IR35 Guides - Are you inside or outside IR35?

In its interim report into small business taxation, the Office of Tax Simplification (OTS) provided three main alternatives to the current IR35 regime:

1. To suspend IR35, with the intention of permanent abolition.

2. Keep IR35 as it is, but improve the way HMRC administers it.

3. Create a 'genuine business' test to help provide certainty to people possibly affected by IR35.

The tax body has looked at each policy option in depth. In this article, we look at each proposal in more detail.

You can read the full OTS report here (PDF).

1. IR35 suspension, followed by possible abolition

In this scenario, the legislation would be suspended at a specific date, with a view to abolishing the rules at some stage, or even re-introducing them.

One of the major benefits to HM Treasury is that it would allow the authorities to monitor the response to the suspension, via metrics such as; the increased number of company formations, the movement of individuals from umbrella companies to limited companies (which are more tax efficient), and the changes to salary levels paid to directors in one or two man companies.

Many contractors use umbrella companies, as the tax benefits from using a limited company under IR35 are massively reduced. This situation might well be reversed under IR35 suspension, and NIC receipts to the Treasury could be significantly reduced as a result (even by as much as £200m per year).

However, the OTS acknowledges that the MSC legislation would deter the mass incorporation of contractors on an "industrial scale".

In the longer term, the integration of income tax and National Insurance would also remove some of the tax benefits of incorporating.

Clearly, the burden to contractors of compliance, the cost to HMRC of administration, and the uncertainty created by IR35, would be removed. The Government would need to balance these significant benefits against any loss in income the Treasury would suffer due to the drop in NICs caused by a suspension of IR35.

Although this option will be popular with many contractors for obvious reasons, will the Government be able to justify the potential loss of revenues at this time?, and could the fact that IR35 could be re-introduced at any time actually add more uncertainty to contractors?

Keep IR35 as it is, but improve the way HMRC administers it.

According to the OTS report;

"Many people have said that after 10+ years of experience, the burden of IR35 has fallen. Individuals organise themselves to fall outside as a matter of routine. However, that itself is a burden. It has been clear that a genuine fear exists amongst those within the freelance workforce. HMRC processes are central to this issue."

Any changes made to current HMRC processes would need to be significant, says the OTS, for this option to be viable.

Some of the recommendations include; improvement of the guidance available, for HMRC to be more consistent in the selection of cases for IR35 review, eliminating the risk of compliance for individuals who have taken 'reasonable care', standardising and shortening the IR35 investigation process to remove the stress caused to taxpayers, and the creation of a 'mediation service' when disputes occur.

The key for success is in removing the uncertainty to freelancers, and making sure that over 90% of them have certainty over their IR35 status.

In this scenario, IR35 would remain unchanged. If IR35 is targeted more effectively as a result, the increased Treasury NIC receipts may compensate for the higher costs of administering the legislation.

Clearly, this option is never going to appeal to the majority of contractors, although it could provide more certainty if the IR35 suspension option is something the Government is unprepared to go with at this time.

It will certainly appeal to umbrella company service providers who stand to lose a great deal from an IR35 suspension!

Create a 'genuine business' test

The final option offered by the OTS report is to provide certainty over IR35 status via the introduction of a well designed test, which would work alongside the existing legislation.

According to the OTS: "The clearer, pragmatic exclusion of genuine businesses from IR35 will lead to better understanding of the legislation and reduced costs of IR35 advice. For those that do not pass, compliance costs would remain unchanged, although they may face a higher chance of being investigated."

This option, more than the other two, would require a great deal of further thought to ensure that the tests created certainty, and were far more accurate in determining employment status than the current tools available.

In an ideal world, this option does seem to be a sensible one. However, it would be very difficult to define accurate tests. The OTS received some very strong views against the use of a 'genuine business' test during the consultation period.

Further Reading

You can gain more of an insight into the proposed workings of these options by reading the OTS interim report (PDF). Analysis of the costs/benefits of the three proposed options, as well as the discarded ones, start on Page 56.