On the 17th of March, Chancellor Rishi Sunak announced that the government has postponed the introduction of their unwelcome new rules on off-payroll working for a year, due to the Covid-19 pandemic. The new legislation, which ostensibly aims to bring contractors deemed to be “contractors by name only” or “disguised employees” into line with regular employees by extracting extra payments from them, will now come into force on April 6 2021. While there has been considerable opposition to the coming changes, HMRC has said that it “believes it is right to address the fundamental unfairness of the non-compliance with the existing rules”. Tens of thousands of self-employed workers are set to be affected, possibly paying up to £7500 a year extra as many more workers are “caught by IR35” and facing increased tax liabilities when the new rules come into force. To offer some relief, HMRC have pledged to allow a grace period of one year during which they will not charge penalties for mistakes relating to off-payroll taxes, unless there is evidence of deliberate non-compliance.
What is IR35?
The term IR35 refers to a notoriously complex and convoluted piece of legislation, more properly known as the “Intermediaries Legislation” that was first brought into law in April 2000, under that year’s Finance Act. The term IR35 is a colloquialism stemming from the fact that it was announced during HMRC’s (or the then Inland Revenue) 35th press release of the budget for 1999, titled Countering Avoidance in the Provision of Personal Services. The then Labour Chancellor of the Exchequer Gordon Brown introduced the legislation in an attempt to curtail the use of personal service companies to avoid paying tax, specifically Income Tax and National Insurance contributions. Basically, the legislation was aimed at clamping down on self-employed workers who HMRC considered to be “disguised employees”, working as if they were an employee but being paid through a limited company.
Workers have for a long time chosen to be self-employed, missing out on benefits such as holiday pay, sick pay and the right to a severance package on being made redundant, in exchange for lower National Insurance Contributions – actually a form of tax not insurance. There are other ways that self-employed status can be beneficial to a worker’s overall tax burden. For one example, HMRC allow you tax relief on a variety of work related expenses as long as they are primarily for use during your paid work – things like computers or mobile phones among other things that you may still use outside of your job. In the past, self-employed workers operating as smaller limited companies could take all of their wages in one month of the year, taking advantage of a monthly cap on National Insurance contributions, effectively paying National Insurance for only a single month each year. This particular method was legislated out of existence by the government some years prior to the introduction of the Intermediaries Legislation. One of the results of this change was an increase in self-employed workers choosing to take dividend payments over wages, as dividends do not incur National Insurance Contributions at all.
The Friday to Monday scenario
The term, the Friday to Monday scenario refers to a hypothetical scenario where an employee would leave a job on Friday, then come back on Monday as a contractor and still do exactly the same work, yet get paid through a limited company that they had created, that their original employer would then pay for work done. The former employee would receive dividends from their new limited company (known by HMRC as a personal service company, although there is no fixed legal definition) and pay less in Income Tax and National Insurance contributions, although the tax regime for dividends was changed in the 2016 financial year, eliminating much of the tax advantages of receiving dividends as opposed to a pay cheque.
IR35: Intermediaries Legislation
The new Intermediaries Legislation in 2000 allowed HMRC to check the contract between the worker’s “personal service company” and the client (the former employer in a Friday to Monday scenario) and then create a “hypothetical contract,” unmasking the “disguised employee.” Any payment made to the worker’s limited company would then be taxed as if they were a normal employee. The responsibility would be for the worker to determine the correct rate of Income Tax and National Insurance deductions that he or she should pay HMRC, and HMRC would then challenge the worker if they thought the worker’s calculations were wrong.
Enter the Finance Act 2017
In the Finance Act of 2017, changes were brought in that would in many cases shift the responsibility to determine the amount of Income Tax and National Insurance deductions from the worker themselves, to the client, ie the consumer, or as HMRC would probably refer to them, the “disguised employers.”
For self-employed workers being contracted for work done by a client within the public sector, and using a so-called personal service company (often known as an intermediary) to receive payment, the public sector organisation became responsible for deciding if IR35 applies to the worker and then making the correct Income Tax and National Insurance deductions, placing the worker on the organisation’s payroll, on 6 April 2017. From April 2021, these changes will be extended to also apply to self-employed workers being contracted by private sector organisations, so the private sector organisation will then be responsible for deciding whether the worker is a so-called “disguised worker” and making the correct deductions for Income Tax and National Insurance contributions.
The government’s claimed reason for bringing in these IR35 changes is due to “widespread noncompliance” with the original IR35 legislation from 2000, estimating that £1.2 billion could be lost annually by 2022/23 due to non-compliance in the private sector, according to an HM Treasury ‘Factsheet’. Also, when organisations that contract workers through an intermediary; the worker’s personal service company, they previously avoided paying the employer’s National Insurance contributions. National Insurance contributions are made up of two parts; one part is paid by the worker themselves and the other part by the “employer”. HMRC also point to the perceived unfairness of two workers doing effectively the same job, but paying different levels of Income Tax and National Insurance. These changes aim to end any perceived loopholes, and bring into line employees and “contractors by name only”, they say.
Who makes the tea?
Determining who falls within IR35 will from April 2021 be decided by the company contracting the worker, but how do they do this exactly?
One example used to illustrate the point refers to a scenario where you are having your house decorated; do you make a cup of tea for the decorator or does he make a cup of tea for you? If you make him a cup of tea, he is likely a genuine self-employed contractor. But if he makes a cup of tea for you, then he would likely be regarded as a “contractor by name only” or “disguised employee” and would fall within, or be “caught by” IR35.
This is obviously a simplistic example, and there is no specific legal definition of a personal service company.
The key consideration is whether the worker is engaged under a ‘contract for services’, making them self-employed, or ‘contract of service’ – an employee or servant – hence the point about the cup of tea! Also key is whether the worker is supervised on a day to day basis by the ’employer’; again this is an indicator that the worker is really an employee.
Small business exemption
In October 2018 when the government confirmed the private sector extension to IR35 rules, they included a notable exclusion for small companies, meaning that only larger organisations will become responsible for determining which contractors may fall within IR35.
“Small organisations will be exempt, minimising administrative burdens for the vast majority of engagers, and HMRC will provide support and guidance to medium and large organisations ahead of implementation.”
This caused some confusion over the exact definition of “small organisation,” but the government later said that it would be using the same criteria as contained in the Companies Act 2006: during a 12-month period, a business is deemed to be a small company if it meets two or more of the following criteria:
Contractors for these smaller companies will be able to continue to operate as they have been doing and will still be responsible for determining themselves whether they fall within IR35.
Who will be affected?
There are approximately 170,000 self-employed workers, it has been estimated (see below), who could be affected by the changes, paying £millions more in taxes each year. The changes will affect those working in the private sector, with IT workers and management consultants expected to among those hardest hit. One of the biggest criticisms of IR35 is its harmful effects on small companies, including small family companies who could end up being taxed at source through their clients at the same rate as employees despite receiving none of the accompanying benefits such as holiday pay or sick or maternity pay, or other worker’s rights such as maximum working hours. Also, many small companies that were set up for reasons that have nothing to do with avoiding tax will still fall within IR35, including IT professionals on short-term contracts.
Furthermore, “employer” companies will be expected to determine whether contractors fall within IR35 and will most likely need costly expert advice in order to correctly determine their tax liability. These clients/employers may simply choose not to take the risk by not engaging this type of worker at all. if this is the outcome, it will cause immeasurable damage to the whole UK economy.
How much money will contractors lose?
Some tax experts have estimated that contractors could lose 20% or more from their yearly earnings. Chief Executive of Contractor Calculator, Dave Chaplin, spoke to The Sun…
“HMRC have estimated that 170,000 contractors will be affected, and claims that 90 per cent of them will have their income dropped.
“That’s over 150,000 individuals who are about to face up to a 20 per cent pay cut overnight in the next nine months.
“For many, that’s the cost of their current mortgage.”
Postponed, but not rescinded
Rishi Sunak’s 2020 Budget speech didn’t mention the IR35 changes, but the accompanying documentation confirmed that it would go ahead.
“At Budget 2018 the government announced that it would reform the off-payroll working rules in the private and third sectors from April 2020,” it read.
“The government has recently concluded a review of the reform, and is making a number of changes to support its smooth and successful implementation.
“The government believes it is right to address the fundamental unfairness of the non-compliance with the existing rules, and the reform will, therefore, be legislated in Finance Bill 2020 and implemented on 6 April 2020, as previously announced.”
However, on March 17 this year, Rishi Sunak announced that the changes to IR35 will be postponed until 2021 due to the Covid-19 pandemic.
Confusion and criticism
The original IR35 legislation in the Finance Act 2000 is notoriously complicated, and the new rules only add to this complexity. HMRC claims to want to tackle the unfairness of different workers doing the same job but paying different rates of tax. However, one wonders if, as much as they claim to value entrepreneurs, they would actually rather people work for large companies with payroll departments that handle calculating worker’s taxes and National Insurance contributions, thereby taking a ton of work off HMRC’s hands.
Employees are also more manageable citizens, compliant and well behaved. Perhaps this is slightly paranoid thinking, but one thing is certain; these changes will be incredibly burdensome to contractors and clients alike, and the amount of revenue that HMRC will raise from these changes is questionable.
HMRC has claimed that the new rules will bring in £3.1 billion in extra revenues between 2020 and 2024 (this was prior to the changes being postponed until 2021), however, their estimates have proven to be quite wrong in the past. In May 2009, a Freedom of Information request by the Professional Contractors Group asked how much revenue the original IR35 legislation from 2000 had raised, and the reply revealed that in the tax years 2002/03 to 2007/08, the IR35 rules had only raised £9.3 million, or roughly £1.5 million each tax year for the period in question, under 1% of the amount expected by HMRC, although it’s not clear if this included National Insurance contributions or just Income Tax. If IR35 is not actually raising that much money then what is the point of it, and furthermore what is the point of making changes that will only harm contractors and businesses, adding onerous administrative costs?
Sources:
https://www.thesun.co.uk/money/9491642/self-employed-workers-extra-tax-employment-laws/
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