Corporate / Company Tax Planning, Personal Tax Planning

IR35 News & IR35 Rules

24
May

Guest article from Tim Warr of Warr & Co Chartered Accountants

In 100 years when people look back at 2012, three events in particular will be remembered.  These are of course:

I’m now going to focus on the most important of these three events.

IR35 was introduced at the beginning of this millennium to fix a perceived problem.  Over the previous 20 years the elected governments in this country, in a gradual process, changed the balance of the tax burden so that taxes charged on earned income became more than those charged on investment income.  Prior to 1984 it was the other way round and in the 1970’s the top rate charged was 83% on earned income and 98% on investment income.

Of course, governments are democratically elected and are, therefore, entitled to set the rules of the game.  Likewise, taxpayers are entitled to play the game any way they like so long as they stick to the rules.

As long ago as 1984, a number of accountants saw a way to convert earned income into investment income so that their clients would pay less tax.  Anyone who was self-employed could convert their business to a Limited Company, draw a low salary and take dividends out of profits.  So income that had been earned income (self-employed profits) became investment income (dividends).  The business paid less tax and everyone was happy.  Likewise, a business operating through a Limited Company could reduce the salaries it paid to its shareholding directors and pay them dividends instead.  All of this was simple, non-contentious tax planning.

In 1999 the Government decided that planning such as this was in fact tax avoidance in some circumstances.  They highlighted that in certain industries, employees were forming Limited Companies to avoid employee taxes.  Examples given included dental receptionists and train drivers.  Unions got involved claiming that employers were pushing their employees in this direction to avoid employment legislation.

It was soon clear however that this legislation was targeted at freelancers providing professional services through Limited Companies such as computer contractors and management consultants.  IR35 was to apply to workers providing services to clients through intermediaries in circumstances where but for the existence of those intermediaries the relationship between the client and the worker would be one of employment.

The principal was simple, but the application was anything but.  Many contractors saw this new tax as unfair.  They considered themselves to be in business the same way as many others are in business and they felt that they had been selected for special treatment.

As cases went before Tribunals it became evident that the picture was not as clear as HMRC thought it was.  More often than not, contractors were winning. But for every case that went before a Tribunal there were perhaps 100 settled in correspondence between HMRC and contractors agents.  In these cases contractors were almost always winning.

By the late 2000’s IR35 has become something of a voluntary tax with the principle of the tax itself poorly understood by the workers within its range, the accountants who advised those workers, and the tax inspectors who policed it.

In 2011 the government missed an opportunity when the Office for Tax Simplification recommended suspending IR35.  The reasons for not doing so in the 2011 Budget were perhaps down to politics rather than common sense.  However, later in the same year news broke that the head of the Student Loan Company had his remuneration paid into a Limited Company.  There were then suggestions that this practice was also rampant amongst civil servants.  This gave added impetus to HMRC to make IR35 work.

And so to The Document.  In the first half, HMRC have come up with a point scoring system to indicate risk.  Points are awarded based on “business entity tests.”  The number of points awarded for each test appears to be set at a level which ensures that almost every contractor in the country will fall into the high risk category.  The second half of the document gives worked examples.  The worked examples are fair and perhaps quite useful.  No attempt is made to point score and so it is easy to be left wondering what the business entity tests are all about.  With a little tinkering, a lot of agency contracts could be made to look like that of the example Emma. { See Chapter 6 of the HMRC document}

If we are to have a point scoring system it is perhaps best to first stand back and look at what the courts have decided over the years.  A good starting point is the 1968 Ready Mix Concrete case.  It was held in this case that three conditions must be fulfilled for a contract to be one of employment:

  • the worker must submit to being under control;
  • the contract must require personal services; and
  • the other factors in the contract must not be inconsistent with a contract of employment.

Subsequently, mutuality of the obligations has become fundamental.  The client has to offer work to the worker and the worker has to accept it.

In the case of a contractor an exercisable right of substitution or a lack of mutuality of obligations are sufficient on their own to result in a contract falling outside of IR35.  It is surprising therefore that the business entity tests award just 2 points for a right of substitution and 20 points for actual substitution which in the absence of any other points would categorise the contractor as medium risk.

Of course in reality few contractors have a real right of substitution and mutuality of obligations is usually present.  These issues are black or white.  Control however tends to be shades of grey.  Control is recognised as a key factor in the example scenarios, but apart from a reference to business premises, it is absent in the business entity tests.

The importance of other factors varies from case to case.  For example, in the case of a delivery man, the provision by the worker of his own van would be fundamental.  Contrast this to a contractor using his own laptop where the provision of equipment has little or no impact.

Tests highlighted such as PII, advertising, business plan, client risk, and billing also have little relevance.  The two other key factors are Intention of the Parties and Ability to Profit from Sound Management.

Intention has been missed altogether from the list of tests, but look for a moment at the Emma example. { See Chapter 6 of the HMRC document}

HMRC conclude that in the absence of intermediaries, she would be self-employed.  But suppose her client offered her a permanent position carrying out the same work and she accepted.  Would HMRC still think she was self-employed?  Obviously not!  The offer of permanent work by clients to contractors is a frequent occurrence highlighting just how important intention is.  I think it deserves at least 10 points.

Ability to profit from sound management is touched upon in the tests under Efficiency, Repair at own expense, and client risk.  But they have missed two key tests in this area.  These are:

  • are you able to negotiate a rate with clients at least 50% higher than the salary an employee of the client would earn carrying out a similar work; and
  • is the rate you can negotiate on an extension or new contract materially affected by market conditions at the time?

I would award 20 points to the forner and 10 to the latter.

Probably giving sufficient weight to Intention and Ability to profit from sound management Barbara in the examples given would still be caught by IR35.

{ See Chapter 8 of the HMRC document}

But a contractor providing services to a bank on a 6 month contract facing the choice of a 10% rate cut or trying to find work elsewhere would be exempt.  And how about a senior civil servant?  Well if he’s accepted a role and negotiated for his salary to be converted to a fee to a limited company for tax planning reasons, the intention is employment, and the ability to profit from sound management is absent. He is clearly caught by IR35.

The document itself states that it is Version 1.  Let’s hope that HMRC can open their eyes and come up with a meaningful Version 2 before the courts and tribunals do it for them.

If you would like to discuss any of the points raised within this piece, please contact Tim Warr @ Warr & Co Chartered Accountants.