Mind the gap
25 May 2017
Consolo鈥檚 Richard Colvill lifts the lid on the complex working of the IR35 tax legislation, which potentially affects companies using agency staff, and outlines what securities finance participants should watch out for in the new framework
Image: Shutterstock
I suspect that to most people reading this, IR35 means nothing more than a random collection of alphanumerical characters. To contractors it means much more, as it should to anyone in business who recruits agency staff or is likely to require temporary resource for any future business or project initiatives.
IR35 is tax legislation designed to prevent 鈥榙isguised employment鈥� and it was introduced in April 2000 by the HM Revenue & Customs (HMRC) in the UK as a countermeasure to personal service companies (PSCs). PSCs are typically limited companies, set-up whereby the director or owner of the company pay themselves a salary and dividends, to circumvent PAYE tax thresholds payable at the commensurate rates. Quite often, spouses are employed to double the drawdown allowance.
The fact that salaries are not subject to corporation tax can make this an efficient tax planning option for contractors, especially when paying themselves dividends, which are with low rates of personal income, currently capped at 7.5 percent. Since 1997, corporation tax rates have hovered on or around the 20 percent level.
HMRC had a simple objective when introducing this legislation: to prevent two people from performing the same job and paying different levels of tax. The intention of the measure was to prevent workers from setting up limited companies via which they would work as employees, but saving on tax dues. It was also designed to counter the 鈥楩riday to Monday鈥� scenario, as it was referred to, to prevent the possibility of a worker leaving his or her job on a Friday evening and returning on a Monday morning to the same company or end-client and performing the same job, but paying less tax.
In this scenario, HMRC would be permitted to look through the contractual arrangement between the PSC and the end-client and formulate a hypothetical contract that showed that the worker was a 鈥榙isguised employee鈥�. In such cases and, pertinently, if successfully challenged in court, then the fee paid to the PSC could be taxed as salary at the commensurate national insurance and PAYE rates.
However, HMRC have had little success in court since April 2000 with many cases found in favour of the defendants (the contractors). In many cases, the strength of the contract has been the key differentiator, with the contractor (or their legal representatives) seemingly successful in proving that that they are different from the client鈥檚 employees, both in terms of the services provided and how they were performed.
Flexible working, investing in training, development and equipment, and working on a fixed package of work or for a fixed fee or a fixed period, have proved to be legitimate ways of evidencing that you are truly independent. Providing a substitution clause not only gives unequivocal evidence that you offer a personal service, and therefore cannot be a disguised employee, it can also argue that you are enabled to profit further from the assignment by supplying cheaper labour to perform the services on your behalf.
In April 2017, HMRC introduced new measures to the IR35 legislation, in the public sector only, that effectively shifts the IR35 status decision making from the contractor or agency worker, to the employee, end-client or hiring organisation. If the public sector client decides that IR35 should apply to the engagement, payment to the contractor will be taxed at source as if it were an employee through the real time information (RTI). Failure to do so accurately will result in penalties, charged to the end-client. It is estimated that this policy will raise an estimated 拢185 million in the year 2017/18.
Penalties
The penalties are steep. A charge all organisations will endeavor to avoid on all occasions. Therefore, what are they to do? The revenue have issued an IR35 calculator to assist organisations in deciding if their contract staff fall in or outside of legislation yet, the rules are so complex, clients will not be able to tell for sure whether the engagement is caught. This decision only comes under scrutiny at the point of investigation by the revenue, at which point all errors result in fines, as they cannot be reversed.
Because end-clients are culpable if they make the wrong decision, they are highly likely to take a risk-averse approach and apply IR35 if there is any doubt whatsoever. Many clients will work with many hundreds or even thousands of contractors at any one time, and may be unwilling or unable to make a calculated detailed assessment of each engagement. This may lead clients to apply IR35 on each engagement, regardless of their actual status. The consultation document alludes to an appeal process, but it has provided very few details on how this would work. The suggestion is that contractors can appeal at a tax tribunal, which they must raise and finance. The likelihood of which, seems too much of a burden for most individuals. It may be that public sector bodies will set up their own appeals procedures, but until the rules are applied in earnest it is not known whether this will happen and how it will work.
Existing contracts
How will this affect contracts that are already in place when the changes come into effect in April 2017? This will be difficult to answer. There will be cases where the engagement has been going on for a few months and the contractor has been satisfied that IR35 doesn鈥檛 apply. After April, the end-client may decide that it does apply and so terminate the contract under the old terms and engage resources for the same role under new terms.
There have been many instances in the public domain where this has been case. The public sector has had sufficient time to react to the legislation change and clients seem well prepared, but what does this mean to the contractor? Contractors are understandably worried that if their clients decide that IR35 should apply, then does this give HMRC the impetus to look at the months or years preceding April and ask if IR35 should have been applied to that income too. There is nothing in legislation that prevents HMRC from doing this, but whether they do or not remains to be seen.
Retrospective legislation is now modus operandi, with a precedent set with the introduction of the disclosure of tax avoidance scheme legislation, which was designed to raise more than 拢4 billion in taxes from 鈥榙isguised remuneration鈥� schemes, dating back 20 years. Due to be enforced in April 2019, this measure will open previously considered 鈥榗losed鈥� years and tax individuals back to 1999. Currently, this standard is four years but six years can be applied if fraudulent activity is suspected. The next few years will prove to be critical to contractors caught by this legislation and it will remain to be seen if this change holds-up in a judicial court, if challenged.
IR35 in the private sector
The UK government is gearing up for a massive clampdown on the private sector, with many industry experts proclaiming that the introduction in the public sector is a precursory event to road-test the policy, as it does not make sense to operate two sets of rules. It is easy to introduce and to enforce because the government are the end-client in many sectors.
Research carried out by the Small Business Research Centre at Kingston University in 2014 estimated that there were 1.4 million contractors or freelancers working in both the public and private sectors in the UK. This represented a 10 percent increase over the 10 years prior, most of whom will be affected by this policy.
Why is this a concern?
There are several opinions in relation to this question. Firstly, contractors play a vital role in the UK鈥檚 industries. There is a common misconception that that they earn too much or take jobs away from permanent staff. Many organisations prefer to employ a percentage of contract staff for various reasons. It allows them to periodically dip into the talent pool for short-term contracts where they don鈥檛 have the knowledge or bandwidth internally and without burdening themselves with all of the liabilities associated with full-time employment.
Contractors do not get sick pay, maternity/paternity leave, holiday pay, health or life insurance, pensions, redundancy or development investment. Their appointment is unencumbered of all of the financial liabilities except severance terms, which is typically either a week or a month. This is usually aligned with their payment regularity, but not always. Many contractors feel the employment uncertainty the most and therefore must make provisions for lean periods, while financing all of the aforementioned employee benefits.
Under the new legislation, many contractors鈥� take-home pay will be significantly reduced, with government analysis estimating this to be as much a 30 percent of their net pay. In many cases, contractors will reside in the higher-rate tax band of 40 percent, which starts at 拢45,001 and ends at 拢150,000, for the 2017/18 period.
Many of you reading this will believe this to be fair enough, as this is also the cross you have to bear being a full-time employee, but now imagine having to finance all of your benefits from this net pay.
Many do not realise how much these premiums cost. Coupled with the uncertainty of employment status, many in the industry see this as unduly unfair.
How will this affect the securities finance industry?
There are a lot of pop-up, short-term, regulatory or business change obligations that require the service of temporary professionals. The current hot-topic is the 色花堂Financing Transactions Regulation鈥攈ow will organisations resource the associated efforts to apply this change? Whether they provide internal solutions or recruit vendors, there will always be a project to support this, which may require topical industry experts outside of their permanent resources.
There are also end-clients that insist on maintaining a portion of their task force as agency staff, because of the recruitment and financing flexibilities. These organisations will now be greatly affected, especially where it is not uncommon that this split can be half of their staff.
Again, many contractors in the public domain are citing this change as reasons to leave the self-employed route and look for permanent employment, citing that they may as well benefit from the financial downturn by reaping the associated employee benefit rewards. Of course, there are only a finite amount of jobs out there, which anyone who has been made redundant recently will testify to.
Others are simply stating that they will have to increase their rates to compensate for the tax hike, a cost that will be borne by the end-client. Or will it? Will the recruiters have to share this burden, reducing their margins to attract talent? The subject of recruiter margins has always been a bit of an enigma, with many refusing to disclose their cut.
Those who鈥檝e been around a while know that they are often highly inflated with the recruiter often pocketing up to 40 percent of the day-rate not unheard of, a price many will believe to be excessive for what is simply an introduction.
How can Consolo help?
Consolo is a dedicated consultancy that specialises in business change within securities finance and can offer project management, resourcing and subject matter expertise within our industry. Contact us now for further information.
IR35 is tax legislation designed to prevent 鈥榙isguised employment鈥� and it was introduced in April 2000 by the HM Revenue & Customs (HMRC) in the UK as a countermeasure to personal service companies (PSCs). PSCs are typically limited companies, set-up whereby the director or owner of the company pay themselves a salary and dividends, to circumvent PAYE tax thresholds payable at the commensurate rates. Quite often, spouses are employed to double the drawdown allowance.
The fact that salaries are not subject to corporation tax can make this an efficient tax planning option for contractors, especially when paying themselves dividends, which are with low rates of personal income, currently capped at 7.5 percent. Since 1997, corporation tax rates have hovered on or around the 20 percent level.
HMRC had a simple objective when introducing this legislation: to prevent two people from performing the same job and paying different levels of tax. The intention of the measure was to prevent workers from setting up limited companies via which they would work as employees, but saving on tax dues. It was also designed to counter the 鈥楩riday to Monday鈥� scenario, as it was referred to, to prevent the possibility of a worker leaving his or her job on a Friday evening and returning on a Monday morning to the same company or end-client and performing the same job, but paying less tax.
In this scenario, HMRC would be permitted to look through the contractual arrangement between the PSC and the end-client and formulate a hypothetical contract that showed that the worker was a 鈥榙isguised employee鈥�. In such cases and, pertinently, if successfully challenged in court, then the fee paid to the PSC could be taxed as salary at the commensurate national insurance and PAYE rates.
However, HMRC have had little success in court since April 2000 with many cases found in favour of the defendants (the contractors). In many cases, the strength of the contract has been the key differentiator, with the contractor (or their legal representatives) seemingly successful in proving that that they are different from the client鈥檚 employees, both in terms of the services provided and how they were performed.
Flexible working, investing in training, development and equipment, and working on a fixed package of work or for a fixed fee or a fixed period, have proved to be legitimate ways of evidencing that you are truly independent. Providing a substitution clause not only gives unequivocal evidence that you offer a personal service, and therefore cannot be a disguised employee, it can also argue that you are enabled to profit further from the assignment by supplying cheaper labour to perform the services on your behalf.
In April 2017, HMRC introduced new measures to the IR35 legislation, in the public sector only, that effectively shifts the IR35 status decision making from the contractor or agency worker, to the employee, end-client or hiring organisation. If the public sector client decides that IR35 should apply to the engagement, payment to the contractor will be taxed at source as if it were an employee through the real time information (RTI). Failure to do so accurately will result in penalties, charged to the end-client. It is estimated that this policy will raise an estimated 拢185 million in the year 2017/18.
Penalties
The penalties are steep. A charge all organisations will endeavor to avoid on all occasions. Therefore, what are they to do? The revenue have issued an IR35 calculator to assist organisations in deciding if their contract staff fall in or outside of legislation yet, the rules are so complex, clients will not be able to tell for sure whether the engagement is caught. This decision only comes under scrutiny at the point of investigation by the revenue, at which point all errors result in fines, as they cannot be reversed.
Because end-clients are culpable if they make the wrong decision, they are highly likely to take a risk-averse approach and apply IR35 if there is any doubt whatsoever. Many clients will work with many hundreds or even thousands of contractors at any one time, and may be unwilling or unable to make a calculated detailed assessment of each engagement. This may lead clients to apply IR35 on each engagement, regardless of their actual status. The consultation document alludes to an appeal process, but it has provided very few details on how this would work. The suggestion is that contractors can appeal at a tax tribunal, which they must raise and finance. The likelihood of which, seems too much of a burden for most individuals. It may be that public sector bodies will set up their own appeals procedures, but until the rules are applied in earnest it is not known whether this will happen and how it will work.
Existing contracts
How will this affect contracts that are already in place when the changes come into effect in April 2017? This will be difficult to answer. There will be cases where the engagement has been going on for a few months and the contractor has been satisfied that IR35 doesn鈥檛 apply. After April, the end-client may decide that it does apply and so terminate the contract under the old terms and engage resources for the same role under new terms.
There have been many instances in the public domain where this has been case. The public sector has had sufficient time to react to the legislation change and clients seem well prepared, but what does this mean to the contractor? Contractors are understandably worried that if their clients decide that IR35 should apply, then does this give HMRC the impetus to look at the months or years preceding April and ask if IR35 should have been applied to that income too. There is nothing in legislation that prevents HMRC from doing this, but whether they do or not remains to be seen.
Retrospective legislation is now modus operandi, with a precedent set with the introduction of the disclosure of tax avoidance scheme legislation, which was designed to raise more than 拢4 billion in taxes from 鈥榙isguised remuneration鈥� schemes, dating back 20 years. Due to be enforced in April 2019, this measure will open previously considered 鈥榗losed鈥� years and tax individuals back to 1999. Currently, this standard is four years but six years can be applied if fraudulent activity is suspected. The next few years will prove to be critical to contractors caught by this legislation and it will remain to be seen if this change holds-up in a judicial court, if challenged.
IR35 in the private sector
The UK government is gearing up for a massive clampdown on the private sector, with many industry experts proclaiming that the introduction in the public sector is a precursory event to road-test the policy, as it does not make sense to operate two sets of rules. It is easy to introduce and to enforce because the government are the end-client in many sectors.
Research carried out by the Small Business Research Centre at Kingston University in 2014 estimated that there were 1.4 million contractors or freelancers working in both the public and private sectors in the UK. This represented a 10 percent increase over the 10 years prior, most of whom will be affected by this policy.
Why is this a concern?
There are several opinions in relation to this question. Firstly, contractors play a vital role in the UK鈥檚 industries. There is a common misconception that that they earn too much or take jobs away from permanent staff. Many organisations prefer to employ a percentage of contract staff for various reasons. It allows them to periodically dip into the talent pool for short-term contracts where they don鈥檛 have the knowledge or bandwidth internally and without burdening themselves with all of the liabilities associated with full-time employment.
Contractors do not get sick pay, maternity/paternity leave, holiday pay, health or life insurance, pensions, redundancy or development investment. Their appointment is unencumbered of all of the financial liabilities except severance terms, which is typically either a week or a month. This is usually aligned with their payment regularity, but not always. Many contractors feel the employment uncertainty the most and therefore must make provisions for lean periods, while financing all of the aforementioned employee benefits.
Under the new legislation, many contractors鈥� take-home pay will be significantly reduced, with government analysis estimating this to be as much a 30 percent of their net pay. In many cases, contractors will reside in the higher-rate tax band of 40 percent, which starts at 拢45,001 and ends at 拢150,000, for the 2017/18 period.
Many of you reading this will believe this to be fair enough, as this is also the cross you have to bear being a full-time employee, but now imagine having to finance all of your benefits from this net pay.
Many do not realise how much these premiums cost. Coupled with the uncertainty of employment status, many in the industry see this as unduly unfair.
How will this affect the securities finance industry?
There are a lot of pop-up, short-term, regulatory or business change obligations that require the service of temporary professionals. The current hot-topic is the 色花堂Financing Transactions Regulation鈥攈ow will organisations resource the associated efforts to apply this change? Whether they provide internal solutions or recruit vendors, there will always be a project to support this, which may require topical industry experts outside of their permanent resources.
There are also end-clients that insist on maintaining a portion of their task force as agency staff, because of the recruitment and financing flexibilities. These organisations will now be greatly affected, especially where it is not uncommon that this split can be half of their staff.
Again, many contractors in the public domain are citing this change as reasons to leave the self-employed route and look for permanent employment, citing that they may as well benefit from the financial downturn by reaping the associated employee benefit rewards. Of course, there are only a finite amount of jobs out there, which anyone who has been made redundant recently will testify to.
Others are simply stating that they will have to increase their rates to compensate for the tax hike, a cost that will be borne by the end-client. Or will it? Will the recruiters have to share this burden, reducing their margins to attract talent? The subject of recruiter margins has always been a bit of an enigma, with many refusing to disclose their cut.
Those who鈥檝e been around a while know that they are often highly inflated with the recruiter often pocketing up to 40 percent of the day-rate not unheard of, a price many will believe to be excessive for what is simply an introduction.
How can Consolo help?
Consolo is a dedicated consultancy that specialises in business change within securities finance and can offer project management, resourcing and subject matter expertise within our industry. Contact us now for further information.
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