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Hundreds of thousands of contractors who hire themselves out through personal companies will see their average take-home pay reduced by about 13 per cent if the government pushes through plans for a tax clampdown.
HM Revenue & Customs has said that 90 per cent of contractors selling services to clients through so-called “personal service” companies are avoiding income tax and national insurance, which existing rules say they should pay.
The authority has proposed that from next April those who work for public sector bodies will have such taxes taken at source by their employers, before their fees are paid.
HMRC says its plan applies only to contracts that self-employed staff undertake in the public sector, although accountants believe it will eventually be extended to private sector companies, such as banks and asset managers.
Mark Groom, a partner at professional services group Deloitte, said: “The government will first get its own house in order and show that the public sector is doing things properly.
“The implication is that this then extends to the private sector, as a two-tier tax system for contractors would be odd.”
There are 309,000 personal services companies operating in the UK, according to freelancers’ trade body IPSE, though government estimates in 2012-13 put that number at 265,000.
Many people operating through these companies carry out a mix of private and public sector work, although those the government is targeting may be people who have worked for the same public body, in the same or similar roles, for several months or years.
According to calculations supplied by Deloitte, a contractor using a personal services company and not paying income tax or national insurance took home 13 per cent more, after tax, than they would if they were taxed as an employee.
Someone earning £105,000 a year — or £500 a day for 42 weeks — through a personal service company would take home £70,988 a year, according to Deloitte. But that person, who is currently paying corporation tax and income tax on dividends, would take home £61,553 if they were taxed as an employee.
At issue is a rule called IR35, which was introduced in 2000, but has never been widely followed by off-the-books workers.
Contractors often say they fail to follow it because the rules are difficult for them and their clients to understand and apply.
Under IR35, anyone hiring themselves out to a client in a way that makes them indistinguishable from a regular employee should pay income tax and national insurance. Contractors who earn their fees instead via personal companies pay corporation tax and tax on dividends, which are generally lower.
The authority has said that off-payroll workers using personal services companies cost the government £440m a year in lost tax revenues. It has previously failed to collect this money because of the complexity of the IR35 rule and the subjective nature of the definition of who is a worker and who is a supplier.
The test includes questions about whether a contractor is taking financial risk on a project, or bringing their own materials to a site.
Asked whether it would take action on contractors using personal services companies in the private sector, HMRC said in an emailed response that its proposal for taxing contractors at source would “only apply to public sector bodies and those who work for them. There are no plans to extend the scope further.
“It is important to ensure that public funds are used correctly, and that those in receipt of them are paying the correct employment taxes.”
But Andrew Chamberlain, the deputy head of policy and contractors’ trade body IPSE, warned contractors working in the private sector to expect the same taxation process to be applied to them eventually.
“Everyone I have spoken to on this issue expects the government to roll it out to the private sector if it works,” he said.
Colin Ben-Nathan, a tax partner at KPMG, echoed this view. “There is a general feeling that the public sector has a responsibility to account appropriately for workers’ taxation, but I think an extension to the private sector would be unsurprising, as otherwise you have a two-tier tax system for contractors.”
Mr Chamberlain of IPSE said such a system would also add to a “public sector brain drain”, as the most highly skilled IT workers and consultants may avoid government work to avoid being taxed at source, particularly if they felt the IR35 rules did not apply to them.