Contractors’ Questions: How might the IR35 rules change?

Contractor’s Question:Is there an overview of the recommended changes to the IR35 rules, as spelt out last week by the Office of Tax Simplification? I understand that it’s up to the chancellor if the OTS recommendations on IR35 are accepted or rejected, but how likely is each one to be taken forward? And do any of the recommendations look appealing to contractors?

Expert’s Answer:The overwhelming conclusion from the OTS is that absolute simplification of the UK’s tax system can only be brought about through major structural changes. The OTS’s key recommendations are that the government looks at reforming structure and that a timetable be drawn up by the end of the year. The two key areas that have been identified for attention are:

  • The unification of income tax and NICs;
  • Introducing a radical approach to taxation for the very smallest unincorporated businesses.

The alignment of NICs with income tax is not a new idea and is something that has been considered long before now but never deemed to be practical. Whilst it would simplify the rules and make IR35 obsolete, it would take a number of years to overhaul legislation. In the meantime the OTS has recommended two options for the government to consider along with a third alternative:

1. Suspend IR35 ahead of its abolition

Temporary suspension of IR35 would take effect from a specified date with a view to permanent abolition, but there would remain the option to reinstate legislation at some future point. The length of suspension would be linked to the timetable for investigating the unification of tax and NICs.

During suspension there would be no new IR35 investigations and the government would use this time to monitor the behavioural response to the removal of IR35, employing such criteria as:

  • The rate of incorporation;
  • Changes to directors salaries; and
  • Migration from umbrella companies and/or agency PAYE schemes into personal service companies.

Whilst suspension of IR35 would be welcomed by all freelancers, and the likes of the PCG, would it really be a viable option for the government? Lifting the IR35 sluice gate would surely result in a tide of newly incorporated businesses whose directors comprise of employees who had previously been prohibited from owning their own companies by IR35. Those ex-employees would no longer be contributing to the Treasury coffers by way of PAYE and NICs. Can the government really afford to waive this revenue during difficult economic times? It seems unlikely.

2. Keep IR35 in its current form

This recommendation comes with the proviso that HM Revenue & Customs’ administration processes are significantly improved and continually evaluated. Examples of how HMRC could achieve this are:

  • Publishing any new IR35 guidance and information on relevant contractor websites as well as their own;
  • Produce a list of “genuine business” criteria that individuals could use to self certify status with certainty;
  • Eliminate the risk of investigation for those that have demonstrably taken reasonable care, for example by conducting an IR35 review of contracts and working practices through a preferred supplier. HMRC to accept this opinion, with the proviso that there will be policing of the preferred suppliers list;
  • Involve IR35 specialists at the outset (the fact finding stage) once IR35 has been identified as a potential issue by the compliance review/enquiry;
  • Set a maximum investigation timescale, such as 12 months;
  • An independent review process for current and future IR35 enquiries carried out by IR35 specialists;
  • Introduce an independent mediation service similar to the role of ACAS. Where no agreement can be reached using such a service then cases could be fast tracked to a tribunal hearing.

Although most contractors would not be in favour of this proposal, it would only be a viable short-term measure to moderate the problem of IR35.

3. Create a ‘genuine business’ test (but keep IR35 in place)

Should the government choose not to implement either of the above options then they could consider introducing a genuine business test to exempt certain businesses from IR35 entirely. This proposal would involve a range of simple tests that businesses could apply to their situation and be able to depend on the outcome. The aim would be for “90%-plus” of businesses to know that they were outside of IR35 leaving HMRC to focus their attention on the remainder.

This is something that we have previously recommended and would welcome. However the OTS may be somewhat ambitious in its thinking that 90% or more of businesses would fall outside of IR35 when one examines the possible criteria it suggests. Some of these are as follows:

  • Diversity of paying customers during one year, say 4 different customers that contribute to a company’s turnover;
  • Minimum capital investment before setting up a company;
  • Dividends, say no more than 6 per year;
  • Minimum salary under PAYE, say one third of turnover;
  • At least three employees;
  • Providing equipment.

Whilst the OTS states that the criteria would require further discussion, their current blueprint appears to be restrictive and would give many contractors currently operating outside of IR35 a nasty shock.

The expert was Seb Maley, freelance services manager at Qdos Consulting.

Monday 14th Mar 2011