Figures taken from an illustrative example within HMRC’s ‘Off-Payroll working in the private sector’ consultation show that 84% of the perceived tax shortfall resulting from IR35 is avoided by the hiring organisation, with just 16% attributable to the contractor.
This statistic may come as a shock to many, given that the taxman’s rhetoric surrounding IR35 and the new Off-Payroll tax has centred on tackling perceived tax avoidance among contractors. The news will be less surprising for contractors, who pay a level of tax on their income proportional with employees following the April 2016 changes to dividend taxation.
Non-compliance among public sector hirers has meant many organisations are yet to feel the full financial impact of the new Off-Payroll tax. However, a private sector rollout of the new legislation would prove costly for hiring firms, who can expect to spend roughly 10% more when engaging contractors.
How hirers are responsible for 84% of avoided tax
The table below derives from an illustrative example taken from page nine of HMRC’s consultation. It compares the tax yield from three working arrangements where the individual is engaged for 12 months:
- Thomas, an employee
- Charlie, a ‘non-compliant’ contractor working outside of IR35
- Charlie again, but this time working inside IR35.
In each scenario, the total cost to the hirer is £50,000.
| Thomas (employee) | Charlie (outside IR35) | Charlie (inside IR35) | Tax difference between Thomas and Charlie when outside IR35 | Proportion of tax difference | |
|---|---|---|---|---|---|
| Hirer taxes | £5,042 | £0 | £0 | £5,042 | 84% |
| Worker/contractor taxes | £11,006 | £10,018 | £15,042 | £988 | 16% |
| Post-tax income | £33,953 | £39,982 | £32,458 | ||
| Total tax deducted | £16,047 | £10,018 | £15,042 | £6,029 | |
The amount of tax deducted from Charlie when operating outside of IR35 is already very close to that of Thomas, the employee. Charlie pays £988 less tax overall but will also have company running costs of £1,500-£2,000 to consider.
Yet, in total, £6,029 more tax is deducted from Tom’s working arrangement than Charlie’s. This gulf is largely because the hirer doesn’t pay employer’s National Insurance (NI) on payments made to Charlie. This tax sum would be £5,042, meaning the hirer would be liable for 84% of the additional tax due if Charlie was employed.
However, when working inside IR35, employer’s NI is taken from Charlie’s income. As a result, Charlie pays £4,036 more tax than he would as an employee but is still ineligible for any form of workers’ rights from the hirer.
Despite this imbalance, HMRC places the blame for the perceived tax shortfall on Charlie when he is operating outside of IR35, stating: “As a result of Charlie’s non-compliance on this engagement, £5,023 less tax is paid”.
Off-Payroll: hirer non-compliance costing contractors and HMRC
HMRC has long used contractors as scapegoats for its perceived tax shortfall, portraying them as the tax avoiders. However, the Off-Payroll tax, which is new legislation in Chapter 10 of the Income Tax (Earnings and Pensions) Act, now legally requires that the hirer makes employer’s NI contributions on top of income paid to each contractor considered to be caught by the tax law – as they would for an employee.
Regrettably, this isn’t how things have panned out in the public sector, where hirers are found to have deducted their liability from the contractor’s payslip. As the table below demonstrates, not only is the contractor paying significantly more tax and earning considerably less, but HMRC’s tax yield is also suffering.
| Employee | Outside Off-Payroll | Inside Off-Payroll (Law) | Inside Off-Payroll (Reality) | ||
|---|---|---|---|---|---|
| Hirer taxes | £5,042 | £0 | £5,042 | £0 | |
| Worker/contractor taxes | £11,006 | £10,018 | £12,987 | £16,047 | |
| Post-tax income | £33,953 | £39,982 | £37,013 | £33,953 | |
| Total tax deducted | £16,047 | £10,018 | £18,029 | £16,047 |
While the hirer avoids a £5,042 employer’s NI bill, the contractor pays £3,060 more tax than they should, reducing their income by the same amount. Meanwhile, as a result of employer’s NI being taken from the contracting income, the taxman loses out on £1,981.
Tax avoidance among public sector hirers: who is to blame?
Non-compliance among hirers could be attributed somewhat to HMRC’s rhetoric and its failure to proportion the perceived avoided tax between contractor and hirer. Many organisations seem to believe that employers’ NI is legally deductible from the contract rate. It isn’t.
The emphasis that HMRC places on tackling supposed non-compliance among contractors, evidenced multiple times within its consultation and the accompanying ‘Off-Payroll factsheet’, only serves to promote this misinterpretation.
For the time being, HMRC has little incentive to offer any further clarification regarding the Off-Payroll tax. The taxman’s efforts to extend the new tax into the private sector would be met with far greater resistance if UK plc was aware that it was to assume liability for employer’s NI on top of the earnings paid out to each contractor.
Certain public-sector organisations have circumvented the tax and passed the liability on to the contingent workforce. The NHS is one of many organisations which has blanket assessed its entire contingent workforce as “deemed employees”, and forced its additional tax burden onto the worker, without providing them with any employment rights.
But though the NHS is saving money, the cost in real terms is far greater. The severe tax hikes suffered by locums are compounded by the fact that travel and accommodation expenses can no longer be claimed. As a result, travelling for work becomes a less viable option for locums, meaning skills shortages are intensifying. As workers leave the sector in their droves, the healthcare sector is losing the flexibility on which it greatly depends.
Off-Payroll in the private sector: the cost of non-compliance
As with the NHS, private sector firms are warned that failure to do right by their contractors will likely yield a similar outcome. The first step to avoiding a repeat of this scenario is to budget and plan for the impending increased business costs that the Off-Payroll tax will bring.
Unlike the NHS, the vast majority of private sector firms aren’t running a monopoly. Whereas the NHS has retained thousands of staff due only to the fact that these workers have few alternative options for healthcare employment, attempts in the private sector to oppress contractors through employer’s NI deductions will only cause them to find contracts with compliant firms.
Free-market pressures will likely lead to the renegotiation of rates. These can be hard to predict, but a good starting point is to consider the additional employer’s NI liability that will be due on current contract rates.
HMRC’s example calculation suggests that a hiring firm pays roughly £5,000 on a contract paying out £50,000, which indicates a 10% rise in the cost of engaging contingent labour.
If you are a contractor, you might like to share this article with your client, so that they can start budgeting for this tax increase. If you are a small business, and you don’t support the Government raising business taxation on your contingent staff by 10%, then you could consider lobbying against these proposals, by joining our campaign.