Gareth Williams rebuts Graham Stringer's defence of IR35

Gareth Williams, Chairman of the Professional Contractors Group, responds to Graham Stringer.

It is nearly two years since the IR35 proposals were announced, and one month before they stand to be struck down by the High Court in a judicial review brought by the Professional Contractors Group. Yet the Government still has so little understanding of the contracting industry that a Minister is repeating the same old sound-bytes in the apparent expectation of being taken seriously. One suspects that if one tenth of the effort that has been spent spinning IR35 had been put into understanding the issues in the first place, the Government would not have got itself into such a mess.

The tax system, we are told, "allowed some people to choose how much tax and national insurance contributions (NICs) they paid." And of course it still does. Anyone who runs a small limited company can choose how to balance salary payments and dividends, and since the Government in its wisdom levies NICs on salaries but not dividends all such people can 'choose' how much NICs they pay. (Furthermore it is open to a person who is not working to choose to make additional voluntary contributions, but I expect it is a long time since Gordon Brown received one of those in the post).

If this is a loophole, it remains available to the incorporated Butcher, Baker or Computer shop. No one tells them how much 'properly' should be salary. Yet the small knowledge-based consultancy company hit by IR35 is not required simply to pay NICs on its dividends, but on 95% of its turnover, with business expenses such as training not allowable against that sum.

Apparently "The practice of using service companies to reduce tax and NICs liabilities has become common." There we were thinking that companies in the modern economy use contractors because they have short-term requirements for highly specialised experts; that this was a global trend; and that contractors received a premium over employees because their skills are more economically valuable when marketed in this way. Well, the clever chappies at the Inland Revenue have seen through that. It's all a big tax scam. As the Revenue's Regulatory Impact Assessment argued, if it were not for the opportunity to fiddle NICs, we would all 'return' to being full time employees of our clients. It is this ineffable ignorance of the real world that has caused such disbelieving fury among those affected.

But there is nothing to fear, because "Those businesses which invest, take risks and create employment, will not be affected." Well that is a bit of a Catch 22, since the main risk involved in putting your skills on the open market, namely that of not finding any work, does not appear in the Revenue's equations. And companies caught by IR35 are not allowed to invest or create employment unless they wish to do so out of already taxed income. Salaries paid by such a company are taxed twice: once as the fee earner's 'salary' and then again as the salary of the employee who actually receives the wage. Not surprisingly IR35 has led to many such companies laying off staff.

Finally "The rules ensure that measures designed to support small businesses are properly targeted, and do not go to people who are really the same as employees." Here "the same as employees" is judged by applying the "hypothetical employment test" which asks, if the worker were hired directly (without a service company involved) would they have been an employee?

Leaving aside the joint problems of making such a determination in sectors where the self-employment rules have never been applied, and making it on the basis of a hypothetical contract invented by the Revenue inspector, it still stretches credibility to describe such workers as "really the same as employees". An actual employee would get holiday pay, sick pay, and all the usual rights and benefits of employment from the client. A contractor gets none of these, and funds their own training, travel and other costs. IR35 seeks to tax the contractor as an employee, but needless to say confers none of those rights or benefits.

The Inland Revenue's whole approach to this issue reveals a number of serious confusions. First, contractors stand accused of avoiding the usual distinction between schedule D (self-employed) and schedule E (employed) income. However contractors working through limited companies have never claimed schedule D status. They are schedule E employees of their own company. The salary/dividend issue discussed above has nothing whatever to do with schedule D/E status, and nor would its resolution.

Secondly, the Revenue has become hopelessly confused between self-employment and out-sourcing, which again are entirely different issues. An out-sourced worker is a worker you do not employ, but bring in (usually temporarily) from another organisation that specialises in the particular business you require. An out-sourced worker can be anything from a cleaner or typist to a software engineer or consultant geologist working on oil rigs. Such a person is not an employee of their client, not because they are self-employed, but because they are an employee of another company.

Out-sourcing is an increasingly important part of the modern economy. It allows companies to concentrate on their own core competencies, maintain flexibility and keep head-counts low. Those industries such as IT that make heavy use of independent contractors also have many large consultancy companies providing staff on similar terms. This is often described as 'bodyshopping', a term explained by Tony Grellier of MMT computing in a recent interview with the Motley Fool:

I mean really when you're selling an individual to a client. You don't have any control over what they're doing. They just work for that person. We provide them with a body to supplement their resources. Every software house does an enormous amount of bodyshopping. It's all bread and butter stuff. Low risk by and large.

It is in the nature of out-sourcing that the work performed will often be employment-like to some degree. If providing such workers is not a genuine business activity, then a lot of large companies would have to shut up shop. But IR35 does not apply to the large companies. Under IR35 'bodyshopping' is a genuine business activity for a large multinational company, but becomes 'disguised employment' if you are a 5% shareholder in a small competitor.

Consider the position of the consultant employed by a large consultancy. He travels all over the country, working for three months, six months or longer for one client before being assigned to the next. The consultancy that employs him has no involvement in the work he does, other than taking the fees from the clients and paying him a wage.

Let's take the case of Simon (a member of the PCG). He was charged out to clients at £700/day, equivalent to £150,000/year. He was paid a salary of £25,000. It should not be too surprising that Simon decided to set up his own independent consultancy company. He charged his clients a much reduced rate (£240/day), and continued to take £25,000 salary from his company, therefore paying the same Tax and NICs. When the profits of the company allowed, he took a dividend.

I think most people would say this was a genuine business, providing a service cheaper than his larger competitors. But according to the Inland Revenue, it is tax avoidance.

Consider his position under IR35. When employed by the large consultancy, no one asked him to pass a 'self-employment' test with respect to his client. No one suggested that the fee paid in respect of his services was 'disguised salary' that should be subject to PAYE and NICs. The large consultancy could use that fee how it chose: to pay for expenses such as Simon's training, to invest in other business activities, or to pay to its shareholders as a dividend (free of NICs).

As an independent consultant under IR35, Simon has to prove he can pass the "hypothetical self-employment test". If he fails, his entire company turnover (minus very limited expenses, but with no allowance for training, books or a PC) is treated as personal salary, subject to PAYE and NICs. The obvious questions are:

Why should Simon be regarded as a tax avoider, when he pays at least as much tax as when he was an employee of the large consultancy?

Why should his small company be taxed on a different basis from his larger competitors?

Why should an employee of a consultancy company be asked to pass a 'self-employment' test, and why is it only employees of small worker-owned companies that have to do so?

The final irony is that if Simon employed another consultant to do the work IR35 would not apply. He could pay that worker £25,000/year and take the balance of profit in dividends. In a Kafkaesque inversion of Labour party principles, under IR35 "bosses" can make profits but "workers" can't.

It is difficult to avoid the conclusion that those who framed this legislation had no idea how out-sourcing operates in the modern economy. When the fees charged for a consultant are between 2 and 6 times the consultant's salary, it is economically illiterate to suppose that a consultancy fee is a 'disguised salary', that companies are using consultants as a cheap alternative to hiring employees, or to save on NICs.

Today knowledge is a tradable commodity, in which large and small companies invest and make profits. What else does the term 'knowledge economy' mean? The Government supports the knowledge economy in principle, but when it sees it in practice, condemns it as 'disguised employment' and vows to stamp it out.

It is not only the PCG that has criticized IR35. Indeed it is hard to find anyone outside Government with a good word for it. It has been condemned by the Institute of Chartered Accountants, whose Tax Faculty memorably gave it 30 points out of a possible 100, including 0 out of 10 for 'fairness and reasonableness'.

The FSB and the CBI have called it 'unfair, poorly targeted and ultimately unworkable' and have called for it to be withdrawn.

Recently the Treasury Select Committee has added its own voice, specifically naming IR35 in the context of the Government 'failing to achieve' a 'fair and efficient' tax system. (Third Report of the Treasury Select Committee, para 46, February 1 2001)

Sir John Harvey-Jones (patron of PCG) recently said on Sky television "I do deplore the bullying of small people and the future of our country depends very largely with small businesses. "

The PCG's expert evidence for the judicial review, prepared by Frontier Economics, concludes:

Our results indicate that, far from representing disguised employment, the contracting services market is an efficient response both to the short-term nature of demand for these skills and to skills shortages in sectors such as IT. There is also active competition between the small contracting firms affected by IR35 and large service providers operating in the same areas. This, combined with the significant market shares accounted for by small contractors in certain sectors indicates the likelihood that an increase in costs resulting from the IR35 could have a material impact on the functioning of competition in these markets. (The Market for Contracting Service, Frontier Economics, January 2001)

This is why IR35 is up before the courts. It applies different tax regimes to small and large consultancy companies, that are providing services on the same terms, and in direct competition with each other. That means it is a 'state aid', and contrary to EU competition law.

This is something the Inland Revenue simply did not understand, and is still blindly denying in its evidence to the judicial review. The sensible course of action would be to accept the flawed basis of IR35 and save the tax payer the cost of a full hearing. Failing that, it is for someone higher in Government to recognise the damage being done to the UK's economy as its flexible workforce is attacked, and the collateral political damage in the run-up to a General Election. It will be much less embarrassing to pull IR35 before the hearing than be forced to do so by the High Court.

There are a number of lessons the Government should learn from this episode. First, this judicial review clearly took it by surprise. But a Government that wants to take the UK into the Euro will have to get used to complying with European law in many more areas of domestic policy, of which taxation will be just one.

Secondly, the fine words about deregulation and consultation have to be put into practice. The Government should (as its own Better Regulation Guide requires) consult with affected industries to help it understand a problem rather than, as in the case of IR35, making up its mind on a solution on the flimsiest of evidence before asking for comments on the implementation. As the Minister responsible for overseeing the Government's programme for reform of regulation, Graham Stringer is well placed to achieve that.

Thirdly, if the Government wants its commitment to the knowledge economy, internet technologies etc. to be taken seriously, it must make a real effort to talk to those involved and understand them. The new economy is not just about new technologies, but about new business models and new working relationships. Never again must it allow policy in this area to be driven by the blinkered concerns of the Inland Revenue.

After IR35 is defeated, the PCG will be glad to help the Government to understand the knowledge economy and introduce proportionate and targeted legislation to help it to prosper.

Gareth Williams

(PCG Chairman)

13/02/01

Tax Faculty of the ICAEW report on IR35

Third Report of the Treasury Select Committee, para 46, February 1 2001