The term “IR35” refers to a piece of legislation introduced in 2000 aimed at addressing the inappropriate use of personal service companies (PSCs) to circumvent tax obligations.
Although a “personal service company” (PSC) lacks a legal definition, it’s commonly understood to be a limited company where the primary or sole shareholder is also its director. Instead of directly engaging with clients or working for other companies, this individual operates through their own company. Clients pay the PSC for the services provided by the individual without subtracting income tax or National Insurance contributions (NICs) as they would for an employee under PAYE.
This setup offers potential tax benefits for the individual, such as a broader range of deductible expenses against taxable profits, improved cash flow by preventing monthly tax deductions at source, and the option to receive payment through dividends rather than solely through earnings, avoiding NICs on this form of income. Client organizations may also reap financial advantages, as they avoid employer NICs and aren’t obligated to offer employee benefits like holiday pay and sick pay.
By the late 90s, there was rising concern about the widespread use of PSCs to mask situations where individuals were essentially operating as employees of their clients, all while enjoying these tax benefits. In response, the Labour Government in the March 1999 Budget announced provisions to allow tax authorities to scrutinize contractual relationships, especially where services were provided through an intermediary like a PSC, but the actual relationship between worker and client resembled employment. In such scenarios, for tax purposes, the engagement would be deemed employment. Initial proposals assigned client organizations the responsibility to determine the nature of each engagement.
These proposals drew significant controversy, with numerous businesses highlighting potential administrative strains due to the lack of a simplistic statutory test for determining employment status for tax reasons.
After consultations, a new strategy was unveiled by the Labour Government. Intermediaries would need to assess:
- Whether a worker’s services were provided under a contract between a client and an intermediary, and
- If the income would have been regarded as coming from an office or employment held by the worker under existing rules differentiating employment and self-employment income for tax purposes if a direct contract existed between the individual and the client.
If both conditions were met, the intermediary would be required to treat the payment similarly to employee earnings, namely, charge income tax under PAYE and Class 1 NICs.
This provision was incorporated into the Finance Act 2000 and became applicable from the 2000/01 tax year. The legislation is colloquially called “IR35”, deriving from the number of Budget press notices initially announcing this initiative.
IR35, for the past two decades, has sustained its controversial status, with abundant arguments advocating for its elimination.
Despite undergoing several reviews, successive governments have preserved it, viewing its abolition as a substantial fiscal risk to the Exchequer.
Throughout the following ten years, IR35 continued to stir disputes among freelancers, while the Labour Government persistently resisted appeals for its discontinuation.
In July 2010, the Coalition Government proclaimed that the freshly-formed Office of Tax Simplification (OTS) would scrutinize small business taxation, which encompassed investigating “alternative legislative approaches to IR35.” The OTS finalized its report just before the 2011 Budget, presenting several reform alternatives, including a fusion of income tax and NICs, which could render IR35 redundant. In the absence of significant structural alterations, the OTS proposed that IR35 could be suspended aiming towards abolition, modified to exempt specific businesses, or maintained but with certain adjustments in its implementation. During the 2011 Budget, the Government affirmed that IR35 would be preserved “as abolition would put substantial revenue at risk,” albeit with enhancements to its administration.
In its initial Budget post the 2015 General Election, the Conservative Government ensured that it would “engage with stakeholders this year on how to improve the effectiveness of existing intermediaries legislation.” A discussion document, released subsequently that month, invited responses by the end of September 2015. Regarding compliance, the document indicated that “in 2011/12 around 10,000 people paid tax under IR35, an estimated 10% of those who should have paid tax on at least part of the income their PSC receives under the legislation.”
The document posed a question concerning whether the responsibility for determining the applicability of IR35 should shift to the client instead of the PSC: “Under such an arrangement, those who engage a worker through a PSC would need to consider whether or not IR35 applies (in the same way as they would need to consider whether a worker should be self-employed or actually be an employee), and, if so, deduct the correct amounts of income tax and NICs as they would for direct employees.” It also sought opinions on whether the tests for determining the applicability of IR35 could be simplified, “such as requiring an engagement to last a certain minimum amount of time to be considered one of employment.”
In November 2015, speculations emerged that the Government intended to modify the rules so that any contractor with a placement exceeding one month would be integrated into the client’s payroll as an employee. However, contrary to expectations, no substantial reforms to the rules were announced by the Government at that point.
During this timeframe, apprehensions also arose regarding the engagement of Personal Service Companies (PSCs) by high-ranking personnel within the public sector, as well as by contractors affiliated with the BBC.
In 2012, skepticism surfaced concerning the extent of senior civil service staff being employed via a PSC. In May, Danny Alexander, the Chief Secretary to the Treasury at the time, disclosed details of a review of these employment strategies and alterations to how departments might designate individuals ‘off-payroll.’ Additionally, the Minister unveiled a consultation – anticipated in the 2012 Budget – on modifications to IR35. Concisely, any individual providing services through a PSC and assuming a senior, authoritative role for their client would be taxed as an employee. However, in December of the same year, the Government declared it would not advance with this proposal “because HMRC’s new approach to enforcing IR35, combined with the measures introduced in the public sector that year, are adequate to prevent losses through disguised employment in this manner.”
Moreover, there were reservations regarding the number of contractors collaborating with the BBC who provided their services through their respective PSCs, coupled with the corporation’s historical propensity to incentivize individuals to operate in this manner – arguably without adequately alerting staff to the potential risks of their placement being subjected to IR35. This matter was evaluated by the Digital, Culture, Media & Sport Committee during its 2018-19 inquiry into BBC pay, and also underwent scrutiny in an investigation by the National Audit Office in the summer of 2018, followed by a report from the Public Accounts Committee released in April 2019.
Several measures have been implemented since 2014 to address the exploitation of Personal Service Companies (PSCs) for tax evasion, including alterations to the operational framework of the IR35 rules in the public sector.
A variety of strategies have been initiated to prevent the utilization of this corporate structure for tax avoidance. Firstly, the Coalition Government, in the 2014 Budget, validated proposals designed to counteract the employment of offshore intermediaries for tax evasion, as well as to hinder UK-based agencies from utilizing fabricated contracts to mask employment as self-employment. Secondly, in November 2015, the incumbent Government announced that it would “limit tax relief for travel and subsistence expenses for workers engaged through an employment intermediary” applicable from April 2016, where the intermediary legislation was relevant.
Thirdly, the 2016 Budget introduced a Government proposal that, as of April 2017, public sector entities would be obliged to ensure that any contractors they employed were in compliance with IR35. A consultation process was initiated in May 2016, and during the 2016 Autumn Statement, the Government affirmed it would advance with this reform. This change was projected to generate approximately £890m over the span from 2017/18 to 2021/22. Concurrently, the Government dismissed the notion of adopting the same approach regarding the application of IR35 in the private sector or introducing a new IR35 application test based on the duration of the contractor’s contract.
After modifying the IR35 application within the public sector, the Government has enacted legislation to implement analogous alterations within the private sector, effective from April 2021.
Subsequent to the adaptation of IR35 enforcement in the public sector, anticipation mounted regarding the Government potentially expanding the new obligations for contractors’ clientele to the private sector.
In the Autumn Budget of 2017, the Government declared it would “engage in thorough consultation on how to address non-compliance within the private sector, leveraging the insights gained from public sector reforms.” This consultation commenced on 18 May 2018 and concluded on 10 August. The consultation paper emphasized that the extension of public sector reforms to the private sector was the preferred option of the Government. However, it acknowledged that “public entities encountered difficulties in adopting the reform, which raises concerns for businesses and individuals in the private sector.”
Simultaneously with the consultation document, HMRC released a brief factsheet on the proposed reform and specifics of an independently commissioned review of the impact of the public sector reforms on client organizations.
In the 2018 Budget, then-Chancellor Philip Hammond validated that the Government would enact this reform, applying to large and medium-sized businesses only from April 2020. At this juncture, the Government pledged to conduct an additional consultation concerning the specific operation of the new rules, which began on 5 March 2019 and concluded on 28 May.
Draft legislation to be incorporated into the subsequent Finance Bill was unveiled on 11 July 2019, featuring stipulations to this end, along with a summary of responses from the consultation and a fact sheet outlining the forthcoming changes and the Government’s rationale for reform.
Though IR35 wasn’t a focal point of the 2019 General Election campaign, all main parties indicated they would ‘review’ these IR35 reforms. On 7 January 2020, Treasury Minister Jesse Norman announced a review aimed at “addressing any persisting concerns from businesses and individuals regarding how the forthcoming reform will be executed.” The review results were revealed on 27 February, with the Government confirming several adaptations to facilitate the reform’s implementation. Chancellor Rishi Sunak did not highlight IR35 in his Budget statement on 11 March 2020, though the Budget report reaffirmed the Government’s stance that, “rectifying the fundamental unfairness of the non-compliance with the existing rules is appropriate, and the reform will therefore be legislated in Finance Bill 2020 … as previously disclosed.”
Nevertheless, on 17 March 2020, Treasury Minister Steve Barclay informed the House of a decision to postpone the reform’s implementation for a year, until April 2021, “in response to the continuous spread of COVID-19 to assist businesses and individuals.” A provision to this effect is now included in the Finance Act 2020 (specifically section 7 and Schedule 1 of the Act). This reform is projected to generate approximately £3.8 billion from 2020/21 to 2025/26.
Since this legislation’s approval, Ministers have resisted additional delays, and HMRC has released information regarding its assistance to organizations affected by these changes. This guidance stipulates, “customers won’t be penalized for inaccuracies during the first 12 months regarding off-payroll working rules, irrespective of when inaccuracies are spotted unless deliberate non-compliance is evident.” Amidst concerns about contractors beginning to pay under IR35 from April being assessed for prior years, the guidance also emphasizes that HMRC “will not utilize information obtained due to the off-payroll working rules changes to initiate a new compliance inquiry into returns for tax years before 2021 to 2022 unless fraud or criminal behavior is suspected.”
Source: https://commonslibrary.parliament.uk/research-briefings/sn05976/
