personal finance

Freelancers face a looming tax nightmare


Peter Aveyard, 56, an IT business analyst working for a large supermarket group, started contracting three years ago. He loves the flexibility of his new career and is clear he “would never go permanent again”.

But his status as a self-employed contractor could be taken away from him next year, due to far-reaching changes to a complex tax law on “off-payroll working rules”. These hand the decision about whether certain freelancers should be considered self-employed to the company doing the hiring.

The reform will have serious consequences for hundreds of thousands of companies and contractors, with hirers facing potentially higher costs and some workers looking at significant cuts to their income, as well as an extra administrative burden to both. Mr Aveyard, for instance, fears he could suffer a potential pay cut of up to 25 per cent if his hirer decides he is employed for tax purposes.

“There’s so much uncertainty around, contractors don’t really know what our clients are going to do,” he says. “A lot of the clients really don’t understand the rules.”

Were he to be classified as employed, he believes he has three options — try another client, take early retirement or move abroad — none of which he wants to do. As firms and contractors begin facing up to the unpalatable scenarios created by the impending tax reforms, FT Money looks at the ramifications of the rule changes and how freelancers and their clients can navigate the challenges ahead.

HMRC’s crackdown

The off-payroll rules were first introduced in 2000 by the then chancellor Gordon Brown. Known as “IR35” after the government release which announced the policy, the rules are designed to crack down on tax avoidance by people who HM Revenue & Customs considers to be “disguised employees”. These are contractors who work in a very similar way to traditional employees but, because they bill for their services via a limited company, gain an advantage by paying corporate rather than employment taxes.

Until recently, contractors using these limited company structures were responsible for judging whether they were “inside IR35” rules — and therefore required to pay income tax and employees’ national insurance contributions — or “outside IR35” and liable for corporate taxes. From 2017, however, the government changed the law so that public sector organisations hiring contractors had to assess whether IR35 applied to these workers. Hiring companies and recruitment agencies are liable for any unpaid tax if HMRC finds that a worker has been incorrectly classified.

From April 2020, the policy is due to be rolled out to the much larger private sector. All companies — apart from those with fewer than 50 employees or less than £10.2m annual turnover — will need to decide whether IR35 rules apply to their contractors. The Institute of Directors, the business lobby group, has warned: “The IR35 extension [to the private sector] is going to be a big headache for contractors and firms.”

HMRC says hiring companies will need to prove they have taken “reasonable care” to assess the IR35 status of their contractors. If they fail to do so they risk being liable for any shortfall in tax and national insurance. Joe Tully, managing director at Brookson Legal Services, a law firm focused on IR35, says businesses should be auditing their contractor workforce now to understand the level of risk they face from the reforms.

HMRC estimates around 230,000 personal service companies used by contractors may be affected by the rule change. It believes that while two-thirds of these people are genuinely self-employed, around one-third may be disguised employees.

“The cost of non-compliance with the off-payroll working rules in the private sector is growing and will reach £1.3bn a year by 2023-24,” HMRC said in a consultation document on the policy. “It is therefore right for the government to take action to address this to secure funds that could otherwise be spent on vital public services.”

One size fits all?

Professional bodies and business trade groups are urging the government to rethink the changes, warning they will embroil workers and companies in disputes and red tape. A lack of preparation by companies, coupled with poor understanding of the highly complex IR35 rules, risks many genuinely self-employed people being classified as employed, they warn.

The Institute of Chartered Accountants in England and Wales (ICAEW) has urged the government to delay the IR35 reforms until at least April 2021, saying businesses do not have enough time to plan because of hold-ups in the publication of government guidance.

Anita Monteith, technical lead and senior policy adviser at the ICAEW, is worried that underprepared companies will be tempted to take blanket decisions about their contractors — classifying them all as employed — to avoid future investigations by HMRC.

“There is no clear way to prevent companies blanketing,” she says. “The first people may know [they have been classified as an employee] is when they find out they have got rather less money because they have been paid through the payroll.

A survey of 500 companies by Brookson Legal Services also suggests blanketing will be commonplace. It found that 59 per cent of companies were considering taking a standardised approach to assessing their contractors — because they did not have the time to make decisions about them individually.

“Poorly-executed blanket approaches were attempted by many in the public sector, causing widespread problems,” says Brookson’s Mr Tully. Hirers might decide not to engage any more contractors using limited companies — or simply treat all of their contractors as caught in the employed net, he added.

HMRC has hit back at these claims, saying it has seen “no reliable evidence” that private sector firms will be unable to assess contractors properly. Evidence from the public sector reforms showed “most public authorities were making assessments on a case-by-case basis”, HMRC says.

“Applying a decision to a group of off-payroll workers with the same role, working practices and contractual conditions can be appropriate in some circumstances. [However] it is not right to rule all engagements to be within or outside the rules irrespective of the contractual terms and actual working arrangements.”

Pay problems

Tax experts warn that if a contractor is reclassified as employed that could mean a reduction in their take-home pay of up to 25 per cent, as hiring companies and recruiters seek to pass on the additional cost of employer’s national insurance. Once a contractors is deemed to be “inside IR35”, they are also unable to claim tax relief on travel and subsistence expenses, another potential hit to income.

“The issue with IR35 is that it raises an employers’ national insurance liability at 13.8 per cent,” says Seb Maley, chief executive of Qdos, a specialist IR35 advisory company. “In the public sector, most contractors who were determined as being inside IR35 were told they could only work through umbrella companies, which deduct an amount equivalent to the employer’s national insurance from the contractor’s gross income. They also charge a fee for their service and there may be further deductions for the Apprenticeship Levy.”

Dave Chaplin, chief executive of Contractor Calculator, adds: “Look at it this way. Two people are sitting at dinner, and the bill arrives for £100. HMRC steps in and says ‘The bill is now £20 more. The client’s portion is four-fifths of that, at about £16, and the contractor’s is an extra £4.’ Each party wants the other to pay the entire £20.”

In many cases, the battle to determine who wins will come down to the contractor’s bargaining power. Mr Chaplin says he has seen examples where clients who believe their contractors are within IR35 have forced them to accept lower wages. Other contractors with highly sought-after skills have renegotiated a higher day rate with their client to mean they are not out of pocket.

“Those with less bargain power will be oppressed,” he says. “Those who can least afford it will be most negatively affected.”

The painful choices soon to confront many freelancers are summed up by Mr Aveyard, the IT analyst. If his self-employed status were removed, he says, he would prefer to keep working. Moving abroad would be tricky as his family is based in the UK. “But if it’s a choice between your income suffering or having to go somewhere else to make sure your family get fed and watered then that’s what I would do,” he says.

To make the picture even trickier, the UK has different regimes for establishing a person’s employment status for tax purposes and employment rights.

Dawn Register, tax dispute resolution partner at accountant BDO, says: “The tax rules don’t correlate with your [employment] legal status, so whether you’re employed for tax purposes could be different from whether you’re considered a worker legally and entitled to employment rights like holiday pay, sick pay and unfair dismissal protection.

“You could end up in the awful situation where you are considered employed for tax purposes but don’t have any clear legal status as [an] employee.”

The ICAEW has called on the government to resolve this tension in the law. “Tax, national insurance contributions and legal status of work should be the same, certain and comprehensible,” it said in response to the government’s consultation on IR35. “Failing to address these issues will perpetuate the current uncertainty.”

What can contractors do?

People who disagree with the tax status decision made by their private sector client will be able to challenge it, according to HMRC’s consultation on the IR35 reforms. The government is proposing that hiring firms set up a disagreement process to provide contractors with the evidence a company has used to come to its decision. While the practical details have yet to be fully explained by HMRC, tax bodies have already issued warnings over the proposal.

“We are concerned that a client-led dispute process will not be robust enough and would be unenforceable by HMRC, potentially leaving the worker with no power to appeal the determination,” says the ICAEW, which wants a statutory appeals process.

Alternatively, a contractor deemed to be an employee for tax purposes might seek to gain employment rights via an employment tribunal. But contractors thinking about taking this route need to recognise HMRC may open inquiries into their past tax affairs if they had previously said they were self-employed but are later found to be entitled to employment rights, Mr Tully warns.

Advisers say the best thing contractors can do is to speak to their clients and recruitment agencies to see how they will be assessed. Contractors can try and predict what their employment status is likely to be under the rules, but working this out is difficult and they should seek advice from their accountants or tax advisers, suggests Ms Monteith.

The calculus will include factors such as the degree of autonomy the contractor has over their work, whether or not they can send a substitute in their place and how much “mutual obligation” exists in their relationship with their hiring company, explains Andy Chamberlain, deputy policy director at the Association of Independent Professionals and the Self-Employed (IPSE), a trade body.

“Contractors should remember their arrangement with their client should be one of a supplier providing a service,” he says. “They may need to start piecing together the evidence of them being outside IR35 to convince their client.”

Sarah Cardew, partner and head of tax at Irwin Mitchell, a law firm, says contractors “should also be proactive by taking on a variety of assignments and having a number of clients”.

Individuals should avoid using “weird and wonderful” arrangements which claim to get round the rules while maintaining income, adds Mr Maley. Contractors should look into umbrella companies, favouring those that are accredited with bodies such as the Freelancer & Contractor Services Association (FCSA).

Some may even want to consider becoming an employee. “They should crunch the numbers, do their research, and decide whether they have a future operating the way they are, or whether it’s time to return to permanent work,” Mr Chaplin says.

Meanwhile, IPSE and Mr Chaplin have both launched campaigns urging contractors to contact their MPs to halt the reforms.

“Low paid self-employed people are going to have their tax status decided by somebody else who has a vested interest in getting it wrong, and which means they will earn less money,” Mr Chaplin says. “How is that fair?”

‘Flawed’ assessment tool

A particular bone of contention between the government, companies and contractors is the tool HMRC has developed to assess whether a contractor should be classed as employed or self-employed for tax purposes.

The “check employment status for tax” (CEST) tool is deeply unpopular. All the tax experts who spoke to FT Money said there were problems with it. Critics of the tool say those who use it to assess their workers’ tax status should be very worried about the risk of erroneous classifications.

The tool, which HMRC admits can only give a result in 85 per cent of cases, has been condemned for missing out key criteria that has been established by tax case law as relevant to assessing whether IR35 applies.

Colin Ben-Nathan, chair of the Chartered Institute of Taxation’s employment taxes subcommittee, says the tool is still unable adequately to account for multiple engagements and contractual benefits such as holiday pay and maternity or paternity pay. “The lack of confidence in CEST will increase disputes between businesses and contractors and so lead to significant time and effort having to be expended by businesses, contractors, HMRC and the courts in trying to resolve them,” he says.

The Association of Independent Professionals and the Self-Employed (IPSE), a trade body, is also calling for a review to the “flawed” CEST tool and for it to be scrapped if it cannot be improved. “The tool massively oversimplifies hugely complex tax legislation to come out with clearly incorrect judgments — which have been overruled by several recent employment tribunal cases,” IPSE said, pointing to HMRC IR35 losses against TV presenters Lorraine Kelly and Kaye Adams.

HMRC strongly rejects the criticism levelled against CEST. “CEST was rigorously tested against known case law and settled cases,” the tax authority says. “It is accurate and HMRC stands by the result if the tool is used correctly.”

It acknowledged, however, that it would be making updates to CEST ahead of next year’s reform to improve its language and presentation. “This will include inbuilt guidance to ensure it still works effectively for customers,” it said.

Inside or out? How taxes compare

Employed and self-employed people currently pay tax in different ways. Employees have income tax and employees’ national insurance contributions automatically deducted from their pay packets. And their employers also pay employers’ national insurance at 13.8 per cent.

Self-employed sole traders pay tax through the self assessment system, declaring their business earnings on a tax return. They then pay self employed national insurance contributions at a lower rate than employees’, and also income tax.

In contrast, contractors working through limited companies pay themselves through a combination of salary and dividends. The company pays corporation tax on its income, minus allowable costs, including any salary paid out. The remaining profit will be either retained in the company or paid as a dividend.

Before 2016 there was a greater tax advantage from taking on work through a limited company, but changes to the way dividends are now taxed has reduced this benefit. The difference between what employees and contractors working through companies now pay in tax is less marked.



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