New laws may make contracting less of an attractive proposition.
Tina Milton provides a cut-out-and-keep guide to IR35
What is IR35?
IR35 was the press release issued by the Inland Revenue at the
1999 budget. Alastair Kendrick, director of PAYE and NI solutions
at accountancy firm Ernst and Young explains, "It outlines the
Chancellor's proposed changes to the taxation of personal services
companies [otherwise know as limited companies]." It becomes law on
Friday.
Why do I need to know about it?
If you do contracting work it will impact the structure under
which you can operate and the amount you can earn. The purpose of
the IR35 legislation is to clamp down on tax avoidance by
contractors who work via limited companies.
Before April 5, to set up a limited company contractors
appointed themselves as director and became an employee of the
firm. They could draw a small salary to avoid paying large amounts
of tax and NI and receive dividends from the company which were
NI-free.
However, under the IR35 regime this structure is likely to
change. Each contract must be tested against the Schedule D
self-employment rules to determine the contractor's working status
- employed or self-employed.
Barry Roback, managing director of accountancy firm JSA,
explains, "If you are deemed to be on a self-employed contract,
then nothing has changed. You will be able to operate via a limited
company and enjoy all the benefits of dividends."
Contractors deemed to be employed will be treated for tax
purposes as PAYE, and subject to income tax and NI. Industry
pundits estimate that contractors deemed to be employed, and
therefore caught under IR35, will see their income will drop by
anything from 10% to 45%, depending on individual
circumstances.
How will IR35 change the contracting industry, if at
all?
A Freelance Informer survey of 1,000 contractors last autumn
revealed that 18% of contractors say they will work overseas if the
IR35 legislation is implemented. Threats of contractors working
abroad have been abundant, and a "brain-drain" is predicted.
Those that stay may look to go permanent but risk losing half
their income. Others are asking for rate increases of around 10%
from employers to compensate for income loss.
The IR35-friendly contract has been a much-talked about
solution. Julian Howes, senior partner at Gloucestershire-based
Graduate and Professional Financial Services, says, "To avoid IR35,
future contracts would have to include features such as a fixed
price for the whole contract rather than hourly rates, and
establish that the contractor has overall responsibility for the
work [ie complete control]."
But agencies and industry bodies alike emphasise that the paper
contract must reflect a contractor's true working practice.
What are the options?
There are several guises for operation. Contractors can work as
sole traders (or self-employed workers) and work directly for an IT
company, but they must fulfil the badges of self-employment, such
as deciding when and where they work, and by working under their
own supervision - for example, consultants who work from home.
Alternatively, agencies predict that the temporary/casual
scenario, where contractors become employees of an agency, is
likely to be adopted by new contractors. Permanent workers are more
cautious about making a total step into contracting from the
permanent world and may therefore want a halfway house.
Peter Searle, managing director of recruitment agency Computer
People, thinks that there will be more temps/casuals (or "permie
contractors") as a result of IR35. Via this method, Searle says, "a
contractor receives two-thirds more than they would as a permanent
worker." And as an employee of the agency would also receives
employment benefits such as holiday pay, sick pay etc.
Another option is to work as part of a management company. Under
this regime contractors become employees of the management company,
which then invoices the agency and deals with tax and social
security payments.
If contractors choose the management company or umbrella option,
it is important to establish whether they will receive any dividend
income from the company. Not all umbrella companies operate in the
same way.
Any contractors that work through a management company that pays
them a salary, and they do not receive an income from dividends,
will escape the IR35 rules as they are already being paid under
PAYE.
However, if they switch to what has been called a composite
company, where they receive both salary and dividends, then the
IR35 regulations would be applied to each of the contracts.
Which option will earn me the most money?
It is difficult to say. It will depend on the impact of IR35.
Kendrick points out, "Some people are saying that if many
contractors go overseas to avoid the legislation, then the staff
shortage will unveil pots of money to those that stay."
It is a mixed view. Contractors who want to push their rates up
to compensate for the legislation may encourage employers to use
permies to avoid paying more. It is a case of wait and see.
What are the pros and cons of working for an agency?
Time saving is the main advantage. Agencies find the contract,
which saves the contractor hunting around for work. Some agencies
also offer training discounts, bonus schemes and even share
options.
On the flip side, agencies will take their cut of a contractor's
income for services rendered. The burning question, according to
Gordon Morrison, partner at accountancy firm Wheawill and Sudworth,
is whether agencies will assist with IR35-friendly contracts.
What are the pros and cons of becoming a limited
company?
Up until now, by working via a limited company tax advantages
were available, but most of these will be outlawed by IR35.
But there are still some plus points even if a contractor is
caught under the IR35 regime. If a company falls foul, a contractor
will still be allowed to deduct normal expenses (Schedule E),
company pension contributions and up to 5% of contract value to
cover running costs of the company.
Contractors often shy away from the limited company option
because of the amount of administration it involves and the
responsibility that goes with it. There are many statutory
obligations to uphold. Kendrick says, "The contractor is liable for
the work of his company, and he must therefore cover himself with
the appropriate indemnity insurance."
Are there any more laws on the cards that will affect
contractors?
No, not that the industry is aware of. But Kendrick predicts
that the Inland Revenue is aware of contractors' plans to get
around IR35 and will attempt to close loopholes in legislation in
future.
Will I be hit by the same tax rules if I work abroad?
The IR35 tax rules won't apply if a contractor works abroad,
according to Kendrick. "But there are tax rules that may bring you
back into a similar position in other countries," he warns.
In Europe, Holland has the best tax levels, followed by Germany
and Belgium, according to Patrick Spaight, manager at recruitment
agency Volt Europe.
Where can I find out more?
Seek professional financial advice from an accountant, or
contact the Inland Revenue. Many of the IR35 Web sites are a good
information source to keep updated with the latest movements. Below
are some of the most useful sites:
Tina Milton is Web editor on Freelance Informer
magazine