IR35 not working, MSC legislation seriously flawed

The Conservatives launched an attack on the new Managed Service Company (MSC) proposals during the recent Finance Bill debate on the 2nd May 2007.  They signaled their intention to continue to challenge some of the issues in the legislation as it continues its passage through the House of Commons where there is the opportunity to table and vote on amendments.  

Theresa Villiers, led for the Conservatives as the Shadow Chief Secretary to the Treasury, we have reproduced her speech which appeared in Hansard afterwards as it seems to capture all the concerns we have in relation to the legislation.

Amendment No. 1, which is in my name and the name of my hon. Friends, would postpone the application of schedule 3 and the measures in it until there has been time for a thorough consideration of the effects of the legislation, and time for the Government to report formally to Parliament on the impact of the provisions proposed on tax revenues, the labour market, the competitiveness of the UK economy, and the cost burdens that the provisions will impose.

In particular, I would like the report to dwell on the impact on freelance workers, contractors and small companies.

According to the Professional Contractors Group, there are just under 1 million freelance workers and contractors in the UK, and they make a significant contribution to gross domestic product, particularly in the information technology industry, where they play a pivotal role in keeping the country competitive.

Paragraph 2.1 of the Government’s consultation document on the proposals acknowledges the importance of varied working patterns in giving “businesses the flexibility to respond swiftly to new opportunities as they arise.”

The Opposition’s view is that imposing unreasonable new administrative burdens on the freelance and contractor community, as the Bill threatens to do, could significantly damage the ability of British business to compete in the globalised world economy.

The Opposition believe that the proposals implemented in schedule 3 by clause 25 are flawed, and that they need to be significantly revised if they are to achieve the Government’s stated goal of cracking down on abusive schemes without penalising legitimate freelance and self-employed workers.

It goes without saying that the Opposition support moves to crack down on illegal tax evasion with respect to freelance and self-employed workers, and as I acknowledged on Second Reading, we also support attempts to stop abusive tax schemes.

Indeed, we, like a number of people who have commented on schedule 3, have a degree of sympathy with some of the Government’s goals in the schedule.

If, in reality, a worker is an employee, and a service company is being used simply to reduce the amount of tax payable, there is a case for measures to tax the substance of the relationship, rather than the label that the parties choose to give it for tax-motivated reasons.

We would certainly be happy to work with the Government on reforming IR35 and on amending schedule 3 to try to target such situations and ensure that the workers in question pay their fair share of tax.

However, as I shall explain, schedule 3 as currently drafted has a much wider impact.

The schedule will place significant limits on the administrative functions that a genuine freelancer, in business on his or her own account, can outsource to advisers. It will force them to deal directly themselves with much more of the red tape that comes with incorporation, rather than delegating it to others.

Does the shadow Chief Secretary to the Treasury not accept that her amendment is inconsistent with protecting revenue, despite what she says?

As I shall come on to say, I think that a pause for reflection, thought and analysis of how we can get the legislation right could have a positive impact on tax revenue.

The first thing to note about schedule 3 is that the proposals are a clear acknowledgement that IR35 has failed.

If the Government had got IR35 right, they would not need to bring further complex legislation before the House to attempt to police the borderline between the employed and the self-employed.

Many hon. Members will remember that in 1999 the Government caused significant controversy in the freelance and contracted-out community with their proposals on IR35—so-called because they were not announced in the Chancellor’s Budget speech, but in Inland Revenue press notice 35.

The Government said at the time that that would raise £300 million for the Exchequer, and cost it just £55,000 a year ongoing to implement.

However, of the IR35 investigations known to the Professional Contractors Group, 1,405 concluded that the taxpayer in question was outside IR35, and only three concluded that the taxpayer was within its provisions.

The Government have repeatedly refused to publish any figures on the amount of revenue collected under IR35 or on its ongoing cost impact for contracts.

The truth is that IR35 has been a hugely expensive failure. It has left thousands of freelancers in an uncertain tax position and created serious difficulty in planning ahead.

It has cost untold millions in compliance checking, and whole galaxies of the blog universe have been devoted to the intricacies of IR35 compliance.

We appeal to the Government to postpone the implementation of schedule 3 to assess the reasons why its predecessor—IR35—failed; to consider the steps needed to ensure that schedule 3 is not a costly failure in the same way as its predecessor; and to establish whether the Treasury will undertake to measure the revenue raised by schedule 3, despite its refusal to do so in relation to IR35.

That investigation would provide an opportunity, too, to see whether IR35 is still necessary.

If schedule 3 is adopted, there will be an even more complex tax framework for the taxation of freelance workers who have incorporated than there was before.

Companies outside IR35 will be on one regime; companies inside IR35 will be on a second regime; and there will be a third regime for companies covered by schedule 3.

Yet again, the Government have introduced highly complex and controversial legislation that is not properly thought through.

They have found that it does not work properly, and to try to fix some of the problems that they created in their first round of tax law they are introducing more complex legislation that is not properly thought through either.

I should like to take the opportunity to explode a myth peddled in relation to both IR35 and schedule 3.

The proposals are not about employment protection.

The impact of schedule 3 will be to change the tax status of individuals working through companies that fall within the definition of a managed service company. It will not change their employment status.

Of course, it is wrong for people to be forced to give up their employment rights by being pushed unwillingly into managed service companies, but the proposals will not have any impact whatever on that problem.

If the Government wish to deal with it, that is not the way to do it.

A fundamental problem with schedule 3 is the collateral damage that it will cause. As drafted, the provision could hit many genuine freelancers who operate entirely legitimately and are genuinely self-employed—they are not employees.

The consultation document asserts that the “underlying nature” of the relationships established by workers in MSCs is “almost invariably” one of employment. No evidence is given to support that assertion in the consultation document, and the Professional Contractors Group has challenged it:
“This ignores the possibilities that MSCs can be used for commercial relationships, and often are. PCG has relatively few members who work via MSCs but those that do are generally conscious of IR35, have no wish to be employees and make a point of using IR35-compliant MSCs.
Several have contacted us following the announcement of the proposed changes to make it clear that they operate commercial relationships and are in no sense employees.”

The Chartered Institute of Taxation has looked at the problem, too, and it says:

“Our main concern is distinguishing between Managed Service Companies and Personal Service Companies...There are workers that operate through a PSC without failing IR35, but who do not have time to manage a company and will therefore outsource its functions to a professional...It is important that the legislation clearly distinguishes between these PSCs and MSCs.”

Freelancers who outsource part of the financial and administrative functions relating to their company to advisers are in danger of being caught by the provisions of schedule 3—that is a key point.

Outsourcing routine administrative work to allow the worker in question to concentrate on what he or she does best, whether it is IT, engineering and so on, could walk them straight into the clutches of schedule 3.

The nature of their working practices and their relationship with their end client is wholly irrelevant to their tax status under schedule 3.

The key question is posed by proposed new section 61B (1) (d) of the Income Tax (Earnings and Pensions) Act 2003—ITEPA—which is part of schedule 3. We must ask whether
“a person who carries on a business of promoting or facilitating the use of companies to provide the services of individuals...is involved with the company.”

That is the issue that determines tax status, and it is the relationship with specialist advisers that is critical to the whole framework.

Any company involved with an MSC provider is caught by schedule 3, whether someone is genuinely self-employed and in business on their own account or not.

Their factual relationship with their end client is wholly irrelevant under schedule 3.

The Law Society expressed concern that the test of involvement is “enormously wide”.

The question that every freelancer up and down the country must ask is whether her professional advisers could fall within the category of an MSC provider under the meaning of paragraph (d), and it is not an easy question to answer.

It is highly likely that, under the provision as drafted, it would take at least a couple of cases going through the courts to determine the answer, and the uncertainty surrounding the meaning of paragraph (d) is a critical reason for supporting amendment No. 1 and postponing the implementation of those proposals until they have been fully thought through.

Without qualification, paragraph (d) would hit any freelancer who uses an accountant to draw up her company tax returns, so its scope is narrowed by proposed new section 61B(3), which states:
“A person does not fall within subsection (1)(d) merely by virtue of providing legal or accountancy services in a professional capacity.”

The meaning attributed to that carve-out will be critical in determining the reach of the legislation.

There are at least three possible approaches to the carve-out and the type of services that are relevant in the context.

First, under a narrow approach, the carve-out would provide safe harbour only for basic, traditional accounting services such as book-keeping.

Secondly, the widest definition could cover any services ordinarily provided by accountants.

The third approach would apply to accounting services ordinarily provided in the course of an accountancy business.