IR35: The employee vs self-employed tax conundrum
Rebecca Seeley Harris reviews the Office of Tax Simplification literature on the taxation of personal service companies and the self-employed. Is the time now right for the government to grasp the nettle of this most prickly of problems?
On 26 March 2020, following his announcement on the Covid-19 support package the for self-employed, Chancellor Rishi Sunak noted with regard to NIC: “It is now much harder to justify the inconsistent contributions between people of different employment statuses. If we all want to benefit equally from state support, we must all pay in equally in future.”
This may have prompted the Office of Tax Simplification (OTS) to released its evaluation update and stock take of the work it has carried out on corporation tax, personal service companies and self-employed people’s taxation. As a previous a Senior Policy Adviser to the OTS, I was personally involved with some of this earlier work.
Peronal Service Companies (PSCs)
Working through a PSC makes it possible to share, or defer, the distribution of income received by the company as dividends, so that it is taxed at a lower rate. If the owner is in a position to significantly defer the distribution of income, then it may be realised in capital form when the company is sold or wound up.
The OTS noted that PSCs were also commonplace because agencies and other engagers will only engage those who have incorporated. This is on the basis that this will help safeguard engagers from employment rights obligations, the costs of employers’ NIC and the risk of later finding themselves liable for PAYE. This was the premise of the IR35 legislation, which provided that engagers did not need to consider status where the contractual service provider was a company
Previous OTS work
The OTS considered a variety of approaches to simplifying the experience of those operating through PSCs, not least in the Small Company Taxation review published in 2016. Much of the focus of the work was on reducing the greater administrative burdens that come with being incorporated as compared with being a sole trader.
One idea that the OTS explored was for a sole trader to be able to register as a ‘Sole-Enterprise with Protected Asset’ (SEPA). This would be to give the owner of the business a limited level of main asset protection, without otherwise changing their legal or tax status. This was subject to a further review in 2016. I was the lead on this particular piece of work and would still recommend it as an alternative so people could disincorporate, but still have protected assets.
The OTS also considered the potential for PSCs to be taxed on a “look through” basis but, the OTS concluded that this would not be simplification overall.
Possible future work
In the OTS’s 2016 small company tax review, other possible legal forms which small businesses could take were considered. One of these possibilities would be the potential for legislative changes to enable the formation of single-member limited liability partnerships; or another approach would be the renewed consideration of the S-Corporations in the USA.
The aim would be to provide small personal service type businesses with a fully recognisable form of limited liability, removing them from corporation tax (but accounts would be filed at Companies House), together with the relative ease of a self-employment style tax calculation.
A key question would be whether any of the alternatives would be elective or not. Making it mandatory would involve significant changes in defining the companies to which it applied. The OTS is presuming that the off-payroll rules would still apply, so any alternatives would still have to consider that legislation, which seems counter-productive.
The OTS will continue considering these issues and would welcome contributions from others to this discussion.
In the Tax reporting and payments arrangements report in 2019, the OTS said a good deal could be done to improve tax administration for the self-employed. In particular, the report recommended HMRC explore the potential of offering a fully integrated Individual Tax Account, providing an end-to-end tax reporting and payment service.
The OTS did not comment on whether it would be pursuing this idea any further.
There are issues with the different categories of employment status for employment rights and for tax purposes. There are three categories for employment rights: employed, self-employed and “worker”. But for tax purposes, there are only two categories: employed and self-employed.
In December 2018, the government’s good work plan committed to improving the clarity of the employment status tests. This followed on from the Taylor review which recommended that the employment and tax frameworks should be aligned as much as possible and maybe set in law. However, this government has yet to respond formerly to the employment status consultation published in February 2018.
The OTS is interested in going further down this path, in particular in relation to the possibility of a statutory definition of employment for tax purposes, and whether it would be practicable or desirable for this also to apply for employment law purposes.
Income tax and NICs alignment
One of the key problem areas is the long-standing structural difference between the treatment of the self-employed and employees for income tax and NICs. The OTS considered this in two reports in 2016: one on the closer alignment of income tax and NICs, and the implications of the possibility of employee’s NICs operating in the same way as PAYE for the self-employed. Neither report considered the very substantial difference in the treatment of pension contributions for NIC purposes.
The key areas for future consideration in relation to people whose work can realistically be done either in a self-employed capacity, through a personal service company or as an employee, are:
- aligning self-employed people’s NICs and benefits more closely with those for employees
- moving to an annual, cumulative and aggregate basis for employee NICs
- bringing taxable benefits in kind into Class 1 NICs
- aligning the definition of earnings and expenses for income tax and NICs.
The Chancellor’s response to the OTS reports was that progressing this agenda would involve a range of challenges. For example, bringing employee NICs onto an annual, cumulative and aggregate basis was estimated to involve 5.5m people paying more NICs and 7.6m people paying less NICs.
In the March 2017 Budget, the government attempted to increase the level of Class 4 NICs paid by the self-employed. The Chancellor then had to U-turn on the issue after a backlash involving the Conservative Party’s manifesto.
However, the government’s view at the time was stated as: “The current differences in benefit entitlement no longer justify the scale of difference in the level of total national insurance contributions paid in respect of employees and the self-employed. Most notably, the introduction of the new state pension in April 2016 is worth an additional £1,800 to a self-employed person for each year of retirement.”
That 2017 statement also re-affirmed the government’s commitment to abolishing Class 2 NIC but again, for various reasons, that hasn’t happened. The government needs to find a broader approach to resolve these issues and develop and communicate a package of changes that can be implemented in a more coordinated way.
The OTS continues to consider and to discuss these issues with government with a view to moving debate forward.
Despite numerous reports from the OTS on a wide range of issues affecting the self-employed, PSCs, micro- and nano-companies, we do not appear to be much further forward.
Alongside the OTS reports, the government commissioned the Taylor review and has issued various consultations, most notably the Employment Status consultation, which has yet to be answered. The Department of Business, Energy and Industrial Strategy also published various reports on the subject of employment status.
Various private individuals and organsiations have contributed to the debate on tax and employment status. Most recently in July 2020 professor Judith Freedman, who is now on the board of the OTS, published Tax and employment status: myths that are endangering sensible tax reform. The Institute for Fiscal Studies (IFS), meanwhile, issued Employment Status, Tax and the Gig Economy—Improving the Fit or Making the Break?
The Supreme Court is currently considering the employment status of Uber drivers, but the judgement isn’t expected for many months to come. Will it clarfy or mystify this very complex area of tax and employment law?
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Rebecca is a leading expert in ‘employment status’ and IR35 and the law involving independent contractors and the self-employed for the purposes of tax and employment law. Rebecca has run her own consultancy for the past 20 years covering all employment status issues such as off-payroll in the private and public sector, otherwise known as IR35...