The government has announced its intention to repeal the recent changes to IR35. What does this IR35 update mean, the rationale, and the likely direction of travel from here.
1. What is a repeal of law?
In effect the scrapping of the law effective from the date of the repeal. In this case the date of repeal is intended to be 5th April 2023. It is not effective immediately.
2. What law is the government proposing to scrap?
The rules relating to ‘off payroll working’ that were introduced in 2017 and 2021 (Chapter 10 ITEPA 2003).
The pre-existing position (Chapter 8 ITEPA 2003) required the contractor to be responsible for assessing employment status and paying tax accordingly but this shifted to the hirer and supplying agency as explained later in this article. Chapter 10 processes do not apply to smaller hirers, e.g., those with an annual t/o of less than £10.2m (note there is other criteria).
3. Who is a contractor?
A contractor is a loose term widely used to describe someone who provides services through another third-party legal entity, such as a personal service company, and sometimes also refers to self-employed workers. However, the legislation does not use the term ‘contractor’ at all and so it is important to be careful in using the term in any specific sense relating to the law. IR35 tax rules do not generally apply to self-employed workers where there is no third-party entity but do apply otherwise. Employers generally regard ‘contractors’ as those who work temporarily on a non-employment basis, historically allowing the employer to avoid employer NICs and work ‘off payroll’ with no liability for employment rights.
4. What does employment status have to do with ‘contractor’ services?
Until the first IR35 rules were introduced in April 2000, individuals could claim the benefit of company tax breaks, for example by paying themselves dividends instead of as employment income, if they operated through an ‘intermediary’. The expression ‘intermediary’ is usually a reference to a personal service company (PSC), although the rules also apply to all companies and partnership arrangements. We use reference to PSC through this to apply to all company or partnership vehicles to make the reading easier.
Since a PSC can be created for very little cost (less than £10 currently) it became attractive for individuals to set up and operate through their own PSCs to gain the tax advantages by paying themselves via dividends, avoid payment of PAYE and NICs, avoid personal liability for claims (the company being the liable party) whilst at the same time helping hirers avoid liability for employer NICs and employment rights.
5. Surely ‘contractors’ are businesses?
All companies are generally regarded as businesses but here is where an anomaly arises. Simply because someone operates through a PSC does not mean they are in business on their own account. Despite having a company, for all intents and purposes an individual may work for an employer in exactly the same way as if they were an actual employee, with few trappings of an actual business, accepting no real risk and no effort to make any profit over and above what they would earn providing their personal effort as an employee. All that is required is to have the company and invoice in the company name.
6. Reason for the ‘IR35’ law in 2000.
Accordingly, HMRC concluded that the fact of the existence of a PSC in the chain of supply should not in itself allow someone to take advantage of tax breaks designed to help genuine businesses. It decided to block PSCs from being used as tax avoidance vehicles – hence the tax rules introduced in April 2000, labelled in an Inland Revenue announcement as IR35 (Inland Revenue bulletin 35). This set up the requirement for the ‘contractor’ to test hypothetical employment status and report the result in their annual tax returns, so removing the tax avoidance advantage of operating through a PSC.
7. Why is employment status relevant – ‘contractors’ are not employees?
The test is to assess whether the individual would be an employee of the hirer were it not for the existence of the PSC. So, take the PSC out of the equation and look at how the parties are working. If working as an employee, then the contractor company would have to pay employment taxes on the value of the invoice for work done. This is simply a test to assess tax and has no relevance to actual employment, or linkage to entitlement for the individuals to actual employment rights. Some argue that contractors are employees if the outcome of the test is that hypothetical employment exists under these tax rules, but the law does not support that position.
8. The problems HMRC has attempted to solve in recent changes.
The idea of assessment of employment status seems quite a simple principle. However, there are two problems. First, in practice as the contractor was responsible for making the assessment, a difficult and complex exercise, many contractors assessed their status as non-employment. HMRC reported that 9/10 contractors wrongly reported their status with a consequent loss to the Exchequer of £1bn. Second, assessing employment status is complex, requiring a review of working practices as well as the contracts on a case-by-case basis. This made it very difficult for HMRC to identify and recover unpaid levels of tax from non-compliant contractors.
9. HMRC’s solution.
The result was a change to the law in 2017 (applicable to public authorities only) and then 2021 (applicable to all except small hirers), in summary
- making the hirer responsible for making and communicating a status determination statement (SDS) based on the hypothetical position as discussed above
- making the hirer and the person paying the contractor liable for the correct levels of ‘deemed employment’ tax that followed an SDS indicating a hypothetical employment arrangement
- where there is deemed employment, requiring the whole of the contractor’s invoice for work done to be treated as employment income.
In effect these changes took responsibility for accounting for the tax out of the hands of the contractor but at the same time established additional costs for the payer. HMRC also published extensive guidance and an online tool called Check Employment Status for Tax (CEST) in an attempt to demystify the employment status rules and make it easier for hirers and contractors to follow. CEST provides a qualified result which users are meant to be able to rely upon, but there have been many negative reports around its actual reliability.
10. Reasons for the laws to be repealed.
Only the government knows! However, we would say that Chapter 10 is very cumbersome and admin heavy for hirers and agencies with, in many cases, great difficulty in achieving certainty where the assessment is that there is no deemed employment. The deemed employment calculation results in higher employer NICs, so acting as an additional deterrent.
Also, from a technical perspective, the CEST tool leaves a lot to be desired. Every case relies upon the specific circumstances, and case law evolves. This can lead to results changing both retrospectively and for the future, a very unsatisfactory result from a tool that is intended to provide certainty. The risk and liability arising from getting the assessment wrong has caused many to refuse to use contractors, and this may be at least one driver for the planned repeal.
11. What now?
The repeal is promised for the next tax year, April 2023. The current rules will continue to apply until then and nobody should feel safe in jumping the gun. Liability for unpaid levels of deemed employment income does not go away until the repeal is effective and will only apply to arrangements after that date, leaving risk and liability open for incorrect assessments on supplies of contractors and arrangements made before the repeal date. Only once the repeal has happened will the responsibility and liability for the assessment revert to the contractor unless things change between now and then.
There is little prospect that employment status for tax purposes will be encoded in legislation, despite the obvious need for this to be done.
12. Next steps for hirers and agencies?
Putting aside any prospect that the repeal plan will itself be scrapped, the government has not laid out any plan for review of the original rules (Chapter 8). However, the repeal could be accompanied by amendment to Chapter 8 to avoid a reversion to the previous tax avoidance position (e.g. £1bn loss to the Exchequer), but there has been no statement to that effect as yet.
In the meantime, it is important to remain vigilant. Having the right advice on status and appropriate reflective contracts in place remains critical. For more information on steps to take see here.
Adrian Marlowe is Managing Director at the recruitment and employment law specialists Lawspeed.
Lawspeed group corporate clients benefit from immediate up to date advice on staff engagement and related regulation; employment status; client, IR35, PAYE and umbrella contract templates; contract review/negotiation; self-employment and CIS contract templates; trade membership and government representation; accreditation services and a state of the art digital contract management platform.