OTS reveals how to make IR35 obsolete

A long-awaited review into the taxation of small businesses – specifically contractors and IR35 - has been unveiled, citing the maxim “you can’t please all of the people all of the time.”

Published this morning by the Office of the Tax Simplification, it argues there is “no clear cut legislative alternative” to the deemed employment tax rules able to address the concerns of all parties.

Scrapping the legislation would be unfair to employees, it claims, “particularly in the current fiscal climate,” and would appear to “legitimise” the underpayment of tax and national insurance.

Suspending IR35 with a view to eventually abandoning it should therefore be considered only within the longer term framework of integrating income tax and NICs, the OTS report adds.

Merging the two taxes to make this structural change to the tax system would “take away the need for IR35” or at least “would lead to a reduction in the tax motivation for incorporation.”

As long as this alignment is committed to, the government’s two nearer term options are to suspend IR35 - or keep it in its current form, though with improvements to how it is administered.

If not, the third route is to create a new “business test,” yet OTS cautioned such a mechanism would not provide instant simplification and would require the drawing up of definitions.

Still, the test should “reduce radically the size of the population potentially caught by the IR35 legislation,” and would end the “worry” for contractors of facing an IR35 enquiry.

“The great majority (90%+) of such businesses would know that they were outside IR35,” OTS said, “and attention (of advisers, businesses and HMRC) could focus on the remainder.”

It added that the details, definitions and assessments within the test, which sounds similar to Australia’s defunct 80:20 rule, could be investigated while IR35 is suspended.

However, OTS admitted that putting forward criteria to test being in business of one’s own account, which may include a maximum of six dividends a year, would be “in addition to the current [IR35] rules and the uncertainty these create.”

The office even considered imposing a mandatory salary on limited company directors, not dissimilar to the National Minimum Wage, but eventually rejected it for being too “unscientific.”

It also turned down the idea of placing the onus exclusively on the end-user to establish the IR35 status of each and every contractor they engage, which was suggested at its road-shows.

Finding fault with the idea, OTS said the engager would only ever see one contract, whereas IR35 “needs to be assessed on an overall basis”. For all three options – keeping IR35 with administration changes, suspending it before scrapping it or introducing a business test – the OTS spelt out the likely pros and cons.

These, the chancellor has 12 nights to consider to - contractors will hope - decide on a definitive course, as currently such workers may be operating with only a “little certainty” over their employment status.

However Mr Osborne has no duty to respond to each of the OTS’s three IR35 recommendations (four including the merging of income tax and NICs); he can merely choose.

OTS chair Michael Jack confirmed: “The ongoing involvement of the OTS on the issue of IR35 should be determined by the option that is chosen by the Chancellor.”

Turning to IR35, he added: “The integration of income tax and national insurance, including reducing the differential between rates applicable to different incomes and legal forms, could, for example remove much of the pressure on the employment and self-employment boundary and should result in the IR35 legislation becoming obsolete.”

And of all the topics OTS tackled in the review, IR35 “proved to be thorniest.”

It explained: “It encapsulates the tension between HMRC, who are tasked with applying the tax code in order to protect and gather revenues, and individual businesses who see IR35 as a barrier to them running profitable small enterprises with all the risks that this involves. What is clear is that no one method of reform currently commands universal support.”

Mr Jack conceded that the office’s findings, which will be firmed up in the summer and timetabled by the end of 2011, “may not satisfy those that have called for an immediate and radical overhaul” of IR35.

Perhaps also because of the lack of industry consensus about IR35’s future, he was unapologetic: “It is our view that this staggered approach best serves the interests of the small business community and taxpayers at large,” he said.

One services provider to IT contractors disagreed, saying the OTS has ‘missed an open goal’ to simplify IR35 which, in turn, could have encouraged existing and would-be contractors to thrive.  She slammed the “lack of incentives” to contractors and said “the wrong message” had been sent to the flexible workforce.

As a potential explanation, the report points out that the contractor workforce is much smaller engine of the economy than once was the case: “Compared to the early days of IR35, contracting itself is in a relative slump,” the report claims. “Based on 197,000 contracting jobs advertised in the first quarter of 2000; compared to the third quarter of 2010 with only 80,921 jobs.”

Further analysis of the OTS’s recommendations on IR35 and small business taxation will follow on CUK. The full report is available from the OTS website.