IR35's damaging impact on knowledge-based freelancers
Here is the text of the submission I have made to the All Party Small Business Group consultation on freelancing. I have also made a separate submission re Section 660
I would like to look at the impact and implications for freelancers of two pieces of tax legislation that have had, are having, the most adverse impact on the activities of freelancers and small family businesses. They are:
· The IR35 legislation, which was introduced in April 2000 specifically to target those who provided personal services to their clients via an intermediary – usually their own service company. And
· Section 660A of the Income and Corporation Taxes Act 1988, which is an anti avoidance measure aimed at restricting the ability of a taxpayer to use a settlement to divert income to a lower rate taxpayer.
This post will cover IR35 and I will post separately on Section 660A
IR35
Background
The tax and National Insurance legislation, which has come to be referred to as 'IR35' came into effect in April 2000 having first been proposed in the March 1999 budget, where the proposals were set out in Inland Revenue Press Release 35.
This press release noted that:
"There has for some time been general concern about the hiring of individuals through their own service companies so that they can exploit the fiscal advantages offered by a corporate structure. It is possible for someone to leave work as an employee on a Friday, only to return the following Monday to do exactly the same job as an indirectly engaged 'consultant' paying substantially reduced tax and national insurance"
It expressed concern that workers who decided to work via their own service company:
" may find their terms and conditions altered - perhaps losing entitlement to sick pay or maternity leave. They may even lose their jobs without entitlement to notice or redundancy pay. They will usually have no right to any claim for unfair dismissal and may lose their entitlement to social security benefits through a failure to make adequate contributions."
and recorded the Government's commitment to:
" encouraging modern businesses which develop and build on the strengths and commitment of their workforce.
A discussion document was issued in April 1999. However these proposals included a complex certification scheme and placed a considerable burden on clients who might have to deduct PAYE and NIC from payments to contracted workers in certain circumstances. It was clear that at this stage the Inland Revenue believed that the majority of workers working via a personal service company were doing so at the behest of their "disguised employer" i.e. their previous employer in a 'Friday to Monday' scenario.
That this was so was evidenced in the original Regulatory Impact Assessment issued in May 1999, which concluded that up to 66000 personal service companies would close and, most tellingly, talked in terms of the workers returning to permanent employment with their 'employers'. This highlighted the fact that the IR35 proposals were initially devised on the assumption that most of the workers concerned were really disguised employees of their previous employer; that is workers forced or encouraged by their employer to operate via the medium of a service company. This was borne out in discussions I had with the Inland Revenue director responsible for these initial proposals, Mark Nellthorpe. He commented on the increase in the use of service companies by groups of workers like train drivers and health service support staff.
Obviously there were and still are many workers who may fall into this group. They are workers who, in all likelihood, might agree that they regarded their 'client' as being their employer.
However, there is another large group of workers who operate via service companies, typically providing what might be regarded as 'knowledge-based' services in IT, engineering, and general financial and management roles. It is rare that these workers leave a permanent employment and return immediately to the same company but in a consultant role. In some cases they are forced into contracting due to redundancy. But often they have chosen to 'contract' via their own service company as they prefer the life of a freelance contractor, where they can focus on using their technical skills on a variety of projects without becoming involved in the internal management of their clients.
They have chosen to work as a freelancer – selling their services on the open market to a succession of clients - and accepting the risks that such a life poses (responsibility for training and periods of sickness or no work) in return for the freedom such a way of working provides and the possibility of greater financial rewards in good times.
This group appears to be totally different from the other group that formed the target for much of the Government's concerns when IR35 was first proposed.
However, in September 1999 revised IR35 proposals were issued. These were changed considerably from the first draft and greatly reduced the potential burdens on clients. In fact these revised proposals made it clear that clients would be absolved of any responsibility for determining whether their contract workers working via their own service company might under the legislation be disguised employees.
Surprisingly in view of the stated concerns of the Government about loss of employment rights for workers forced into using service companies, the legislation that went into effect in April 2000 made it specifically clear that there was no intention that the tax status of 'disguised employee' should have any impact at all upon the 'disguised employee's ' ability to claim any employment rights from their disguised employer. In fact the legislation makes it clear that the 'disguised employer' has no responsibility for the additional tax and NIC payable under the legislation. And those additional tax and NIC contributions do not enable the worker to obtain any additional benefits from the system. They still have to fund their own periods when they are not working – whether due to illness, holidays or lack of a new contract. It remains almost impossible for a worker, working via their own service company, to make themselves redundant if their company is unable to obtain new work.
Hence, in the case of the weakest groups of workers, who might be unable to obtain work except by agreeing to work via a service company the new legislation reduces their post tax income while providing no additional employment protection whatever. And for the more highly skilled knowledge based freelancers who have chosen to work via their own company IR35 now introduces considerable uncertainty into their business life and the threat of a significant reduction in post tax income – typically 25-30 %.
Uncertainty
Why uncertainty?
IR35 is based on identifying situations where the worker provides services to a client via an intermediary (usually a service company but sometimes a partnership) where the circumstances are such that:
" if the services were provided under a contract directly between the client and the worker, the worker would be regarded for income tax purposes as an employee of the client." (section 49[c] Chapter 8 Income Tax (Earnings and Pensions) Act 2003.)
There is no statutory definition of 'employment' or 'employee'. This is determined by the contracts between the worker and the business they are providing services to and the actual working relationship between the two parties. Ultimately employment status is based on case law as derived from employment and tax status cases.
Employment status issues are complex and the tests gradually evolve under changing business and social practices. As an illustration of the complexity of status issues, in the Judicial Review of the legality of the IR35 legislation - (Case CO/2302/00) it was reported that a freelancer had submitted their contract to the Inland Revenue for an opinion on their status for IR35 purposes.
Due to administrative errors two separate Revenue officers had issued opinions on the same contract. One found the contract to be a contract of service (i.e. caught by IR35) while the other considered it a contract for services (outside IR35). This illustrates the complexity and uncertainty faced by freelancers who might be subject to the legislation.
Costs faced by service companies
For businesses that wish to reduce the uncertainty they are now forced to incur additional professional fees for advice and assistance regarding their status under IR35 and in meeting their responsibilities as regards the payment of additional tax and NIC liabilities. The majority of service companies use agents to find new work and each agent will use a different standard contract. Before accepting a new contract many freelancers want to be reassured as to its likely status under IR35. Although the Revenue offers a free contract review service this is somewhat discredited in the eyes of freelancers, who doubt its impartiality as a result of cases such as that mentioned in the Judicial Review. In addition the Revenue will only review a contract after it is signed which is of little help to a freelancer.
Hence many turn to independent experts, lawyers, accountants and tax advisers for advice.
Having your contract reviewed by an expert will cost anything from £100 to £500 or more for a review by a lawyer, accountant or tax expert. . Service companies can also buy model contracts to use when contracting direct to the end client. Typically at a cost of £100 upwards.
Because of the risks of facing a Revenue challenge over their tax status many service companies now buy professional fees insurance to cover the costs of having an expert act on their behalf. These policies generally cost in the range of £75 to £150.
Because a status challenge may start when a business faces a routine employers' compliance visit ('PAYE audit') – which is not usually covered by a standard professional fees policy - a service company may also buy additional insurance to cover the costs of professional support to handle the compliance visit – typically at a cost of £100 or more.
Finally, if the service business also wants to be protected against the additional tax and NIC that might be payable if their status is successfully challenged by the Revenue, they can also take out tax liability insurance. This usually costs between about £450 - £750, but also requires that the relevant contracts are reviewed – the cost of which is in addition to the insurance.
Competition is driving down the costs of obtaining professional advice and covering the contingent liabilities that businesses face. But the total costs of contract reviews and insurance for a service company with, say, a couple of new contracts a year will still be anything from around £500 to £2000 or more every year.
This does not include the additional time spent by the freelancer keeping abreast of IR35 issues and developments in status case law, coupled with ensuring that they document fully the evidence to prove their assertion they are outside IR35. I would estimate this to be of the order of 5 hours per month, which would represent an additional lost opportunity cost of £3600 per year for a freelancer who normally earns £60 an hour.
The Revised Regulatory Impact Assessment (see here
Revised RIA) issued in September 1999 assumed that, for a service company that chose to continue to operate after the introduction of the legislation, there would be additional compliance costs, relating to understanding and implementing the new rules, of between £50 and £100 a company. The reality is that for many companies the compliance costs are greater by a factor of 10 or 20.
The alternative is not to seek professional advice or insure against the costs of professional representation and the potential tax, interest and penalty liability. However this is potentially a considerable risk for a freelancer.
For a typical freelancer, who charges say, £50 an hour, being caught by IR35 may mean an extra £15,000 to £20,000 of tax and NIC in a year. With the Revenue able to go back to the start of IR35 in 2000 a freelancer over this three year period might have an exposure to tax, interest and penalties of anywhere between £50,000 and as much as £100,000. In the event of a challenge they would also face substantial legal and professional costs to defend themselves. If uninsured these could easily amount to £50,000 if it went as far as a High Court appeal. This means that a freelancer can be facing potential contingent liabilities and costs of up to £150,000. Clearly these are worst case figures but any prudent business looks at the downside.
Understandably these costs and risks are driving people out of business
IR35 has resulted in significant additional professional costs for many companies – not just those services that were the intended target of IR35 but many others who provide personal services and whose activities might bring them within the ambit of IR35 and who need advice on whether they are at risk or not.
In business on your own account
An additional issue for freelancers is the fact that, while they may be regarded as operating in business on their own account (via their service company) on some contracts (which are therefore 'outside' IR35) they may still be held to be a disguised employee (and 'caught' by IR35) on another contract, even when contracts all operate in parallel.
This was the situation in the first appeal to the High Court of an IR35 status issue, the case of Synaptek Limited and Mr G Young (HM Inspector of Taxes) ([2003] EWHC 645 (Ch)). This was an appeal against a General Commissioner's finding that, in respect of its main contract the main director of Synaptek, Gordon Stutchbury, was in fact a disguised employee of his client EDS. This conclusion was reached even though the Commissioners accepted that he was in business on his own account with a long established business that had, in the past, won awards for innovation. It also had two other contracts in parallel with this main contract neither of which were caught by IR35.
Such was the level of uncertainty created by this decision that Mr Stutchbury decided to stop working as a freelance IT expert and close his company.
Finally the status tests are not well suited to establishing the status of knowledge based freelancers, whose work tends to be based on working closely with their client's staff, on their client's premises, using their client's equipment on projects or tasks that require their full time input over quite lengthy periods of time. This tends to give them the classic attributes of an employee – dependence on one paymaster over a reasonable period of time in circumstances where the client appears to have a degree of control over the worker. Hence, superficially, they may appear to be working in a way that is equivalent to that of an employee.
Why is this a problem?
Why is it a problem if freelancers face such costs and uncertainty and decide to close their company?
1. First it seems to me to be grossly unfair that these taxpayers should now have to operate under such a degree of uncertainty, when for many years past, it was accepted that the use of a service company meant that the corporate veil served to isolate them from the taxation risk of having an employment relationship with clients. They could choose to operate as a freelancer working via a service company knowing that it posed additional risks and costs but secure in the knowledge that there were tax advantages to balance those risks and costs. They have now lost that certainty
2. Tax law relating to such a basic issue as employment status should not be so complex as to force many taxpayers to seek professional guidance at almost every stage.
3. Thirdly no taxpayer should be placed in the position that their tax status can change almost day-by-day, depending on the unclear and uncertain interpretation of case law precedents in the context of their current contract.
4. Fourthly the uncertainty makes it very difficult for businesses to plan and invest. If their work is caught by the IR35 rules they are forced to pay income tax and NIC as if almost all of their income were a salary – regardless of whether that income is withdrawn from the business as dividends or not. Many freelancers plan to develop new services or products for their company to sell but are now constrained by IR35 issues. This has the effect of stifling innovation and entrepreneurship in an area that could be vital to our economic future.
5. It also seems to me to be inherently unfair, that a piece of legislation that had, as one of its key objectives, the safeguarding of employment rights, should tax workers as if they were employees of their client but do absolutely nothing to ensure that the worker benefits by obtaining some degree of increased employment protection compared to that which existed before the legislation was introduced.
The fact remains that an employer can insist that its workers operate via a service company (where they may be caught by IR35 and taxed accordingly), they can benefit from their services for many years and can still dispense with their services at a moment's notice and with little or no employment risk.
Solutions?
Many of the issues that underlie IR35 relate to the differences in tax treatment between companies and individuals and between salary and dividends. By introducing IR35 the Government seems to have taken the easy option of trying to cure a symptom without attempting to address the root causes.
The Government appears to accept that innovation and entrepreneurship are vital for the continued growth of the UK economy in a world where production and services are constantly seeking economies with cheaper labour rates. We can only continue to grow by remaining at the forefront of new industries and by deploying greater skills and expertise.
Freelancers in knowledge-based services provide the flexibility to enable larger businesses to develop and grow and are themselves a major source of new ideas and new businesses. Measures like IR35, that stifle and deter freelancers from setting up on their own and from investing in developing new ideas, will adversely affect our competitiveness.
Freelancers need greater certainty to be able to plan and invest for the future. Tax legislation that depends upon the application of employment status case law does not provide that certainty. We need to develop some clear simple criteria for tax status that properly distinguishes the disguised employee from the worker who has made an informed and conscious decision to forgo the security of employment in return for the greater rewards and risks associated with self employment or employment by their own service company.
Kevin Miller FCA