IR35 and the future for contracting

IMG_0186There has been much discussion in recent weeks and months as to the effect that the HMRC rule changes will have on the availability of contractor resources to the public sector.

This article does not propose to cover old ground that can be readily found by a trawl of the web using search words “Public Sector”, “HMRC” and “IR35”.  Nor does this article propose to discuss the rights or wrongs of the IR35 rules.  Instead, the purpose of this article is to look at the impact that all of this is likely to have and what, possibly, we might witness in terms of changes in the market and it might respond.

The Problem

To date, the public sector has been employing large numbers of contract resources to deliver essential programmes.  In some cases, these contract resources have been performing very much as though they were interim staff (in other words within the IR35 rules) and in other cases they have been working as bona fide suppliers, delivering specific outcomes and in other ways satisfying the criteria that would see them outside IR35.

So far, it has been down to the individual contractor to make their own determination as to which camp they fall into and to meet their tax obligations accordingly.  This is not an easy task as there is a large amount of criteria that HMRC have outlined as IR35 determining factors and HMRC has estimated that only around 10% of contractors who should be working within IR35 are actually doing so.

So responsibility recently shifted from the individual contractor to determine if he or she fell within IR35, to it being the responsibility of the end client to make the determination. (It’s worth underlining here, that at the time of writing, this only affects public sector end clients: public sector bodies being defined as those that fall within scope of the Freedom of Information Act.)

In the event that a contractor is determined by the client to be within IR35, then National Insurance contributions and Income Tax will be deducted by the fee payer (the end client in cases where the contract is direct with the contractor or the agency or umbrella company where there is an intermediary) before the net amount is paid to the contractor. Depending on the individual circumstances of the contractor, this could represent a significant increase in a contractor’s tax bill, additionally compounded by the fact that, now that the contractor is treated effectively as an employee, business expenses would no longer be tax-deductible.

Taking on the task of making this determination is a major undertaking for public sector bodies – especially as few of them are likely to be specialists in this area of taxation.  The risks of making an incorrect determination are significant and include:-

  • Contractors who previously had determined that they were outside IR35 and now find themselves inside might decide that they have no option but to terminate their contracts.  There is a key point here not to be missed: the rules for determining whether a contract is “in” or “out” of IR35 have not changed.  All that has changed is who makes the determination.  Therefore if the determination is made by the client that a contract is inside IR35, it would logically follow that this applies to the whole life of the contract – not just from the 6th April 2017.  So by remaining on contract after an “in” determination, the contractor might implicitly be deemed to have accepted that determination for the whole of the contract and thus may leave themselves open to a retrospective tax assessment for unpaid income tax.  We believe that HMRC have stated that they have no current plans to follow this route, but neither do we believe they have committed to granting an amnesty. So it remains a personal judgement for the contractor as to whether he or she is willing to accept this risk.
  • A further risk is to the end client. We believe that where an end client determines that a contract is outside IR35, but a subsequent investigation by HMRC overturns that, the bill for income tax and NICs that should have been paid to date will land at the feet of the fee payer and this might ultimately be passed on to the end client. For this reason, we believe that many end clients may be tempted to take the low risk route and “rule” all of their contractors inside IR35 as a blanket decision, irrespective of what the IR35 rules would indicate based on working practice and contractual provisions of the individual. This does already appear to have happened in a number of cases, with a not-unexpected outcome that contractors are making preparations to leave their current assignments. According to industry press reports, some organisations may also have altogether ruled out working with contract resources that use limited companies.  [Further link]

What will the effect of this be?

We believe that a number of behaviours will be witnessed:

  • Those contractors currently working in the public sector, who are sufficiently marketable, will already be seeking alternative contracts in the private sector. This will inevitably constrain the public sector from delivering against their project commitments – particularly given that over recent years, the Civil Service has become a lot leaner and there isn’t the spare capacity in the permanent workforce to make up any shortfall that there might have been in the past.
  • The contractors who remain working in the public sector may only do so for a short while if they are unable to secure a rate increase to cover at least some of the loss in their take home pay. We have heard various estimates as to what would be needed to achieve this, varying from around 20% up to as much as 50% in cases where the contractor has travel and accommodation expenses that they can no longer offset as a business expense. Those contractors who are unable to secure a rate increase, may also leave their current assignments as the impact to their pay packets starts to be felt. Given that the private sector will have limited capacity to soak up this additional supply of resource, we believe it likely that many contractors will no longer see value in working within this model and will seek permanent employment.
  • Longer term, those contractors who have found alternative private sector assignments may find that their reprieve is short-lived. Although we believe that HMRC have said they have no current plans to do this, it would make sense to extend this approach to the private sector. Public sector clients, witnessing the “exodus” of contractors to the private sector, will in our view quite likely be lobbying to have the playing field levelled, so that those still attracted to working as contractors will not automatically be swayed in favour of one sector over another. According to one press article we have seen, HMRC may already be preparing the way for this. So if (when?) this approach is finally also applied to contracting in the private sector, we may see a second exodus of contractors leaving this working model altogether.

So in summary, we believe there will be a sharp reduction in the contractor workforce available to public sector, possibly coupled with price increases. Ultimately thereafter we believe the private sector will also be affected by this, leading to an overall fall in the number of people who are willing to work as contractors, where they risk falling within the IR35 rules, but without receiving the benefits that a full-time, salaried employee enjoys – namely pension, paid holiday and sickness leave, parental leave and protection against unfair dismissal.

A case, maybe, of killing the goose that laid the golden egg?

So what is the way forward?

What is clear is that, irrespective of the sector, there is demand to be able to call upon a pool of interim expertise to deliver short-term project outcomes. We don’t see that this is likely to change. Most organisations carry very little spare capacity within their permanent workforce and, to recruit additional permanent staff for the duration of a short (or even medium) term project is not likely to be seen as a realistic option.

Yet, despite this clear demand for contract staff, IR35 and this recent clampdown act as a disincentive for people to work in this manner.

We believe that the way forward, therefore, is to meet demand through a different model – namely in the form of micro-consultancies.

These deliver a consultancy service and behaving as a completely separate commercial entity to the client organisation. They are engaged to deliver specific outcomes, with clearly defined scope, they are entitled to substitute their nominated resource with another and in many other ways that clearly satisfy IR35 definitions, such as supervision, direction and control, can show that they are not in disguised employment. There may be additional measures that these consultancies will need to put in place so as to clearly demonstrate that they are truly outside the IR35 net. For example accepting an increased element of risk to show, for example, that errors in the services they deliver are put right in their own time and at their own expense. Maybe some consultancies might be prepared to accept slightly lower day rates but making up the difference through stage payments based on delivery milestones, thus clearly demonstrating acceptance of risk that failure to deliver satisfactorily means not being paid.

But client organisations also need to modify their approach to the engagement of these consultancy resources. For example:

  • They must be in agreement and fully prepared to accept a consultancy’s substitute (assuming in the case of public sector that that substitute holds adequate security clearance for example) in the event that the named resource becomes unavailable.
  • They must not seek to manage how, when or where where the services are delivered. (This isn’t, by the way, seeking to rule out the consultant being at a client site in order to attend progress or planning meetings, just as any other supplier would need to.)
  • Where the client develops a new set of requirements that are outside the scope of the delivery that the consultancy is contracted to deliver, then these need to be captured as a completely new set of requirements and let as a new contract.

There is some excellent advice on the web, for example here or here, that goes into more depth on some of the measures that can be taken to demonstrate that the rules do not apply.

In the case of the public sector, there is a framework that may enable this sort of service to be delivered. Known as the Digital Outcomes and Specialists 2 (DOS2) framework, requirements that are carefully scoped around a specific set of deliverables (outcomes), and which satisfy the rules for the service being out of IR35 scope, may be the way forward for clients who need external specialists to help them meet their project commitments.

Many companies, this one included, have been accepted onto the DOS2 framework and may be able to meet a requirement advertised through it. Care would still need to be taken to specify a requirement that clearly falls outside the IR35 rules and a trawl through some of the requirements currently being advertised through this framework show that suppliers are asking whether these are expected to fall inside or outside of the rules. Where the client responds that the requirement is (or is likely to be) outside IR35, we believe there will still be significant interest in bidding for the work.

Ultimately all “stakeholders” in the contracting and IR35 debacle are faced with a choice. Short of IR35 being taken completely off the table (desirable for contractors and the end clients alike – but ultimately unlikely) the options are to attempt to navigate minefield or to innovate and find a new way of doing business. We believe the above model might well be worth further consideration.