11. IR35: the end of a dream - A contractor's view

2001 saw with the introduction of the now famous IR35, more politely called the "Intermediaries legislation."

For many it was the end of a dream. Prior to the dot-com bust and before the millennium-bug was proved toothless, job boards had more positions than you could happily surf during lunchtime and rates swelled at every contract renewal.

Then disaster. Rates plummeted, positions were shed, IR35 bit into profits and long-time contractors with greater skills than a peregrine crossing a wind farm found themselves with long periods between contracts and rates that put their careers back fifteen years.

"If it wasn't annoying enough that work became thin on the ground and rates plummeted, the revenue told me I was not running a proper business" said Robert Wallace, contract software developer.

At the time, most IT freelancers happily worked via a limited company that employed just them, and perhaps a company secretary that might be the spouse or accountant or a friend. (The rules of limited companies back then required at least two shareholders and a company secretary.) The limited company added a legal barrier between the client and the freelancer so that commercial contracts could be applied rather than contracts of employment. With costs and administration for hiring permanent staff for short term roles simply not worth it to most companies, this legal status represented an excellent commercial proposition.

It's apparent that government officials and civil servants regarded this state of affairs as a "tax dodge". When running a limited company you gain certain payment advantages such as being able to pay dividends to shareholders, or the ability to pay expenses for costs incurred by staff in the day to day running of the business. These payments are not counted salary, and are therefore not subject to the usual taxes.

The Government decided that these contracts could be disguising a true employment relationship.

IR35 decreed that the contractual status between companies, and in particular between clients, agents and limited companies run by contractors was almost irrelevant, with the ("implied terms") day-to-day events in the working relationships and environment also to be considered in assessing whether a worker was employed or not.

Not employee but not self employed either

Suddenly, your tax status as a contractor was determined not just by the wording of the contracts but by the way your client treated you, how long you remained on site, whether you took orders from a project manager and a whole host of other tests used to determine if you were in fact not a contractor at all, but an employee.

If found to be caught by IR35, then the tax advantages of running a limited company would be largely lost. No wonder the world of contracting was up in arms.

Perhaps luckily, the rationale behind IR35 and the reality of its enforcement did not match up. HMRC largely failed to win cases it brought and contractors re-arranged their affairs, by contract and by subtle changes to working practice, so that IR35 no longer applied – or so they could argue.

HMRC is not supposed to dip into people's affairs at random, and yet the success rate, based on cases HMRC must have thought were sound, suggests HMRC consistently failed to understand the law. And more worryingly, HMRC seemed unable to re-interpret the law after each investigation fell apart.

But despite the embarrassing failure rate, HMRC said only, "HMRC continues to address compliance issues arising from the intermediaries legislation. HMRC uses compliance resources to achieve maximum effectiveness, and has increased efficiency by getting more value from the resources deployed, and taking a risk-based approach."

"IR35 is so awkward and complicated that even HMRC cannot understand how it works" said the Professional Contractors' Group.

But, if you thought an HMRC bloody nose was enough to keep them away from harrying IT contractors then think again. In April 2007 chancellor of the exchequer Gordon Brown introduced a crackdown on Managed Services Companies (MSC).

William Knight

Further reading on IR35.

Further reading on S660 & MSC legislation.