Contractors face taxing time as IR35 gets final revision

The Inland Revenue last week released the definitive guide to its IR35 revision to contractors' tax, confirming that for many freelancers, their tax holiday is over.

The document seeks to clarify which contractors the Revenue will see as self-employed, and which it won't. The prize for self-employed status can be a quarter of a freelancer's net income, as such contractors will be allowed to retain the full tax advantage of working through their own company.

The whole IR35 saga sprung from the difference in taxes between normally earned income and company dividends, which attract a lower level of tax and, more significantly, are not subject to national insurance contributions.

Single-person company charges
To take advantage of this, many contractors in IT and other industries currently charge their clients through a single-person company. This company then pays its owner a modest annual salary, often between £6,000 and £12,000, with the freelancer then taking the rest of his or her income in lightly taxed dividends.

Since Chancellor Gordon Brown said this would change, in his Budget of last March, freelancers have been trying to defend this approach by pointing out they carry costs such as training and pensions, and have no guaranteed work or rates. Indeed, contractor rates in IT have fallen sharply in some skills over the last six months, but still remain significantly higher than equivalent full-time pay.

The original plan was that the Inland Revenue would tax contractors working through their own companies as full-timers. This approach was softened in September when the Revenue granted a 5 per cent exemption to allow for the cost of running a company, with the stated aim of creating a level playing field.

The end of concessions
Last week's document is likely to be the last major revision to the rules - and offers no such concessions. The Professional Contractors' Group, which has lobbied against what it sees as an unfair tax hike on its members since its establishment last spring, claimed in December that the Revenue would need an extra 2,000 staff to cope with queries from freelancers, as to whether their work qualified as self-employed and was therefore exempt.

The tax collector's response is to say that all standard job agency contracts of more than one month's duration, where the work is based in a client's office, will automatically be taxed as if the worker is employed - no appeals. That takes care of a big chunk of the country's IT contractors. Accountant 3 Sixty estimated that 40 per cent of freelancers will automatically fall under IR35, and another 40 per cent in the grey area.

The Inland Revenue's unequivocal statement stance was attacked by specialist chartered accountant Tim Warr. "This demonstrates arrogance in the extreme. It would appear that almost any contractor provided by an agency on a standard contract will have to fight the Inland Revenue through the courts if he believes that his engagement should be exempt," Warr wrote in this week's Computer Contractor magazine.

Good news in small doses
There are two small pieces of good news for contractors in last week's document, according to Anne Redston, chartered tax adviser at Ernst & Young. "The Revenue has highlighted how important it will be to have more than one contract," she said.

If contractors have multiple, simultaneous jobs on their books at the same time, this will help them gain self-employed status. "It emphasises the importance for [contractors'] companies to have some form of business opportunities of their own, rather than taking a series of contracts from agencies," she said.

Another change responds to contractors' requests that training be made tax-deductible. Although the government has not granted this wish, the Revenue said substantial spending on training is another way to win brownie points towards self-employed status. "I doubt if it will be enough on its own, but it will help," said Redston.

The Revenue will also consider factors including working from home, using one's own equipment, charging a fixed rate for a job and taking financial risks as pointers towards self-employment.

Scathing attack on the government
The Professional Contractors' Group (PCG) has been scathing of the government throughout the process of consultation and revision, and the tweaks announced last week did nothing to alter this.

"These guidelines are disappointing," said spokeswoman Susie Hughes. "They show that, despite the Treasury having no reasonable answer to the PCG's arguments and concerns, it has decided to railroad though this ill-conceived legislation."

"The government will learn to its cost that it can't dictate market forces, and there will be many casualties en route." The PCG is running a series of seminars for freelancers on what action to take.

Defeat for IR35 unlikely
Despite the hostility from parts of the IT industry, IR35 looks nearly certain to go ahead. The government must still make it law as part of the finance bill that follows the Chancellor's Budget speech this year, for it to come into effect this April. However, a defeat at this stage would be unlikely, especially since clauses enabling IR35 have already been passed as part of the Welfare Reform and Pensions bill.

Furthermore, Paymaster General Dawn Primarolo gave fresh backing to IR35 on 28 January, just before the Revenue's definitive guide was published.

"The proposals we have published will ensure that people who would otherwise be taxed as employees, but currently work through service companies - many of whom are very well paid - can no longer avoid paying the tax and NI [National Insurance] contributions that other employees have to pay," she wrote in a letter to the Financial Times. "That is only fair to all concerned."