The government is facing renewed calls to scrap the IR35 legislation it has relied on for 20-plus years to curtail tax avoidance by limited company contractors, as concerns about the after-effects of its introduction continue to grow.
More than two decades have passed since the government pushed through the original version of the IR35 legislation in April 2000 to clamp down on disguised employment by limited company contractors seeking to minimise their income tax and national insurance contribution (NIC) liabilities.
The aim of the legislation was to curb the number of limited company and personal service company contractors who essentially work as permanent employees, but use their off-payroll working status to avoid making pay-as-you-earn (PAYE) and NI contributions.
Under the original legislation, contractors needed to decide and declare for themselves whether the work they did and how it was performed meant they should be taxed in the same way as a salaried employee (inside IR35) or as an off-payroll worker (outside IR35).
An inside-IR35 designation, therefore, means the contractor should be considered an employee of the company for tax purposes, and should pay broadly the same income tax and NICs as a permanent employee performing the same duties would do.
The IR35 working rules have been subject to repeated criticism since their introduction, with a House of Lords inquiry concluding in April of last year that the legislation had never worked satisfactorily since it was introduced more than 20 years ago.
The inquiry described the IR35 legislation as flawed, and said a fundamental revamp of it was long overdue. That is a view many share, including Dave Chaplin, CEO of contracting authority ContractorCalculator.
“It has always been sold to Parliament and the Treasury as a tax-avoidance measure and a threat to the Treasury, but this has always discounted the fact that contractors earn more money than their permanent counterparts,” Chaplin told Computer Weekly.
“Comparing the tax take from a contractor and an employee earning the same amount is misleading, because contractors typically charge more than the employees are paid.
“This is due to free market forces, which dictate rates of pay. Firms are willing to pay more for short-term access to essential skills, and contractors are entitled to accept nothing less, especially given that they are already surrendering employment rights and stability.
“Contractors who earn significantly more than their permanent counterparts inevitably generate a considerable amount more in tax, which is, of course, more beneficial for the Treasury. Meanwhile, flexible working continues to stimulate and benefit the economy.”
On a related point, another criticism levelled at the legislation is that it commands that contractors be taxed in the same way as permanent employees, but workplace benefits – such as holiday pay, paid sick leave and pension contributions – remain off-limits to them.
One IT contractor, who spoke to Computer Weekly on condition of anonymity, said: “I work for myself for the flexibility to save for a rainy day, and I can’t do that any more because I’m working inside IR35 and I’m a zero-rights employee as a result of this legislation.
“I pay all the tax, all the national insurance, the apprenticeship levy, the employer contributions to my pension. I pay my own sick pay, my holiday pay, and when the contract ends – that’s it. I could easily have no work next year and no income.”
IR35 and the rise of umbrella companies
The legislation is also credited with accelerating the proliferation of umbrella companies at the turn of the millennium, which claimed they could offer contractors and their end-clients a way of neatly side-stepping the legislation.
All contractors had to do to take advantage of this would be to cease trading as a limited company contractor and start providing their services to clients through the umbrella company instead.
Doing so means the contractor becomes the umbrella company’s employee and moves onto its payroll, which means IR35 no longer applies to the assignments they do for their end-clients.
In among the many reputable and tax-law-abiding umbrella companies that emerged during this time were others that claimed to be HM Revenue & Customs (HMRC)-compliant, QC-approved and could offer contractors take-home pay rates in excess of 85%.
These take-home pay rates were typically achieved by a small part of the contractor’s salary being processed through the umbrella company’s payroll to minimise the amount of income tax they paid, with the remainder of their salary paid out to them in the form of a non-taxable loan.
Assured by accountants and tax advisers that the mechanisms umbrellas in this category were using to secure such high take-home pay rates were legal and above board, thousands of contractors joined these firms, only to be saddled with life-changing, retrospective tax bills decades later by HMRC through its controversial loan charge policy.
Since its introduction in November 2019, the policy has seen thousands of IT contractors receive six-figure tax bills from HMRC that they are struggling to pay, resulting in mass bankruptcies. The policy has also been linked to at least seven suicides to date.
In recent years, the government has sought to tweak the way the IR35 legislation works through a series of revisions that were first introduced to the public sector in April 2017, and are set to be repeated from next week (6 April 2021) across the private sector.
The main change the reforms introduce is that they see contractors cede control for determining how they should be taxed to the clients that engage them.
The onset of the public sector reforms in 2017 led to a renewed surge in the number of contractors working through umbrella companies, as well as a marked rise in the number of contractors being paid in non-taxable loans.
Loan-based remuneration schemes
HMRC’s own figures show that more than 6,000 individuals took part in loan-based remuneration schemes for the first time during the 2017-18 tax year. This is the highest rate of first-time usage since records began.
In the lead-up to the private sector version of the reforms being rolled out to the private sector, Computer Weekly has reported on numerous instances of the medium to large firms in-scope of the changes tweaking their hiring policies to favour the use of contractors working through umbrella companies.
For that reason, the number of contractors working in this way is predicted to soar over the coming months, which has contracting stakeholders worried given the unregulated nature of the umbrella company market.
As previously detailed by Computer Weekly, the activities of umbrella companies remain ungoverned by statutory regulation, despite repeated assurances by the government over several years that it would push through legislative changes to correct that.
“It is manifestly clear that the flawed IR35 legislation has been a key factor in causing the misery of the loan charge scandal,” said Steve Packham, spokesperson for the anti-loan charge policy campaigners, the Loan Charge Action Group (LCAG).
“Fear of being caught by the original IR35 legislation pushed people into using umbrella companies, rather than limited companies, and this led to a proliferation of umbrellas, including, alas, non-compliant ones that have sought to mislead and exploit contractors.”
Aside from umbrella firms acting as fronts for tax-avoiding disguised remuneration schemes, Computer Weekly has recently reported on contractors experiencing difficulties with ensuring they are paid and taxed correctly when working through umbrella companies in other ways, too.
For example, thousands of contractors could be in line to receive compensatory payouts from umbrella companies and employment agencies after having employers’ NICs unlawfully deducted from their pay since the public IR35 reforms came into play.
This is because the reforms mean limited company contractors are no longer required to cover the cost of employers’ NI on assignments that are deemed in-scope of the IR35 rules.
The umbrella company or employment agency that pays the contractor’s limited company is supposed to cover the cost of employers’ NI at 13.8%, but there is mounting evidence that many are side-stepping this requirement by unlawfully deducting the NI from the gross pay of the contractors on their books.
A series of group litigations is being prepared to reimburse contractors that have fallen victim to this practice since the onset of the public sector IR35 reforms, and experts predict that thousands more could join them once the changes are rolled out to the private sector.
What we have now is a situation where a piece of legislation that has already been described as flawed by the House of Lords has given rise to essentially two scandals, said another IT contractor, who asked not to be named.
It also serves to highlight exactly why statutory regulation for umbrella companies is so urgently needed to remove rogue players from the market, he added.
“If regulation had been done years ago when umbrella companies really bloomed, the loan charge scandal could have been avoided,” said the contractor. “The legislation needs clarifying on where the liabilities lie [for employers’ NI], but it’s not going to happen quickly.
“In the meantime, there are far too many dodgy brollies out there and the new contractors [joining them as a result of the private sector reforms] don’t know what to watch out for to avoid them.”
For all these reasons, said LCAG’s Packham, it is clear that the IR35 legislation is “not fit for purpose” and is in need of a “complete overhaul”, given how out of step it increasingly seems to be with the way the flexible economy operates in 2021.
“There now needs to be legislation to recognise contracting and to support, rather than penalise, this increasingly common way of flexible working, one that is crucially important to the economy,” he added.
Back to the drawing board
Chaplin is in agreement on this point and said the fallout from the legislation alone should convince the government to consider scrapping IR35 and going back to the drawing board.
“The side-effects of the legislation are the proliferation of disguised remuneration schemes, the loan charge, the problems with NICs and forcing contractors into unregulated pay schemes,” he said.
“It is laughable that the question now being asked is ‘how can we fix it?’ because before April 2000, nothing was actually broken.
“Unfortunately, HMRC and the government don’t get it, and if MPs continue to overlook this, it will destroy the advantage that UK plc has held over many other countries that don’t promote flexible working.
“Markets are changing, and there is a move towards more flexible working. But the more HMRC tries to swim against the tide, the more it will damage the UK economy.”
Computer Weekly contacted HMRC for a response to calls for IR35 to be scrapped in the light of the issues it has been linked to, detailed in this article.
In response, an HMRC spokesperson said in a statement: “The off-payroll working rules ensure that individuals working like employees are taxed like employees. The government has consulted extensively on off-payroll working, with four consultations since 2015, and has been clear that the reform will be introduced on 6 April 2021. Organisations should continue to prepare on this basis.
“HMRC continues to deliver an extensive education and support programme, and is actively working with stakeholders, industry and contractors to help them prepare for and implement the reform.”