Taxing time for tech workers

An obscure section of the last Budget called IR35 threatens to drive thousands of IT contractors abroad. By John Whiting

Anyone starting their own business has a key decision. It doesn't have to be taken immediately, but at some stage it needs to be tackled: are you going to be a company or not? Going out as John Smith is simple and easy - but are you going to rank as employed or self-employed?

Anyone starting their own business has a key decision. It doesn't have to be taken immediately, but at some stage it needs to be tackled: are you going to be a company or not? Going out as John Smith is simple and easy - but are you going to rank as employed or self-employed?

You may think you are in business on your own account, but the tax man may think differently. John Smith Ltd will get fees, getting them paid on an invoice, and can supply John Smith's services. Then again, setting up and running a company costs money and time. This issue is in sharp focus, with the Inland Revenue's assault on "Personal Service Companies" (PSCs), usually known as IR35 after the number of the Revenue's press release that started this particular ball rolling. The Chancellor Gordon Brown has claimed tax is being avoided and that fairness at work is threatened - with adjacent staff on different tax bills and employees being forced out of employment.

Are there tax savings with a PSC? It has been possible to save tax - if you count National Insurance Contributions (NICs) as tax, as most non-politicians do - by operating through a PSC rather than being an employee. Anyone paid through a payroll pays NICs, as does their employer. Fees paid to a PSC are outside the NIC net; pay yourself a modest salary and take some NIC-free dividends, and tax savings are possible - even allowing for corporation tax.

Are there other reasons for using a PSC? But to stop at the tax-saving point misses the practical reason why most PSCs exist. Many people want to have a company to show substance. Among many factors, you can convince a prospective user of your services that you are there to stay if the letterhead says "John Smith Ltd". The company route will be easier to bring in employees, manage costs and generally run a business through for many people.

So who uses PSCs? PSCs have always been used. People in the IT industry are probably the most frequent users, with a lot in the oil industry as well. Many names in entertainment and sport have their own companies.

It can be more practical than acting as an individual in these sectors, given the range of activities that people can carry on, let alone the often short earnings span of today's megastar.

So why do the Revenue object? The Inland Revenue feel there are too many people operating through PSCs who would be employees if the PSC wasn't there and they worked directly for the client.

In other words, they look like employees to all intents and purposes - but they are not taxed like the employee at the next desk because of the use of the PSC.

Do the Revenue have a remedy? The Revenue's solution to this is to tax the PSC and its owner as if the owner was an employee of the client. In other words, if John Smith Ltd supplies John's services to Mega plc, then John Smith Ltd will either have to pay John the fees received from Mega as a salary - with PAYE and NIC - or will be taxed as if it had.

So where's the problem? The Revenue's stance may seem fair enough if John has worked full time for Mega through John Smith Ltd for many years with all the trappings of being an employee. (Though let's not forget that he won't be getting the employment benefits that Mega's employees will be getting.) But there will be a great number of cases where it isn't at all clear cut - so where is the dividing line? The IR35 test is whether you would be self employed without the "wrapper" of the PSC.

How do you prove you're self employed? You do not just say you are self-employed and everyone falls into line. Are you told what to do and how to do it? Are you given the necessary tools? Are you given a place of work and set hours? Do you have to do the job and no-one else? Are you paid by the hour/week/month? All these point towards employment. But are you hired for your expertise and left to do it your own way? Provide your own tools? Work where and when you need to do to do the job? Are you allowed to bring in others and can send a substitute? Generally have the trappings of business and do more than one task at a time? These point towards self-employment. It will be a balance - and it will also be an overall assessment.

Can you give me an example? There is another key factor - the number of jobs undertaken. There was a famous case a few years back concerning a TV vision mixer on programmes including Have I Got News for You. "Employed!" said the Revenue - on the basis that some of his contracts were long-term. "Not so," said the courts, as he worked for over 20 companies during the year and that made him self-employed. None was so dominant as to be a separate employment.

Why is a group of contractors challenging IR35 in the courts? Many PSC users feel that the new rules will cause them real financial loss and fail to reflect the fact that they are in business on their own account, even if they are at one organisation for a long time. There is talk of people being forced to move offshore to better fiscal climates. It has to be acknowledged that the rules we have now are considerably better than the original proposals and reflect a lot of hard work by tax advisers and others in convincing the authorities that changes had to be made. Given the Government's conviction that tax avoidance is around - and their well known antipathy to that particular activity - it is inevitable that some action will be taken. But the case now being taken claims that the IR35 rules are too oppressive and unfair. Those taking it have won the right to a proper Court hearing next February.

So are the IR35 rules going to be struck down? It's an intriguing prospect: The Courts saying that the Government has to cancel some tax law. Even if the taxpayers lose in the High Court, they could go on to challenge the law in Europe. The Government is sure of its ground and feels they have ended up with a reasonable solution at the end of the day. But I, and many others, will be watching the progress of the Court case with interest.

John Whiting is a chartered tax adviser at PricewaterhouseCoopers