Freelancers are facing a taxing time

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The Independent Online

By David Heaton

By David Heaton

27 October 1999

THE THIRD reading of the Welfare Reform and Pensions Bill in the House of Lords today will be watched with apprehension by small consultancy businesses. From the Government's point of view this is just the latest crackdown on tax avoidance. It says it is simply closing the loophole that allowed individuals to disguise full-time employment, deferring income tax payments and avoiding National Insurance Contributions, by setting themselves up as "personal service" or "slave" companies and selling their services as consultants.

Some critics see the proposals as going against ministers' much-advertised enthusiasm for entrepreneurship by putting off freelances and small niche consultancies by loading them with expenses that put them at a disadvantage to larger competitors. They say many large businesses would not be where they are today if their founders had been forced into the proposed system from the outset. Estimates of the number of freelancers who will leave the market in April 2000 range from 60,000 (the Inland Revenue) to 300,000 (Adam Smith Institute survey report). Many have exportable skills and there is talk of a new "brain drain", or for information technology businesses a "geek leak".

The plans started life as the now-notorious proposal IR35 in the Budget earlier this year. The Revenue's original solution was to force the clients to apply the usual pay-as-you-earn rules for income tax and National Insurance Contributions when paying the consultancy's bills - unless the consultancy could produce a Revenue certificate rather like the certificates used in the construction industry, to demonstrate that it was "clean". But, after an unprecedented campaign of protest from contractors when IT specialists, in particular, used the Internet to marshal their forces, this idea was abandoned last month.

There was a further setback for ministers two weeks ago, when the House of Lords threw out the revised clauses on slave companies. Even so, costs for these businesses look set to increase in April, when they will be forced to pay tax and National Insurance on nearly all of their income from clients, leaving nothing in the pot for investment or training, because it is a safe bet that the proposals will come back. The tax changes will be in the Finance Bill, which the Lords cannot block, but it is not yet clear how the NIC changes will re-appear.

So what is the taxman so worried about? In a nutshell, disguised employment, as the practice is known, is seen as robbing the public purse of hundreds of millions of pounds a year because it enables freelance contractors to pay less in tax and National Insurance than the permanent staff they are working with. This is because a small niche consultancy, typically selling the skills of one person, may be organised as a limited company. The shareholder-director draws dividends instead of salary and pays income tax under self-assessment instead of paying tax as he or she goes. The deferral apparently costs the Treasury around £255m a year. The company also pays no NICs, costing another £220m.

The widespread antipathy to the crackdown stems from the belief that in trying to root out abuses the proposals threaten industries, such as IT, engineering and oil and gas, that rely on flexible labour to provide knowledge and skills not possessed by permanent staff or to deal with extra workloads. Genuine abusers include "consultants" who leave employment on Friday and return for his own small company on the Monday, doing the same job, at the same desk, with the same colleagues.

The Revenue has revised its proposals. But the concern remains. Under the new plans, all income of the consultancy from disguised employment would be treated as subject to PAYE and NICs, with an allowance for pension contributions, travel and subsistence expenses, employer NIC costs and 5 per cent of gross income for expenses. Even if it hadn't been taken as pay by the end of the tax year, it would be treated as paid out and the company would account for the tax and NIC. Money for investment and growth would come out of net income.

Those consultants deemed as genuinely self-employed (if they weren't inside a company wrapper) would be able to ignore the new rules. But the treatment of the consultant who has a mixture of income which falls either side of the line - such as writing, teaching, designing, programming, managing projects - is more of a grey area.

Personal service companies are now in limbo and will have mixed feelings towards their Lordships. The only certainty now is that tax advisers will be busy. And the complications will multiply if the tax rules apply from April but the NIC rules are delayed until later.

David Heaton is a tax director at KPMG

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