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HMRC and the taxation of the self-employed in the UK: Observations from 'Down Under'

July 2019

1. Overview

The UK tax authority HMRC (Her Majesty’s Revenue and Customs) has been at ‘war’ with the self-employed since April 2000.

HMRC claims that the self-employed avoid paying the same amount of tax as employees. But, in reality, it’s businesses that avoid paying a tax (Employers' National Insurance) that bears some close similarities to Australia’s payroll tax.

Both HMRC and businesses keep pushing and/or arguing that the ‘payroll’ tax liability should be passed to the self-employed. The situation is exceedingly toxic.

2. Background: the rise of self-employment in UK

The number self-employed in the UK has increased from
  • 3.3 million people (12.0 per cent of the labour force) in 2001 to
  • 4.8 million (15.1 per cent of the labour force) in 2017.
[Source: Office for National Statistics (UK)]

The rise in UK self-employment makes up for almost all of the drop in UK unemployment since 2001:
  • 5.1 per cent unemployed in 2001 to
  • 4.0 per cent unemployed in 2018.
[Source: Statista]
(Note the GFC-related unemployment spike in 2011.)

Even with the growth of self-employed numbers in the UK, this percentage is still below that of Australia where the self-employed rate has declined from
  • 19.1 per cent of the workforce in 2008 to
  • 17.1 per cent of the workforce in 2016.

3. Background : How the UK tax system works

In the UK similar personal income tax rates apply whether a person is employed or self-employed. However, the UK also imposes National Insurance (NI) contributions on top of income taxes.

Payment of NI contributions builds up entitlement to social security benefits such as the state pension, unemployment and maternity allowances.

NI contributions have two parts:
  • Whether someone is an employee or self-employed they pay NI at similar rates. In the case of employees, the employer withholds the employees’ NI contributions and sends them to the tax authority. Self-employed people remit NI contributions themselves. Self-employed people who use limited companies don’t pay NI, but the increased taxes they pay on dividends effectively claws this back.
But
  • Employers must also pay an additional “employers’ NI” on their employees of 13.8 per cent. It works exactly like a payroll tax and is administered by the central UK government. However, businesses do not pay the additional NI when they engage self-employed people. **It is this that is the source of so much contention.

4. HMRC says the self-employed create revenue losses in the UK

HMRC has long held the view that the self-employed create significant revenue losses. But these losses occur largely because the engaging businesses do not pay the additional NI when engaging the self-employed. That is, the revenue losses happen because businesses legally avoid paying their NI (payroll tax).

5. HMRC efforts to ‘solve’ the ‘problem’

HMRC has sought to ‘solve’ the problem of revenue loss principally by attacking the self-employed, declaring them to be “deemed employees”. HMRC does this while ignoring the real source of the problem—the avoidance of the NI (payroll tax) by engaging businesses.

But HMRC’s efforts have become very messy, distorting the economy as described below.


5a. IR35 (2000)
In 2000 HMRC introduced the Intermediaries Legislation, commonly called “IR35”, to address the ‘problem’. IR35 effectively pushed the cost of the employers’ NI on to the self-employed, massively increasing the taxes paid by the self-employed.

IR35 has been hugely controversial and ineffective. IR35 cases have been challenged in the courts, with HMRC losing about 90 per cent of the cases in modern times.

HMRC therefore looked for another ‘solution’.


5b. Public Sector (2017)
HMRC introduced new legislation in the public sector that forced government-sector hirers of self-employed people to assess the status of individuals to see if they were “deemed employees”.

HMRC created an online tool (CEST – Check Employment Status for Tax) through which hirers could allegedly assess whether the people they hired were self-employed or “employed for tax purposes”. By answering just 16 questions HMRC sought to impose NI on the self-employed when HMRC said that the CEST tool found a person to be an employee.

Many experts have been highly critical of CEST, claiming it to be heavily biased and prone to giving inaccurate results. CEST is not legally binding and even HMRC’s own legal counsel have argued in court that it is ‘irrelevant’. HMRC claim that it is for guidance only, but it almost always requires public-sector bodies to use it.

Public-sector organisations used CEST to check whether an engaged person was self-employed or an employee. If the person was an employee, the public-sector organisation then had to pay the employer’s NI. Many organisations imposed blanket rules declaring the self-employed to be “deemed employees”.

The consequence/reactions were as follows:
  • People assessed as employees: Public-sector organisations which assessed self-employed people to be employees then insisted that the workers’ remuneration be reduced to cover their employers’ new NI tax bill. This resulted in major desertions of self-employed people from the public sector.
  • Tax avoidance schemes: Some public-sector organisations then encouraged self-employed people to seek engagement through third-party (mostly offshore) labour hire companies that used creative schemes to reduce tax. This resulted in the creation of potential tax cheats and tax losses for HMRC.
  • Third party engagement: Some organisations stopped hiring contractors directly, or through agencies, and instead approached larger consultancies in order to circumvent the need to assess. But this had the adverse effect of forcing organisations to pay considerably more to access the same skills.
The areas of the public sector negatively affected by this have been in information technology and systems design/support, but the National Health Service (NHS) and the BBC have also been affected, along with major rail infrastructure projects like High Speed 2. The NHS has lost doctors, nurses and other key health professionals.

Surveys have shown that
  • 50 per cent of public-sector hiring managers had lost skilled contractors as a direct result of the changes to IR35 regulations.
  • 70 per cent of hiring managers said that they were now struggling to hold on to their contractors in the public sector.
  • 52 per cent said they had witnessed cost rises, delays and even project cancellations.

5c. Loan schemes through third parties

Part of the fallout from the Public Sector ruling was that third parties promoted tax avoidance ‘loan’ schemes to the self-employed. These were legal, HMRC knew about the schemes and public-sector organisations encouraged people to go on to such schemes.

Public-sector organisations engaged the self-employed through a third party. The third party would ‘lend’ money to the self-employed (which was never to be repaid) and the self-employed person’s taxable income was then lower, reducing or eliminating the additional NI liability (that was really the liability of the public-sector organisation).

What followed was that
  • Thousands of public-sector workers were incorrectly assessed as ‘employed for tax purposes’.
  • There was no appeals process (other than an expensive court case).
  • It incentivised the widespread adoption of the loan tax avoidance schemes.
Effectively, the “employer’s” NI obligation was transferred to the self-employed workers who sought ways to overcome paying tax rates that were significantly higher than those of employees.

HMRC is now clamping down on the loan schemes.
  • It’s estimated that up to 100,000 workers have unwittingly been seduced into tax avoidance payroll schemes. These individuals are now exposed to substantial tax risk, with many reporting they will need to go bankrupt.
For example:
  • A locum GP says HMRC has demanded £120,000 from her and that she will have to sell her house. This in spite of the NHS requiring her to be on the books of an agency.
  • Another person had to pay £180,000 and his family are now living in a two-bedroom council flat. He is also facing demands for more than £95,000, a charge for back-tax for a year during which he hadn’t even worked.
Although HMRC is trying to close down the non-compliant labour hire companies involved in the loan schemes, they are fighting a battle they do not have the resources to win.

HMRC has been taking legal action:

6. Extending the Public Sector Rule to the Private Sector (2017)

HMRC has pitched the problem as “off-payroll reform” and has earmarked April 2020 as the date to extend the public-sector rules into the private sector. A consultation closed on 28 May 2019 and a response followed just a few weeks later, where all concerns were dismissed and ignored.

HMRC estimates that, in total, about 500,000 workers are targeted, but says that around 170,000 are not legitimately self-employed. Of this HMRC says some 90 per cent (150,000) people are likely to ‘get the chop’ under the ‘off-payroll reform’, or have their income fall by up to 20%, equivalent to the cost of their mortgages.

HMRC had originally planned to introduce the extension of the rule in April 2019, but such was the political uproar that plans were delayed until April 2020. There is still considerable opposition to the changes.

7. Summary

This is a study of a mindless tax bureaucracy which is incapable of properly thinking through an issue.
  • The central problem is that the law allows businesses/engagers to avoid paying their NI obligations by engaging self-employed people.
  • Instead of fixing this, HMRC has chosen to attack self-employed people by pushing the business/engagers’ NI obligations on to the self-employed.
  • Self-employed people then end up paying more tax than employees and it’s unsurprising that the self-employed have looked for ways to not pay the extra tax.
Further
  • In trying to resolve the problem through the method of forcing self-employed people into being employees, HMRC thought that it could impose its will through the public sector.
  • This meant that HMRC imposed additional costs on the public sector in order to raise more revenue. But the additional revenue was simply lost in the additional costs.
  • The outcome was/is major disruption/dysfunction within public-sector organisations and reduced service capacity—for example in the NHS.

8. Comment

The behaviour of HMRC demonstrates an obsession in tax administration circles with the view that the self-employed somehow ‘rip off’ the tax system. This is in spite of the evidence that the revenue loss is a result of a failure to close a tax loophole that allows engaging businesses to avoid their tax obligations.

Since 2000 HMRC has tried to ‘fix’ the issue by forcing self-employed people to be employees. This has at all times failed, created significant distortions to economic activity and caused individual harm to large numbers of self-employed people.

The upshot of all this is that tax authorities must learn to accommodate and work with the self-employed sector.

Moreover, there is evidence that successive UK governments have been ‘asleep at the wheel’ on this issue, blindly doing what the HMRC and Treasury told them to do. In the context of Brexit it demonstrates that the elected UK government is failing to govern on core, basic matters for the people of the UK.





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