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IR 35 - what do YOU think?

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1st Nov 2010
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The Institute of Directors has had its say, now it's our turn. Rebecca Benneyworth offers the Office of Tax Simplification some suggestions on how to reform the small company taxation regime. What points would you like to raise?

The Office of Tax Simplification has made a review of IR35 one of the key planks of the review of small business tax; indeed the review of IR35 was identified as part of the review of small business taxation by the Treasury when the office was first set up.

Terms of reference
The terms of reference of the wider small business tax review are:

To conduct a review and make recommendations to the chancellor on how to simplify the tax system, ease administration and reduce uncertainty for small businesses. In conducting this review, the office will provide an initial report to the chancellor by Budget 2011 that:

  • examines evidence and identifies the areas of the tax system that cause the most day-to-day complexity and uncertainty for small businesses;
  • recommends priority areas for simplification; and
  • considers the impact of any simplification in these areas on different business sectors, including large business

Once the government has considered the initial report the OTS will be asked to produce specific recommendations on tax simplification for small businesses.

IR35 – priority area
In setting up the OTS, the government indicated that reviewing IR35 is a priority and that it would seek to replace it with simpler measures intended to prevent tax avoidance, but which do not place undue administrative burdens or uncertainty on the self employed or restrict labour market flexibility. The task the office must set about in reporting on IR35 has also been specified by HM Treasury:

  • identify and provide evidence of the complexity and uncertainty created by IR35
  • consider alternative legislative approaches that would be simpler and create certainty while ensuring that, where intermediaries are used to disguise employment, any income that is effectively employment income is taxed fairly; and
  • consider the scope for tax avoidance and the extent to which alternatives to IR35 would affect it

The focus of this work should be exploring alternatives to IR35. However, the government will be interested in issues in relation to the structure of the tax system and the employment status test more generally. This may have a bearing on wider issues about employment status and the boundary between employment and self employment, including the impact on larger businesses.

Our response
Responses so far seem to indicate that uncertainty is the real issue with IR35. That practitioners and clients alike cannot decide whether they are genuinely "caught" by IR35; they do all they can and then have to leave it to the fates – which is an unsatisfactory solution for businesses.

Complexity (for the adviser) is not the real issue in dealing with the fallout from IR35, but most are not experts in employment status, and even then the courts seem to manage to come up with new angles almost every time. I would go further – in view of recent decisions by the courts, most contractors working through an agency cannot correctly determine their IR35 status without sight of the agency contract with the engager, which they do not have access to. So ultimately the courts have made the legislation practically unviable.

Coming up with alternatives is a difficult task, as my article of about 18 months ago shows. So maybe rather than viewing the task as re-engineering small business tax as a whole (indeed we have had some recent suggestions along those lines), maybe we can focus on a solution designed to meet the specific issues addressed by IR35.

The stated problem
Workers will move to self employment via a limited company (if given the opportunity) thus saving themselves significant amounts of tax and NIC. They are encouraged by employers who also save significant amounts of NIC and other employment costs such as holiday, sick and pension liabilities. The words "disguised employment" have been used to me by senior HMRC staff in this area on more than one occasion.

The numbers
Looking at a single income stream, and comparing the tax burdens on each it is easy to see why contractors feel that IR35 is unfair:

Income of £60,000 per annum

 
Tax
%
NIC
Total
%
Sole trader
13,930
23
3,338
17,268
29
Ltd Company
13,534
23
0
13,534
23
Ltd IR35
11,625
19
10,091
21,716
36
Employee
13,930
23
4,359
18,289
30

Income of £80,000 per annum

Tax
%
NIC
Total
%
Sole trader
21,930
27
3,538
25,468
32
Ltd Company
21,684
27
0
21,684
27
Ltd IR35
18,770
23
12,415
31,185
39
Employee
21,930
27
4,559
26,489
33

I don't have the figures on how many contractors there are, but clearly, the difference between these shows the problem. In each case, the contractor is considerably worse off than as an employee – but one assumes that he is compensated for this by better rates, in view of the loss of employee benefits. But he is very significantly better off as a limited company, extracting all profits by way of dividend (subject to a small salary). If profits are retained, or there is any income shifting then the limited company burden comes down still further.

Solutions
One member has suggested the Monday/Friday test – anyone who starts contracting having previously been employed by the engager should be subject to a form of IR35. While this addresses the complexity of the employment status tests it could be avoided by companies engaging staff through a new subsidiary or through a non group company formed for that purposes only, so is too easily avoided.

My own preference - recognising the emphasis on labour market flexibility – is for a separate classification of worker – a contractor. Whether the contractor is self employed (unusual) or works through a limited company then they are subject to a tax regime which prevents the tax avoidance that the government is concerned about. As the tax burdens above are so close between the employee and the self employed, it would seem sensible to apply the new contractor status only to those working through limited companies liable to UK Corporation Tax – as it is this structure that can be used to greatest effect.

Simplistically, from the above figures the numerical solution lies in a 5% of profits levy, which would bring the numbers in the £80,000 case to around the self employed and employee amount, but in the £60,000 case there is still a saving of in excess of £1,000.

The problem comes with designing a test of contractor status – and here we meet a further problem – we are replacing the hugely unsatisfactory IR35 test with another test. Might we construct a list of conditions, where if say 7 of the 10 are met then the company is a 'contractor'? What might they include – working on the engager's premises for x% of the contract time, paid by the hour/day?

Another way?
Of course, there is a fairly simple solution which lies outside the scope of "classification", but which would replace the lost revenue fairly easily. It would, however, affect all small companies, and might therefore be unpopular for those reasons. This solution lies in abolishing the exemption for directors from minimum wage. If all companies were required to pay minimum wage for the hours worked, this would raise quite a significant sum in NIC:

Additional tax and NIC burden – minimum wage

£60,000 profit - £5,720
£60,000 profit - min wage
£80,000 profit -  £5,720
£80,000 profit - min wage
30 hrs pw
£13,534
£14,101
£21,684
£22,251
40 hrs pw
£13,534
£14,728
£21,684
£22,878

You can see that the additional tax burden is quite modest – I have assumed a single director drawing £5.93 for the hours worked, taking the balance of profits by way of dividend.

This does indeed impose a burden on all small companies – the rule does not need to specify "small" – we just remove the exemption from minimum wage. It does require a bit of extra record keeping for directors of "normal companies" as they will need to estimate their hours worked to put through the salary – possibly at the end of the tax year.

One of the issues with this approach is what to do when there are losses. The attraction of simplicity is lost when extra rules have to be introduced, but members may feel that this is an issue.

So there are a few ideas to be going on with. Let us know what you think. I'm looking to prepare a formal report before the end of this month.

Replies (102)

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By mikewhit
05th Nov 2010 13:01

Expenses for temporary workers ?

"If this is unpalatable to the government, then it needs to change the law to make it easier for the client companies to take on temporary employees"

But how then would workers claim away from home and travelling expenses, if they are employees ?

It's relevant to IR35 in that your suggestion above would lead to some of the contract work becoming temporary employee-based, which would mean that the worker would have to claim expenses back from the client company, if at all.

Thanks (0)
By silicondale
05th Nov 2010 15:00

@mikewhit - expenses ??

But how then would workers claim away from home and travelling expenses, if employees ?

Not sure there's any question to answer here. If the contract defines that expenses can be recovered from the end-client, then one would assume they will be. The company will then pay the expenses of its director or any non-director employee in the normal way, and include them in the P11D (or not, if there's a dispensation in force). Expenses would then be recovered by the company by invoicing the client.

If the contract doesn't specify that the end-client pays expenses, then the company may or may not cover them, depending on a board decision. For an employee, presumably expenses would be paid in the normal way as above. For a director, it's up to him/her whether to claim or not. Where's the problem? And what on earth does the question have to do with abolition of IR35?

Thanks (0)

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