as currently penned is unfair to the point of being nonsensical, but the ways to correct it have to be clearly in line with tax levels in all other cases. Unfortunately that's not true of what you suggested with the 50% thing, nor is it true of what you suggested here:

"I happen to agree with your assertions that you should pay the same tax whichever way you are paid but there is more than one way in which this can be achieved e.g a 25% Corporation Tax Rate and Er's Ni reduced.".

I'm not sure why you're increasing CT in lieu of ER NI if ER NI is not felt to be appropriate?

The main issue with all these "solutions", including the actual IR35 calc is that they are simply not accurate. It may be approximately true in some cases but not in other cases. That is because each tax comes with its own set of rules and no two are alike (or, presumably, they would be one tax). The OTS report claimed in para C25 that those Inside IR35 were in approximately the same position as employees. That can easily be shown to be totally untrue - and that the divergence widens as income increases.

This is the problem with all such "tinkering" solutions, they may appear accurate in some cases, when the take-home pay is roughly equal, but it will generally be roughly equal and rarely exact - and most importantly there will be cases that are wildly different. In fact, in the examples given in the OTS document they seemed to be  claiming that £55k take home was not much different to £45k! Although they used the wrong figures in their examples (sigh), the gap is actually a bit less than that.

All in all, I strongly believe that the best/only approach is to simply say "You're deemed to be an employee -  now, here is the amount of tax and NI you owe based on what you would have paid as an employee" using the same calculation as is used for employees. Why do anything else? There is no need to invent any clever methods here, using the existing method is all that is needed. And it is not only fair but also transparent.

I won't re-hash the political argument re other solutions - we all know that equity is the best freelancers can hope for, so... that should be the objective in the end game. Ensuring that the Inside IR35 situation is not as horribly unfair as it is now should always have been a key element of policy for the PCG, but they chose to ignore it. And they are still ignoring it - even if their business tests had been everything they wanted, the Inside IR35 people would still be totally shafted. Shame on the PCG - those of their members who are Inside IR35, and the wider freelancing community, deserve better.

As you say, this has been done to death now. I hope you can see why the best approach is to aim to be taxed as whatever you're deemed to be, no more and no less and using the same calculation as anyone else in that situation, deemed or otherwise.

Edit: typos