Trying to square the circle

The only realistic hope of a reprieve now lies with the legal challenge that the Professional Contractors’ Group is mounting. The group has been formed in direct response to these proposals in order to represent the interests of knowledge-based contractors.

According to recent reports, the PCG’s challenge is focusing on the narrow issue of whether by discriminating against ‘one-man bands’ (in response to lobbying the government has chosen to exempt large firms from the scope of these proposals) the proposed change in legislation contravenes European law. However, this change raises other wider issues, which the government does not appear to have addressed fully.

A political party that does not use its time in opposition to develop and define its policies in advance of taking office is likely to be overwhelmed by the day-to-day pressures of office when it comes to power – and the Labour government is proving to be no exception to this rule. The new tax regime for personal service companies, the infamous IR35, is a perfect example of inept policy-making, and the Budget in general confirms that the government has no sensitivity to the fundamental problems bedevilling the UK’s tax system.

Under IR35, with effect from 6 April 2000, individual assignments will be subject to review to determine whether they have the characteristics of an employment – existing case law will apply to this determination. An individual who provides services through a personal service company may well receive some incidental sources of income that the Inland Revenue will accept as being in the nature of self-employment income. However, if he or she accepts a large contract it is possible that this contract will be treated as falling within the scope of IR35 and deemed to be employment income. Indeed the Inland Revenue has stated that they will categorise an engagement under a standard agency contract lasting for a month or more as a disguised employment.

IT professionals and others who obtain work, in the name of their personal service companies, through agencies are extremely concerned at the apparent broadening of the application of the proposals in this way. The fact that consultants, with a variety of assignments, can still be regarded as deemed employees in relation to one or more of these assignments means that particular care will need to be taken in structuring all contracts and will result in the need to review all sources of consultancy income on an item-by-item basis.

The different tax treatment applying to different categories of income will extend to expenses; under IR35, a round sum deduction of five per cent will allowed against deemed employment income. In addition to this round sum deduction from deemed employment income, a subcontractor will be able to claim other deductions on the same basis as an employee. In relation to indemnity insurance, the Inland Revenue suggestion that these will be deductible on the same basis as a payment by an employee is evasive. Since employees in general don?t pay their own indemnity insurance it is highly unlikely that tax relief would be available to an employee in such circumstances. As a consequence, a subcontractor under IR35 should assume that no relief would be available.

In response to the question whether training expenses incurred by a will be allowable, the Inland Revenue forgets to obfuscate and admits that ‘no deduction will be allowed for service companies’…so much for promoting a knowledge-based economy. Because the rules that apply to employees’ travel expenses are reasonably generous, IR35 should not pose too many problems for the majority of consultants. However, anyone who employs secretarial help and is caught by these rules is likely to find that the 5% deduction ensures that he obtains little or no effective relief.

Revenue helplines
In response to consultation and taxpayers objections at the uncertainty that the proposals will introduce into the tax system, the Inland Revenue has agreed to establish helplines to determine the nature of items of income. However, the people staffing this helpline are unlikely to be worked to death as most taxpayers will realise that, in any case of doubt, the Revenue will treat the item in question as being within the scope of IR35. In the circumstances it will be better to take the benefit of any doubt and leave the courts to resolve any borderline issues, if challenged.

Where someone, who operates through a personal service company, has other income, in addition to deemed employment income, it will be necessary to apportion expenses. The interaction of IR35 and the sub-contractors scheme in the building industry creates further complications, as does overseas taxation suffered at the corporate level. As will be obvious from previous comments, the uncertainty, tax risks and sheer complexity of IR35 will impose a heavy burden on anyone who operates in this way. Accordingly a considerable proportion of the 5 per cent round sum deduction is likely to be absorbed in professional fees.

The government in its original proposals targeted ?employing? companies and not consultants. However, in response to lobbying, the government modified its original approach and shifted the entire liability and risk on to the sub-contractor. This policy decision will now reinforce the previous incentive of businesses to use the services of only those consultants who operate through personal service companies. Whereas, in the past, all agencies and the more sophisticated would impose this requirement on their consultants, now almost everyone will be aware that this arrangement is guaranteed to absolve the contracting party of any attendant tax risk. Accordingly the number of personal service companies can be expected to grow as a direct response of these proposals. Bearing in mind that the new regime will be extremely difficult to police, it does not make any sense from a policy perspective to increase the taxpayer population that potentially comes within the scope of the proposals.

So far as concerns tax avoidance abuse, employers of consultants were avoiding employer’s NIC. In addition, the employers apparently avoided giving consultants the protection that employment law. So far as concerns the consultants themselves, they were avoiding/deferring tax through a variety of planning devices. However by adapting their proposals to accommodate the most vociferous and influential lobbyists, the government has shifted responsibility for all the tax loss on to consultants. If the consultants have a strong bargaining position, this does not matter very much because they can simply shift the burden back on to the ’employers’ by increasing their fees. However, the majority of consultants who are caught by these proposals, are likely to be forced to absorb the increased incidence of tax themselves. In a comment in an internet newsletter, Businessweek comments that in Silicon Valley ‘plenty of people are being left behind by the greatest wealth machine in history. Average wages for low-end workers are 10% lower than a decade ago. A key reason: high tech’s heavy reliance on outsourcing and subcontracting, which holds wages down for the less skilled’. It is precisely this category that will be forced to incur the costs of incorporation and bear the brunt of the government’s additional tax charge.

The real policy problem that the government needs to address (not in a piecemeal fashion) is the future of PAYE in the context of the ‘brave new world’ of flexible employment that it is championing and encouraging its reluctant European partners to adopt. As the Better Regulation Task Force acknowledges, in a recent paper, PAYE is unlikely to survive the era of flexible employment. PAYE with its system of cumulative assessment and collection is suited to withholding the correct amount of tax from employees in a stable employment but struggles to cope with individual employees who change employment frequently or are in multiple employments ?hallmarks of the new flexible labour market.

With these proposals the government is trying to ‘have its cake and eat it’…it is trying to create a flexible employment market of incorporated one-man bands while, at the same time, deeming their income to be employment income in order to secure its own revenues. Because consultants have historically been poorly represented – the Federation of Small Businesses has recently suffered internal dissent because of members’ concerns at the small proportion of its subscription income that it spends on policy issues – matters have been allowed to go so far that the government is unlikely to back down.

Positive outcomes
One positive development from this fiasco is that the Professional Contractors’ Group has been formed to represent the interests of consultants and is proposing to mount a legal challenge to these proposals. Perhaps it should arrange for its legal challenge to be extended to question whether the UK government can ‘aid and abet’ UK employers in undermining the social chapter – to which the UK government has only recently signed up – by employing consultants through personal service companies? It may well be that the European Court of Justice will adopt a purposive approach and lift the veil of incorporation in such circumstances.

Adrian Ogley of Interfisc Consulting is a former deputy head of tax at the CBI

IR35 – the exodus begins?

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