IR35 in the private sector
The new IR35 legislation (or off-payroll working) which came into force on the 6th of April in the private sector will impact an estimated 180,000 contractors, freelancers and service workers who provide their services through an intermediary, such as a limited company or private service company (PSC) without which they would be fully employed, and the many thousands of businesses they engage with across the UK.
The reforms usher in a sizeable change as to where responsibility for tax now falls within the extended end-client to contractor supply chain. The fact that from today HMRC will be able to collect additional payments, where a contractor is deemed to be an employee in all but name, will have major repercussions for Britain’s burgeoning gig economy.
HMRC believes that many contractors who are operating in the same way as employees, are intentionally or unintentionally gaining a tax advantage over others working in the same way as them. The government has said that it wants to use IR35 to remove this unfair advantage, and at the same time increase its overall tax revenue.
Following the change, contractors who had previously seen fit to trade job security and benefits – such as pensions contributions, holiday, sick pay and parental leave – for a slightly higher salary, will be forced to pay the same tax and National Insurance Contributions (NIC) as full-time employees. This would mean that contractors would then be essentially doing the same work but for less, and without the perks that accompany full time employment.
As a result of the reforms, a freelance contractor in the UK for example, on £675 a day who earns around £160,000 - £170,000 a year, could see their salary cut to approximately £100,000 a year. Not all contractors will be willing, or able, to make the kind of lifestyle compromises that could come with taking such a pay cut. Many businesses fear an exodus of talented contractors – either abroad, or to British small and medium sized businesses, who are unaffected by the new reforms.
In this article, Graeme Strain, Commercial Director of New World Tech looks at how the new legislation will effect behavioural change in the use of contractors. He believes that whilst the government may rightly dictate how public sector bodies should operate, he questions whether this approach is appropriate for application to the private sector.
Originally introduced at the turn of the millennium, IR35 is a piece of anti-avoidance tax legislation designed by HMRC to close a loophole in the tax system to ensure contractors are paying the correct amount of tax based on the work they do and how it is performed. The new IR35 changes launched today will help generate an estimated £1.02bn in additional tax revenue during the 2021-22 tax year with the bulk of the money coming from missing employers’ NIC that are currently avoided or evaded altogether.
HMRC is of the view that allowing contractors to decide for themselves how they should be taxed is a system that has been used and abused in the past by individuals who have sought to mis-classify their engagements as outside IR35 so they can minimise their employment tax liabilities.
According to figures jointly published by HM Treasury and HMRC, the cost of non-compliance with IR35 within the private sector is on course to rise to £1.2bn by the 2022-2023 tax year. The departments have also previously claimed that shifting responsibility onto private sector end-clients for deciding how contractors should be taxed, will generate an additional £3bn in tax by 2023-2024.
The changes coming out today will basically have implications on three main groups:
Individuals who are supplying services through an intermediary, such as a limited company or PSC, without which they would be fully employed
Medium and large private-sector organisations (with 50 or more employees), which hire workers via a PSC
Recruitment agencies, umbrella companies, consultancies and other intermediaries which supply contractors to businesses on a flexible contractual basis.
Genuine freelancers and self-employed workers that can prove they operate outside of IR35 will not be affected by the reforms.
In a working arrangement where someone is hired on a permanent basis to perform a job, the company they work for (their employer) covers the cost of employers’ NIC. But in the world of flexible employment and contracting, the situation is a lot more complex.
Basic-rate employed taxpayers in the UK pay 20% tax on income above the personal allowance up to £50,000 (rising to £50,270 in 2021-22), and 12% in National Insurance on earnings between £9,500 and £50,000 in 2020-21 (£9,568-£50,270 in 2021-22), and 2% on any earnings over and above. Employers also contribute 13.8% in NI payments above the £9,500 threshold for each employee on their payroll.
But if a self-employed worker operates in the UK under their own limited company or PSC, they effectively employ themselves and can therefore reduce their earnings so that they can completely avoid or significantly reduce the amount of income tax and NI they pay. They can instead top up their salary with dividends which are taxed at a lower rate. This is perfectly legal, as long as the worker does not fall inside of IR35 rules. By doing this, instead of paying income tax rates of 20%, 40% and/or 45% on their salary (depending what income tax band they fall into), they might pay just 7.5%, 32.5% or 38.1% on dividend income.
Until today, a company using a self-employed contractor would not have to pay employer’s NI payments as the individual(s) are not on their payroll.
Originally due to come into force from 6 April 2020, the new private sector IR35 reforms, which were deferred to this year as a result of the Covid-19 pandemic and to give businesses more time to prepare, passes the responsibility for setting IR35 status and paying relevant tax from the contractor to the private sector business (or fee-payer) engaging them.
With the new legislation responsibility for paying employers’ NIC shifts up the supply chain to the organisation that pays the contractor’s intermediary, private company or PSC, as they are effectively considered to be the contractor’s employer for tax purposes. The fee-payer is the organisation directly above the contractor in the supply chain and could be the end client, an employment agency, a consultancy, umbrella company or managed services provider.
As well as ensuring the correct PAYE and employee’s NI deductions are taken from the contractor’s gross pay, the fee payer is now also liable for paying employers’ NIC at 13.8%. The new rules will not currently apply to the small businesses defined by the Companies Act 2006 as having an annual turnover less than £10.2 million, balance sheet total less than £5.1 million and less than 50 employees, although I would not be surprised if this changed in the future.
Many end-clients have already announced that they will cease engaging PSCs as part of their IR35 compliance strategies. In almost all of these cases, the firms in question have told contractors they can either apply for a permanent role with the firm or provide their services through an umbrella company.
The number of contractors working through umbrella companies is predicted to soar on the back of the private sector IR35 reforms coming into play, which is what happened when the same changes were introduced in the public sector in April 2017. To ensure employment agencies or umbrella companies can comfortably accommodate the cost of employers’ NI, the end-client could be asked to pay 13.8% more for the contractor’s services. Or the contractor could be asked to revise their day rate down by the same percentage to keep the overall cost of their engagement static.
Employers’ NIC is an extremely hot potato that no one in the extended labour supply chain wants to end up holding. HMRC’s messaging about how things will change under the new IR35 reforms focuses mainly on how firms in scope of the new rules will assume responsibility for conducting the IR35 status assessment instead of the contractor.
HMRC published a comprehensive update to its Employment status manual in early March 2021 that sought to flesh out its guidance on where liability for employers’ NIC should fall within the context of the incoming IR35 reforms. The previous month, however, HMRC apologised to attendees of an educational webinar for any confusion it may have caused after it neglected to include employers’ NI in an example shared during the session, setting out how payments work within the labour supply chain once the IR35 rules apply. This serves to highlight just how complex this issue is, if the government agency overseeing the reforms is also struggling to grasp how employers’ NIC should work.
So, what does this all really mean for businesses, third party service providers and contractors?
Going forward businesses that employ contractors direct will face a tricky choice: continue to treat contractors as contractors and risk a hefty fine if HMRC takes a different view – or treat them as employees with the additional costs and responsibilities this involves. Alternatively they could work with a managed services partner that provides services on a ‘services and statement of work’ basis that allows them to engage with the consulting marketplace and deploy a flexible scalable expert workforce whilst remaining compliant with the law.
Many people choose contracting for the flexibility it offers, but this flexibility will be lost if they go permanent. To some extent, it will depend on whether they believe they genuinely operate outside IR35, can prove this, and can find other clients offering suitable outside-IR35 assignments and of course how in-demand their specific skills are. Contractors deemed to be inside IR35 will still be able to continue working through a limited company, intermediary or umbrella company. The third party acting as the contractors’ employer, invoicing for and receiving payment from the end-client will makes the relevant tax deductions and pays the contractor their final take-home payment each week/month. And, vitally they will also need to pay 13.8% employer’s NIC to HMRC.
Working via an umbrella company also means that the contractor does not need to take on any of the director’s responsibilities, such as ensuring accounts and tax returns are submitted on time and the correct amounts of tax are paid, as these are done by the umbrella company. However, it is important to point out that not all umbrella companies are created equal and that there are promoters and operators of non-compliant umbrella companies that offer contractors take-home pay rates that are only possible to achieve by employing known disguised remuneration mechanisms.
These payment mechanisms include processing a small part of the contractor’s salary through the umbrella company’s payroll to minimise the amount of income tax they pay, while the rest of the money they are owed is paid out in the form of a non-taxable loan or annuity. Be wary of the indicators of a non-compliant scheme, such as dubious or unclear payment terms, or a lack of professional accreditation.
And also remember HMRC guidance clearly states that employer’s NIC cannot be deducted from the contractor’s day rate.
If you are a contractor working through an intermediary it is vital that you understand how the legislation works and apply best practice. This means you must meet HMRC’s definition of self-employment by making sure your work is project based, you are not managed by anyone client-side, you have not offered exclusivity to any clients and you have contracts linked to completion of services, as opposed to a continuous relationship.
Remember it is the end client who decides whether the contractor is inside IR35 or not. But remember it is possible for the contractor or the intermediary to challenge the status determination if they think it is wrong. The end client who made the determination will need to have processes in place for dealing with disagreements about determinations they make.
The new rules have already started to a significant shake up across the private sector and many large corporates, including HSBC Bank, Barclays, BP and consultancy giant Deloitte have recently announced they would reduce their use of contractors and look to hire many of these workers as employees to ensure complete compliance and avoid any risk of reputation harm as a result of falling foul of HMRC.
It is obvious that many hirers are not prepared to take risks when it comes to assessing employment status for fear of getting it wrong. Rather than review and assess each contract, which would be a time-consuming and admin-intensive process, firms are taking the cautious approach. In many cases it is a knee-jerk reaction in response to legislation that hirers perhaps don’t fully understand. Genuine self-employed contractors will miss out [on job opportunities], and so will the hiring firms.
Corporates are also likely to switch the procurement of project-related services away from contractors and umbrella companies and towards consulting firms operating under a specific statement of work (SoW). This reduces the IR35 risk for the end client and transfers it to the consulting firm, meaning that if the price is right, medium and large corporates will ultimately prefer to procure services in this way. Engagements that are focused on ‘outcomes’ and delivered by substitutable teams as opposed to individuals are likely to fall outside of IR35.
NWT provides a full spectrum of consulting services to our clients and is therefore heavily impacted by the new IR35 changes. We have been working with our clients and associates for some time to ensure that we, and they, are well positioned for the new legislation.
We have provided services on a ‘services and statement of work’ basis for some years now and have a portfolio of ‘as-a-service’ solutions that our clients can use to engage with our independent consulting marketplace and to continue to deploy a flexible scalable expert workforce whilst remaining compliant with the law.
NWT leverages an associate model drawing upon a pool of independent service providers who support project delivery for our own growth, to ameliorate fluctuations in demand and to draw upon specialist expertise on an ad hoc basis as projects necessitate.
Most of our clients are fully up-to-speed with their approaches and preparations for IR35 and the delay in implementing the changes has given them and us more time to prepare.
NWT recognises that change needs to be made but is concerned that the use of fear and risk as a tool to drive behavioural use of contractors in the private sector is not appropriate. The new legislation is overly onerous and there is a real risk that many private businesses will not be able to understand or correctly apply the requirements.
We believe it is vital that everyone understands that there needs to be a process in place that will deliver fair and consistent outcomes each time a contractor is engaged. Similarly, work evolves and so too will the nature of the relationship, contracts that were once outside IR35 could gradually find themselves inside and vice versa.
Contracts must be reviewed regularly to assess whether the relationship has changed. Systems must be in place to collect and stores assessment decisions (in case they are subsequently queried either internally or by HMRC) and ensure that any information stored meets GDPR and cybersecurity requirements.
We have been preparing for IR35 for some 18 months and have found that most consultants are pragmatic and flexible in considering each engagement whether ‘inside’ or ‘outside’ IR35. We will continue to deploy service providers who are set to fall inside IR35 on a contractual basis in a legal way. Despite the uncertainty of the new legislation, we believe that we are effectively positioned to provide a credible alternative to the contractor marketing, while ensuring our own exposure to these seismic reforms is minimised.
The solutions that enable NWT to comply with the new law, but still harness the agility and depth of talent from the gig economy, include:
A new ‘employed’ model (PAYE), where a consultant does not operate through a PSC but instead is engaged by NWT on a fixed term PAYE basis
A MSP solution – consisting of service output-based arrangements, with project service provision based on task completion and key deliverables
Client-led determination, where the client wishes to retain control on assessing each engagement on a case-by-case basis.
As HMRC’s interpretation of the IR35 legislation across the private sector remains unclear, it is likely to be some time before enough cases have been through the courts to provide sufficient clarity as to which employment arrangements fall within the legislation. Nevertheless, going forward the reforms materially shift the risk from individual contractors to clients and are likely to lead to more projects being delivered with a defined outcome, as opposed to a ‘body’ for a defined period.
For more information, please feel free to contact NWT’s Commercial Director Graeme Strain at Graeme.firstname.lastname@example.org