Redrafted IR35 taxes the patience of contractors

The government has finally produced the redraft of its IR35 proposals to change the way contractors are taxed - and provoked fury.

Despite the passion the subject creates among those affected, there is little understanding of why the issue matters so much to those who say they keep the IT industry going by providing flexible, skilled - if pricey - supplements to the full-time workforce.

The original proposals were brought out in the Budget last March as one of a series of press releases issued by the Inland Revenue (IR) heralding this year's tax changes. As the last of 35 releases concerned with the IR, it carried the reference number IR35.

Chancellor of the Exchequer Gordon Brown's stated aim in the original release - which IT contractors do not contest - was to stop people leaving a full-time job on Friday and returning on Monday as a self-employed freelancer working through a one-person company, and thereby enjoying the tax advantages such a status brings.

Computing contractors, however, quickly realised that the change could easily be applied to 80-90 per cent of them, especially when the IR issued guidance notes advising that anyone reporting to a line manager would be taxed as if they were a full-time worker. In fact, any IT contractor working through their own company and hit by IR35 would be worse off than a full-timer.

At the moment it is common practice for freelancers to pay themselves a small salary - often the minimum wage of £7,500 - from the proceeds of their companies, to which all payments for work are made. They take the rest in corporate dividends.

Tax differentials

The reason is a big difference in tax rates. Salary is mostly taxed at 23 per cent basic rate, but is also hit by National Insurance (NI), adding another 10 per cent on earnings above £3,432 and up to a roof of £26,000. Dividends, however, are taxed at 20 per cent, with no NI. Both are charged at 40 per cent when gross income reaches £32,335.

However, the big difference is that companies have to match employees' NI with a further 12.2 per cent of their own, and there is no ceiling on this levy. If you are both employer and employee, as computer contractors working through one-person companies are, then abandoning dividends means higher income tax, and both employee and employer NI - with the last item representing the biggest cost. Contractors claimed that the IR35 changes would cost them a quarter of their net income.

The reaction was swift. The Professional Contractors' Group (PCG) was established by a marine engineer, Andy White, since engineers are another group that make extensive use of the one-person company structure. It quickly gained several thousand members, operating largely on the Internet for speed and economy. An experienced parliamentary lobbyist, David Ramsden, was subsequently appointed to co-ordinate its activities. The contractors' group of the British Computer Society (BCS) voted overwhelmingly to oppose the changes and support the PCG. Conservative MPs took an interest in the matter, and Peers spoke against it when the House of Lords debated clauses enabling the IR35 legislation in the Welfare Reform and Pensions Bill. Angry contractors wrote numerous letters, to Computing and other IT magazines. National newspapers also started taking an interest.

In July, the Paymaster General, Dawn Primarolo - who decides the government's position on IR35 - met with tax experts, and stated she had an open mind on the issue, leading to hopes of concessions for contractors. After all, the aim was to help those forced into single-person companies - by employers too stingy to pay NI or give too many rights at work - not to bash everyone's favourite high-growth part of the economy - wasn't it?

It appears not. The revised implementation of IR35 released last week reveals only modest concessions to IT contractors

Tim Warr, a chartered accountant who specialises in freelance computing staff, estimated that the first set of proposals would take an extra 20 per cent of an average contractor's income ? the revised ones 18 per cent ? and the contractors feel cheated . The Revenue say it is aiming to make one-person firms 'tax neutral' - with no advantage or disadvantage from full-time staff in terms of total cost to employer.

According to one of their representatives, the ministerial approval came through during a meeting with IR and Treasury civil servants, held on Wednesday last week, leading to the PCG describing the consultations as a 'sham'.

However, tax experts from outside IT have reversed many of their previous criticisms, so diminishing the pressure on the government to make further concessions.

Brain drain

What happens next is anyone's guess. A Department of Social Security assessment of IR35 assumed between 33,000-66,000 businesses would close as a result. The Conservatives, along with the PCG, said many freelancers may move abroad under the original proposals - and there is little overall difference in the new ones.

Mike Cullen, chairman of the BCS's contractor group, described last week's events as 'a great day for Holland', as that is where he thinks much IT work could go. Other freelancers may decide to become full-time consultants for outsourcers such as EDS, Cap Gemini or ICL.

Others may make use of a slight change in who will be hit by the new tax. The IR will now apply IR35 to those who work as if full-time employees - as IT freelancers currently tend to, on contracts which can often last at least six months - rather than those who report to a line manager. This is covered under existing guidelines on self-employment provided by the IR.

So, perhaps contractors will branch out into working concurrently for a number of clients. Others may form partnerships.

Indeed, chartered accountant Anne Redston, of Ernst & Young, said last week partnerships have a better chance of avoiding IR35, although this is not yet clear. Working entirely from home may also avoid the penalty.

However, the government's determination to charge one-person company contractors more tax is now clear. Thousands of freelancers will have to change radically the way they work - or go back to the relative security and lower pay of full-time employment.