IR35 – A very public issue

From the 6th April 2017 we will see a new divide in the way contractors working for the public and private sector are treated.  From this date the way IR35 will be administered for Personal Service Companies (PSCs) – limited companies operating in public sector organisations – will change. 

IR35 is a regulation intended to minimise tax avoidance by people supplying their services to an organisation by incorporating as a PCS, who would be considered an employee if the intermediary was not used.  Such workers are called ‘disguised employees’ by Her Majesty’s Revenue and Customs (HMRC). 

At present, employment businesses do not deduct PAYE and National Insurance contributions at source from interim managers operating as Personal Service Companies (PSC), the PSC is held liable to make the correct tax contributions. Where an interim manager operates via an umbrella company that entity holds the responsibility for deducting the correct PAYE and NICS, it lies under a Contract of Employment not a Contract for Services and falls outside the scope of IR35.

While Local Authorities have largely set out their policy positions they are far from ready for 6 April. Most are refusing pay rises for contractors and interim managers who will have to move inside IR35 on the basis that they should have been paying full employment taxes in the first place. Some, worryingly, are stating that all contractors and interims are inside IR35 and are ignoring the HMRC test. Most are taking case by case decisions on how to retain key individuals.

Public Sector organisations will now be required to determine whether an engagement is inside or outside IR35 using a recently launched online tool.  Those assignments deemed outside IR35 will continue as before and the PSC remains solely responsible for the correct payment of tax. However, these will only account for a small proportion of assignments going forward – perhaps no more than 20-30% or so.

In essence, all that is changing is the shift of liability for the deduction of correct taxes away from the interim (operating as a limited company) to the organisation paying that person. Typically that is a recruitment agency but occasionally that is the Local Authority itself.  It is now the Local Authority’s responsibility to determine the IR35 status of the work being delivered by the interim (i.e. inside or outside) and to inform the recruitment agency of that outcome. The recruitment agency then is responsible for and indeed liable for the correct deduction of taxes and for the payment of Employer’s National Insurance back to HMRC.

It’s a very public issue as commentators have argued that it could cause public sector bodies, such as the NHS, to lose out in the war on talent, drive wage inflation and increase risk.

The changes to the IR35 tax system for contractors and interims operating in the Public Sector are already having an adverse effect on the market. Whilst we support a fair taxation system, the net effect will be to drive away talented individuals from the Public Sector and to increase the cost burden when public bodies hire to new roles.   

Specialists with transferable skills in areas such as IT, engineering and change management will be more inclined to work for private sector clients where there is greater freedom to operate outside IR35. 

At Green Park we have already seen clear upward movement on rate requirements from candidates when pricing new assignments, as well as for those with ongoing assignments that fall inside IR35. The new rule changes are reducing the flow of available talent for roles inside IR35 in the Public Sector and are increasing the cost of hiring to such posts by up to about 25%. Those roles likely account for circa 60-80% of all appointments and therefore the cost burden on a sector already strapped for cash is acute. Roles outside IR35 will continue to be managed as is.

Contractors and interim managers in ongoing assignments deemed inside IR35 will find themselves out of pocket, as PAYE and National Insurance will be deducted from them at source. The prevailing tax system has enabled contractors to tax themselves in a more efficient way to their permanently employed counterparts so there is little sympathy among Public Sector clients who are refusing to sign off rate increases for those currently contracted.

Inevitably this means that many assignments will end prematurely before 6th April solely due to these changes, which will further destabilises the market.  Contractors are unlikely to be willing to accept a significant income drop, if they can leave and will potentially take crucial project knowledge and expertise to the private sector.  This generates significant inefficiencies as new contractors will need to be recruited to infill these roles, inevitably at increased wage rates and there will likely be a productivity lag as people get up to speed. 

The Public Sector has long relied upon a flexible workforce, particularly for the delivery of critical savings and service improvement initiatives and these changes sadly put the continuity of such programmes at risk, at a time when the Public Sector is struggling with diminishing budgets.

HMRC asserts its belief that it is failing to collect over £400m annually from IR35 and has passed this responsibility onto the rest of the Public Sector and the recruitment industry, which is a clear sign that it has failed as far as IR35 is concerned. HMRC released the online tax assessment tool on 2 March. Whilst the test is not mandatory or legally binding and is only a guide, it is the best metric Authorities have available to test whether the scope and manner in which a role is delivered fall inside or outside IR35. Whatever additional revenue it does collect will be to the direct detriment of the wider Public Sector and in this case the Government is simply robbing Peter to pay Paul.

Additionally, if this move is a teaser towards an expanded application of the rules across the private sector we can expect to see rapid wage inflation, lower labour market flexibility as contractors switch to full time roles and even a brain drain as contractors move internationally to more favourable tax regimes.