Why IR35 is bad for business

The UK government's IR35 proposals, which are part of the 'fairer' tax regime passing through the House of Commons, have generated considerable controversy.

The proposals will affect one-person service companies, and are part of the Welfare Reforms and Pensions Bill. IR35 is targeting individual consultants who set themselves up as limited companies, but work for a client on a more-or-less permanent basis and pay themselves a wage while taking additional revenue from share dividends.

Under current legislation, these limited companies get favourable tax and National Insurance rates to help their growth. However, the government believes there are many cases where people are using this law as a loophole to avoid tax.

Social Security minister, Stephen Timms, told MPs during the second reading of the Bill in the House of Commons that this kind of practice is "simply not fair on other workers who are employed directly and who do not avoid their National Insurance contributions".

Apart from claims of making the system more equitable, some proponents of IR35 say that it will add balance to the IT industry, which has a heavy reliance on consultants: get them to pay more tax, and they might well go back in-house again, the story goes.

The government is keen to stress that end users will be the ultimate beneficiaries. Permanent staff will be cheaper to employ than their temporary counterparts. The legislation should also make it less attractive for trained and experienced staff to leave full-time employment with a company on a Friday, and go back in on Monday as a consultant.

However, the weight of argument against these changes is increasing. For a start, the actual number of consultants who abuse the law is very small, according to Iain Sutherland, director of IT contracts accountants 3 Sixty Group. He said: "It is in less than two per cent of cases that this goes on."

He added: "The government admitted that IR35 would force all one-man service companies to pay higher levels of National Insurance than they currently do - whether they are genuine small businesses or not."

The stark choice for these small operators is to pay more tax and charge the customer more (and hence risk pricing themselves out of business), or simply give up the ghost and return to full-time employment. The government's own Regulatory Impact Assessment showed that 66,000 one-person service companies would be put out of business and forced back into permanent employment as a direct result of IR35. But David Ramsden, director of the Professional Contractors Group (PCG), believes these figures are a serious underestimate, and puts the real figure in the hundreds of thousands. They aren't all dodgy dealers...

Some end users - the very group the legislation is supposed to help - also see no problem with the current situation. Contractors provide a flexible workforce that is much needed in the IT industry. IT projects tend to be short-term and it is often more practical to bring in a contractor to do the job rather than invest in permanent staff.

One UK IT manager for a global telecoms provider told Silion.com: "Companies are often forced down the contract route, not through the lack of ability or desire to hire permanent staff, but through headcount restrictions on permanent employees - thereby forcing the need for contractors to complete specific projects."

One finance director said: "For IT specifically, it would be financially better to have a full-time member of staff, but that is virtually impossible because contractors provide a specialist skill, and while there is a skills shortage they will continue to command high wages."

Research carried out by the 3 Sixty Group among managing directors and IT directors in some of the top FTSE 100 companies in the UK - such as BAA, LloydsTSB and Shell UK - showed that IR35 will not change this. It found that most respondents would continue to hire short-term contract staff and if the IR35 legislation forced contractors to increase their charges, companies would simply pay more for their services.

It's not just the legitimate sole traders and small companies that may lose out: end users themselves may well suffer if they're forced to take on more full-time IT staff. Their wages are likely to be high. There will also be administrative and legal costs, as companies have to process more National Insurance contributions, tax payments, holidays, pensions and so on. The 3 Sixty Group predicts the total cost of hiring contractors will rise by around 25 per cent. As a result, many multinational companies said they would take drastic action. Thirty per cent said they would definitely move projects abroad, while another 35 per cent said they would consider it.

But it won't just be companies moving their operations out of the UK. Thirty per cent of IT contractors would also leave, creating a brain-drain in what is already a market short of skilled workers.

The 3 Sixty Group concluded that IR35, which is intended to generate more than £450m in the first year for the Inland Revenue, is likely to cost industry £2.1bn as a whole.

Although most in the industry agree that people abusing the system should be forced to pay the correct levels of tax and NI, this legislation does not provide the level of distinction necessary for such a complex issue. It also doesn't tackle the issue of enforcement - will the burden of proof fall on the company hiring the company, and in so doing add to the costs?

What is clear is that the government failed to consult the industry properly before introducing the IR35 proposals. It has also provided little evidence to support its claims that this legislation is really what end users want. The manner in which IR35 has been passed through Parliament - being tacked onto the end of the Welfare Reforms and Pensions Bill after the committee stage in the House of Commons had taken place - is also questionable.

It now looks unlikely that one-person service companies will escape from the clutches of the Inland Revenue. The only hope is that the House of Lords will listen to the businesses it is trying to 'help' and make the necessary amendments at its own committee stage to prevent it becoming a fait accompli for British business.

For further information see: http://www.360-group.com , http://www.engineerjob.com and http://www.dss.gov.uk/hq/pubs/welfria/append6.htm