IR35 to be abolished - Beware son of IR35

The small business minister Mark Prisk is quoted as saying:

"We want to make sure that we could undertake a comprehensive review of small business taxation in a way that makes the need for the current IR35 legislation redundant,"

This follows on from the statement in the June Budget Red Book that the Coalition Government:

"remains committed to a review of IR35 and small business tax," and plans to "release further details shortly."

As I repeatedly tell accountants: Be careful what you wish for. Of course IR35 needs to go. BUT it will be replaced by "son of IR35" as part of the wider review of small business taxation. Related discussions have been ongoing for 2+ years as between ministers, shadow ministers (as were), Treasury, HMRC and the professional bodies.

The change of Government makes it easier to junk the rules that emanated from IR35. Many of those who comment on this subject however look at it only from one perspective. That of the genuine freelance contractor. The review however will inevitably also want to influence the following :

• The reluctance of some employers to take on more employees - perhaps due to recruitment restraints. So instead they only want to use freelancers;
• The preference of some employers to use freelancers (rather than employees) so that they can avoid responsibility for employers' NICs and employment regulations. Stories abound of unscrupulous employers sacking staff and then letting them continue working on similar terms. The difference being that the 'staff' have to supply their services through personal service companies;
• The fact that many self employed contractors only set up a personal service company in order to pay less tax than they would do if they continued to operate on a self employed basis; Others become aware of this opportunity after being persuaded to set up a company at the request of their 'employer';
  
• The insistence by some 'employers' that even genuine freelance contractors must provide their services via a personal service company. This approach means the 'employer' can never become liable for employers' NICs or PAYE no matter how aggressive HMRC argue the case. It also means that the 'risk' of a successful HMRC challenge moves from the employer to the personal service company (due to the IR 35 rules as they currently stand);
  
• 21st century working arrangements. The fact that someone has notified HMRC that they are self employed does not prevent them from also having a part time job as an employee. Equally a freelance contractor who normally works on a self employed basis could occasionally provide their services on terms that make them an employee (either on a full time or part time basis).
  

The Government will also want to ensure that:

• unscrupulous employers cannot evade their responsibilities and obligations under employment law and PAYE;
• contractors who choose to provide their services on a self employed basis are not motivated to do so through tax advantaged personal service companies. It is this latter 'abuse' that IR35 originally sought to prevent. And the announced tax changes from April 2011 again make this attractive from a tax planning perspective; and that
• genuinely self employed contractors do NOT become liable for the same tax as employees. This would be very unfair as contractors have no protection under employment laws and are not able to build up a contribution record for earnings related benefits.
  

Bottom line. We can reasonably expect the rules that emanated from the 35th Inland Revenue press release on Budget day 1999 (known as IR35) to be abolished. BUT there will be new rules to prevent undue tax avoidance. If the Coalition Government keep their promise of a new approach to tax policy making, we can expect to see a consultation over any specific new rules before they become law.

IR35 avoidance scheme - Dispute between the promoters

Full details of an old IR35 tax avoidance scheme are explained in the judgment from September 2009 of Montpelier v Jones and Morris.

The case centered on a dispute between various parties who had arguably either conceived, funded or promoted the scheme. The judgment includes:

• a summary of the background to the scheme which followed the introduction of 'IR35' in 1999;
• an explanation as to the development and promotion of the scheme from 2000-2003;
• names of all the companies involved including Montpelier Tax Planning (Isle of Man) Limited, Westwood, OMPS Limited, Contractor Solutions Limited ("CSL"), Executive Solutions Limited ("ESL"), MTM Consultants Limited, MTM (Isle of Man) Limited ('MTM') and www.suomotu.com.
  
• reference to Counsel's opinions (including those of David Milne QC, Philip Baker, Adrian Shipwright and Robert Argles) and extracts from some settled notes of conferences with Counsel;
• reference to E&Y London instructing E&Y IoM to withdraw from participation in the scheme, which was allegedly described as a "political hot potato";
• reference to alternative structures involving the use of Employee Benefit Trusts (EBTs);
• Montpelier's claims of breach of confidence, breach of copyright, passing off and procuring breaches of contract;
• The counterclaim by Mr Jones and Mr Morris that Montpelier repudiated contractual arrangements.

Although this was not a tax case the level of detail contained in the judgment will be of interest to anyone who advises on tax avoidance schemes. And also to those who shy away from them.

As I've indicated in previous posts here, the existence of Counsel's opinion does not guarantee that a scheme will succeed. The ultimate decision in this regard will rarely be known with certainty until after it has been tested in the courts. And that often means a long wait.

Contractors continue to lose out - Dragonfly case is just a symptom not a problem

The press have given plenty of space to the High Court decision last week in the case of Dragonfly Consultancy Ltd v HM Revenue & Customs. The case concerned a contractor, who had provided his services through both his own intermediary company and an agency to the AA. I will use this case to highlight some key points relevant to anyone who supplies their services to an 'employer' (or a company that would be their employer were it not for some special arrangements).

Raw facts
Mr Bessell, the contractor in question, had been working on the assumption that his company was not caught by IR35. HMRC believed otherwise and succeeded in their claim both before the special commissioner and the High Court. HMRC's argument was that Mr Bessell would have been an employee of the AA but for the imposition of his company (Dragonfly Consulting Ltd). HMRC's success means that the company is liable to account for tax in accordance with what we know as the IR35 rules.

Consequences
What does all this mean? Well, even if you're familiar with IR35 and the various indicators of an employment relationship, you would be forgiven for finding some of the reports a little confusing. (The case is complicated also be the fact that an agency was supplying the services of Dragonfly/Mr Bessell to the AA).

It is by no means clear why the taxpayer was encouraged to take his appeal to the High Court. As is generally well known, such appeals have to be on points of law. No new facts can be introduced. This is one of the reasons why it is SO critical to present the best possible case before the Commissioners. You get no second chances. Many taxpayers have come unstuck when considering an appeal only to find that their case was poorly presented and argued before the Commissioners.

Substitution
The detailed facts in this case are too complex to set out in this blog. Suffice it to say that, as reported in the press, the Judge placed particular emphasis on the lack of a 'right of substitution'. This was in the context of the contract between the agency and the AA - even though there was a right of substitution in the contract between Dragonfly and the agency. The Judge held that this right was ineffective in practice for a number of reasons. (eg: it wasn't replicated in the other contract, it never happened and was never likely to happen as the AA wanted the services of Mr Bessell personally).

Lessons
What this all seems to mean is that anyone involved in cases where the IR35 rules could be in prospect needs to be more confident than ever that:
- ALL of the contracts in the chain are watertight - ie they avoid any deemed employment status between the contractor and the end-user 'employer';
- The FACTS accord with the contractual terms;
- The end user 'employer' is also clear and consistent as regards the contractual terms and the facts. Thus, for example managers responsible for the contractor would need to treat him/her as an independent contractor.

Unchanged
As ever the most frustrating aspect of all such cases is the lack of joined up thinking as between employment law and tax law.

End user 'employers' are keen to avoid engaging contractors as employees. This is invariably due to a combination of:
a) the onerous legal obligations imposed on employers by employment laws; and
b) the obligations to pay employers' NIC at 12.8% of all staff pay. This is, in effect, seen as a payroll tax and best avoided by NOT taking on staff.
However it is the onerous obligations imposed by employment law that really drives the 'employer'. It must be as the daily rates received by independent contractors are often much, MUCH higher than the same people would earn if on 'staff'.

Underlying problem
Employers suffer few disadvantages if they refuse to engage workers as employees. That is as long as the 'employer' doesn't pay the independent contractors direct. If they do and HMRC successfully challenge the arrangements, then it is the 'employer' who is penalised.

This is what drove the rise of personal service companies. 'Employers' avoid the prospect of being liable for payroll taxes by refusing to engage independent contractors direct. In effect the 'employers' insist that the contractor forms their own company. This means that if there is a problem with the taxman it is down to the contractor and his personal service company to resolve.

For some years the tax system relevant to contractors who ran their business through such a company was very attractive. It favoured the extraction of income from such companies by way of dividends and this reduced the tax payable by the contractors on their earnings. And this led to the introduction of the IR35 rules (so called because they were initially set out in the 35th press release issued by the Inland Revenue on Budget Day 1999) . The aim of the legislation foreshadowed by that press release is to ensure that if someone is, in reality, an employee of the end user 'employer' the personal service (intermediary) company must effectively tax their income as earnings. This limits the possibilities to reduce taxes by drawing money out of the company by way of dividends.

In effect the only person who can lose is the contractor.

Dispensations dispensed like smarties

I've long been an advocate of employers seeking dispensations to cover straightforward business expense reimbursements. But I've just learned something rather shocking. Let me explain.

First, some background.
If the application for a dispensation is agreed by HMRC the employer has a reduced compliance burden. The other advantage is that the employees do not have to include the expense reimbursements on their tax returns and claim tax relief - to avoid being taxed thereon.

Earlier this year there were reports that HMRC was cracking down on contractor umbrella scheme dispensations. HMRC announced that they would not tolerate negligence or misrepresentation. They would be looking to identify expenses and benefits provided under a dispensation when they should have been subject to income tax and NICs. In such cases, said, HMRC they would pursue retrospectively the income tax and NICs liabilities due when the expenses payments and benefits were originally provided.

And it is these same contractor umbrella companies (and agencies) that are the target of a recent discussion paper, published jointly by HMRC and the Treasury, on tax relief for travel expenses. It focuses specifically on 'temporary workers and overarching contracts'.

Following on from the earlier announcement we learn (at para 6.2) that:

"some umbrella companies and employment agencies often urge their employees to claim the maximum amount their dispensation allows, regardless of whether these expenses were actually incurred, or that the underlying journey actually qualified for relief."

And at para 6.4 that:

"Evidence, both from HMRC compliance activity and anecdotally from the sector, suggests that the abuse of dispensations by umbrella companies is widespread"

So, you might wonder, as did I, why do HMRC continue to dispense dispensations like smarties when they are rightly concerned about the potential for abuse?

It was when reading Anne Redston's excellent Comment article on this subject in the current issue of Taxation magazine that I learned the answer and identified a solution.

Anne asks the same question as do I. She notes that:

The difficulty, apparently, is that HMRC have no way of identifying the umbrella companies in advance. The tax office receives a fairly standard dispensation request, and, in the interests of reducing red tape, agrees it, only to find out later that it is an umbrella with 3,000 temporary workers."

Is my answer to that issue too simple? It must be or surely HMRC would already have changed their procedure. Couldn’t HMRC simply put a cap on the number of employees that would be covered and the aggregate amounts that can be paid within the exemption granted by the dispensation? How difficult can it be to amend the application form? Or am I missing something obvious?