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IR35: The ‘Third Way’

Would another way of working spell the end for IR35?

Contained within the Office of Tax Simplifications’ (OTS) recent report on employment status is the suggestion of the introduction of a category of worker sitting between employment and self-employment that might provide a route to the abolition of IR35.

The report seeks to address the long-standing problem of employment status and whilst IR35 is not part of the OTS’s remit on this occasion, there is some synergy with the intermediaries legislation.

It was clear from the outset that the OTS were highly unlikely to solve the complex problem of employment status and instead their broad agenda was:

  1. To test whether there really was a problem.
  2. Why is it such a problem and what are the underlying causes and trends?
  3. Develop and assess possible routes to improve the situation.

Improvement routes are categorised under two broad headings, namely:

  1. Direct – actually tackling the definitions inherent in employment status.
  2. Indirect – changing the rules, tax and otherwise, that would take the sting out of the issue.

What was clear to the OTS is that the tax system is stuck in an out-of-date mindset more appropriate to the 1950s and 1960s.

In developing their ideas as to why a problem exists with employment status, the OTS arrived at three key points:

  1. The tax (mainly NIC) differential between employees and the self-employed is significant and as long as it exists there will be pressures on the employment status boundary from those who wish to gain an advantage or manage the risk of getting it wrong.
  2. Often of greater significance to business is the issue of employee rights.
  3. It is because the dividing line for status is blurred that it causes a lack of certainty and invites a ‘gaming’ of the rules.

Ultimately the aim is to develop ideas that lead to simple rules that can be readily applied in practice and easy to enforce and with this in mind the OTS has made a number of recommendations:

Code of principles

There should be a joint review between HMRC, Treasury, Department for Work and Pensions and the Department for Business, Innovation and Skills to examine the possibility of drawing up a coherent set of principles, developed from case law, to guide and govern decisions on employment status. However, the OTS remain pessimistic that this can be achieved and therefore at the very least there should be developed clearer guidance, including principles, for tax purposes.

Office holders

This term is outdated and confusing and should be removed from tax legislation. This would apply to both tax and NIC.

International comparisons

In more than half the countries that the OTS looked at it was found that there were more than two categories of employment, with the most common additional category being independent contractor or freelancer.

In Australia, a business engaging a contractor is required to withhold Pay As You Go (similar to PAYE) tax if:

  • the contractor does not quote their Australian business registration number to the business, in which case the business should withhold 49% from payments made to the freelancer; and
  • the business enters into a voluntary agreement with the contractor to withhold tax from payments made to the contractor.

In the USA, an ‘ABC’ test applies whereby to be considered an independent contractor an individual must meet all three of the following tests:

  1. The worker must be free from direction and control in the performance of the service, both under the contract of hire and in fact. (Essentially this is the common law definition).
    AND
  2. The worker’s services must be performed:
    EITHER:
    (1)  Outside the usual course of the employer’s business
    OR
    (2)  Outside all of the employer’s places of business.
    AND
  3. The worker must be customarily engaged in an independently established trade, occupation, profession or business of the same nature as the service being provided.

The OTS believes there are lessons we can learn from a number of countries.

Managing in practice

This involves the exploration of a set de minimis level for payments to an individual who carries out some activities for a business, which would definitely not be an employment. This might be in terms of time spent or payments made.

HMRC administration

All of the government’s guidance material on employment status should be unified in some form of ’employment status portal’, covering both tax and employment rights.

HMRC should establish an employment status helpline, where businesses are able to discuss specific queries with an HMRC officer possessing the requisite specialist knowledge.

HMRC’s guidance should contain more examples of common real life situations, showing how employment status case law applies to them.

The Revenue should consider allocating more resources to employment status and ensure that more of its employer compliance staff receive specialist training.

Employment status indicator (ESI) tool

The ESI tool allows the user to check the employment status of an individual or a group of workers but at present it cannot be used for PSC workers. It is regarded by the OTS as valuable and who believe that it should be maintained and improved by:

  • Including more ‘real-life- business examples.
  • Consider using more industry specific questions.
  • Improving some of the supporting guidance and help functions so as to give clearer answers.
  • Software improvements to prevent ‘freezing’.
  • Consider developing two or more versions of the ESI to apply to different major industry sectors.
  • Presentation and content should be influenced by who the main target of the ESI tool is, ie, individuals, businesses (small or large) or agents?

If these improvements are made then the results could be definitive.

Statutory employment test

This is an idea that the OTS are keen to see tested and would involve a set of rules enshrined in statute. These rules could either be:

  • Detailed – a comprehensive set of rules, dealing with all situations and reflecting all aspects of current law that are still relevant and appropriate.
  • Simple – a short set of quantitative tests that are easy to address and deal with.

In Australia, for instance, where more than 80% of income or time relates to one organisation, the individual is an employee.

An alternative would be to develop a de minimis approach thus:

  • Working for an organisation for more than X months continually would mean you are automatically an employee.
  • Working for less than Y days/weeks for an organisation (possibly over a year) means that you cannot be an employee.

Tax/NIC differences

Reiterating its recommendations made in its Small Business Review, the OTS emphasises that by merging tax and NIC would remove many of the anomalies within the tax system and contribute significantly to simplifying issues around status by reducing the differentials.

There should be a full study into the alignment of tax and NIC payments and benefits across the employed and self-employed.

Tackling employers NIC is the key to “taking the heat” out of the employment status issue. Whilst there is no easy way to abolish what is, in effect, a payroll tax, reform is needed in this area.

Deduction of tax at source

Apart from the Construction Industry Scheme, payments to the self-employed are not subject to any deduction of tax at source. The concept of a wider withholding tax for payments to self-employed workers is justified in the following broad terms:

  • The system could be designed to make it easy for hirers to decide whether or not to deduct tax.
  • Deducting tax would ensure the income is subject to some tax and would be logged on HMRC systems.
  • Proper integration with the wider tax system would mean that the worker would end up paying most of their tax liability throughout the year rather than afterwards.

A third way

This involves the introduction of a new category of worker, a ‘third way’ between the employed and self-employed, acknowledging that some workers do not fit easily into either of the two traditional positions and that they should be subject to a modified set of tax rules. Freelancers might fall into this ‘third way’ and who might be seen as people who have chosen this route of working and want certainty over their status.

However, this middle status would mean that those covered by it would have to accept the tax consequences that were part way between employed and self-employed. The Freelancer Limited Company idea, for instance, whereby the entity agrees to a fixed but fair salary:dividend split to ensure that some income is exposed to PAYE and NIC.

The OTS is not keen on this concept due to the many difficulties in establishing it fairly, although it has not ruled out returning to the idea should its proponents be able to address some of the OTS’s concerns.

Where there are any ‘quick wins’ that can be adopted from this report then it may be possible for these to be taken forward quickly. However, it is likely that should the report point towards significant reforms, these would be for the next government to consider.

The full report can be downloaded below.

Office of Tax Simplification: Employment Status Report

 

By Qdos Contractor

Comments

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3 thoughts on “IR35: The ‘Third Way’”

  1. mike

    The question shouldn’t be do contractors pay too little employee tax, employer tax and NICS? But the overall income HMRC recieve from a contractor. I am outside IR35 with contract income of £100k pa. HMRC recieve more income via reciept of my VAT payments £17k, corp tax £16k, and personal tax on dividends than they would recieve if it was taxed as an employee. That 100k would include my salary, employee tax, employers tax and NICS. HMRC would not recieve any VAT or corporation tax, and their cut would be less.

  2. kev

    if the client who is paying your invoice is VAT registered – don’t the govenment just end up refunding the VAT – in which case there seems little point in collecting it in the first place

  3. Andrew Harrison

    Very brief mention in the article of dividends. I think they should have mentioned MDs of big companies who get share options and therefore are partially remunerated by capital gains and a future flow of dividends.

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