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IR35 and the Law of Unintended Consequences

freelancesupermarket.com newsroom

RSS 16 July 2009
Have you ever wondered why there has been such a huge rise in the number of people using tax avoidance schemes in recent years?

Well, a lot of this is directly attributable to the introduction of IR35 back in 2001.

In the past, tax planning was mainly the preserve of the rich and famous. However, more recently a plethora of schemes have been marketed at self-employed contractors (also known as freelancers). The individual sums involved are smaller but because they have been used on a much wider scale, the loss to the Exchequer is considerable.

There must be in the region of several hundred thousand contractors in this country, so this poses a very serious problem.

Background to IR35

The IR35 legislation was targeted at self-employed contractors, many of whom work in the IT and Telecoms industry. Prior to IR35, most contractors set up a limited company, paid themselves a small salary, and received the rest of their income as dividends. Not only is the tax treatment of dividends advantageous but also this arrangement significantly reduces Employers NI contributions.

Contractors are required by agencies and clients to operate through a Limited Liability Company, so they cannot benefit from the lower rates of national insurance enjoyed by sole traders.

Before IR35, a contractor could have expected to net about 75% of their gross income. Under IR35 they would be subject to PAYE and full Employers NIC, and their net income could have dropped to as low as 55%.

Self-employed contractors are, by nature, risk takers. It goes with the territory. They surrender the safety net of job security and employment benefits in return for a higher remuneration. They also have to be extremely resourceful to compete in what is a fiercely competitive market.

If a Government introduces legislation to attack their income then it should come as no surprise that a majority will seek out any means within the law to get around it.

Business as usual

Despite the introduction of IR35, many contractors have continued to operate their limited companies as though it simply never happened.  A whole industry has sprung up to help contractors draft contracts in such a way that their working practices fall outside the scope of the legislation. Many of these companies (eg. Qdos Consulting) also offer insurance products to cover the legal costs of any investigation by HMRC. However, even now there is still a lot of uncertainty around IR35, and as a result large numbers of contractors have turned to tax avoidance schemes instead.

Tax avoidance schemes

The tax avoidance industry were very quick to seize on the opportunity handed to them by IR35. In recent years, we have seen all manner of schemes emerging:

  • Managed Service Companies. The Government introduced legislation in 2007 to put a stop to MSCs and Composite companies
  • Double Taxation Agreements - Section 58 Finance Act 2008
  • Loans denominated in rapidly depreciating currencies
  • Employee Benefit Trusts
  • Offshore EBTs
  • Family Benefit Trusts
  • Foreign company dividends
  • Receiving income as a capital gain (exploiting the new lower rate of CGT)

And the list goes on.

Many of these schemes have attracted thousands of users. Even the introduction of the disclosure rules in 2004 has not curbed their proliferation. Although some of the schemes provide the contractor with a somewhat higher net income than running a limited company, none of them would have been viable prior to IR35. Any marginal benefit would simply not have compensated for the additional risk.

Most of the schemes typically charge around 10% of the contractor's gross income in fees. In other words, a large chunk of money that would previously have gone to the Exchequer is now lining the pockets of the tax avoidance promoters. This has allowed these companies to accumulate huge war chests so they can hire the best legal representation and vigorously fend off any challenges by HMRC or Government.

Hidden Costs of IR35

The combined effect of many contractors changing their working practices and the widespread use of tax avoidance schemes makes it doubtful whether net tax receipts have benefited that much from IR35. However, IR35 has also cost the taxpayer in other ways. HMRC have expended considerable time and money trying to enforce it. Despite undertaking many litigation proceedings, they have lost in all but a handful of cases. In addition to this, there has also been the relentless cost of investigating and plugging all the various loopholes exploited by the tax avoidance industry.


IR35 has singularly failed in its intentions. A lot of contractors have just modified their working practices and taken out insurance products to protect themselves from investigation. However, what should be of greater concern is that it has driven many into the arms of the tax avoidance industry. The Government has had to introduce raft after raft of legislation every year to close down ever more ingenious schemes.

In response to the Arctic Systems case, the Government has recently switched its attention to what it calls "income shifting". A large number of contractors currently engage in this practice, so if the Government brings in measures to curb this then it could encourage yet more people to turn to artificial schemes.

Until something fundamentally changes, the tax avoidance industry will continue to target the lucrative contractor market, and the Government will be forever fighting a losing battle.

© 2009 All rights reserved. Reproduction in whole or in part without permission is prohibited.
Image: The Sophistication of Mr. Lamp-shade by DerrickT

Nigel Jagger
16th July 2009

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