It was a couple of years ago that I heard a speaker at a dinner put on by the East Midlands Development Agency. His name was Caspar Berry.
He’s a really interesting guy, having started out life as an actor in Byker Grove, moved to the US to write screenplays and then became a professional poker player. What he spoke about was the concept of risk in business, which obviously drew on his poker experience.
He covered quite a lot of different themes, but the one I took away was the idea of how to think about risk-taking in business. The basic idea is that you should view investments, any investment including your time, as taking a risk. You then need to assess that investment as to the likelihood of its success, and the potential gain in the event of success.
Of course, in poker you can actually calculate the odds of your hand winning. And you can calculate the potential winnings in the likelihood of success.
By multiplying the odds of success with the gain from success, you end up with a weighted average, the sort that insurance brokers use, that you can compare against your initial investment.
If the investment is good, the weighted average will exceed the investment. Berry referred to these as a ‘calculated risk’.
The investment is bad when the weighted average exceeds the investment. Berry called this ‘gambling’.
In the long term, if you take calculated risks, you win money, you make profit. When you gamble, you inevitably lose.
So how does this relate to IR35?
Well, as I explained in a blog I did for Taxation magazine, I think that IR35 incentivises the use of personal service companies, by allowing the deemed employer to bear no tax risk whatsoever in the relationship.
Prior to the introduction of IR35, the risk, no matter how small, fell on the ‘employer’, and the price for getting it wrong was potentially huge. Where it is deemed that PAYE has not been paid, the amount received by the ‘employee’ would be treated as the net amount.
PAYE is then applied on the gross amount.
If a subcontractor had income tax and NICs totalling a rate of 20% and they received £100, instead of the subcontractor being liable for £20, the ‘employer’ would be liable for £25.
If you play around with the numbers, you see that as the tax and NIC rate rises, the level of risk increases exponentially:
A 30% rate sees ‘employee’ facing £30, but ‘employer’ facing £42.
A 40% rate sees ‘employee’ facing £40, but ‘employer’ facing £67.
A 50% rate sees ‘employee’ facing £50, but ‘employer’ facing £100.
And so on.
So, the higher paid the ‘employee’, the higher the rate in tax, the exponentially greater the risk.
The problem with IR35 is that it removes risk and puts it on the employee. In one respect it is good. This encourages the use of subcontractors by eliminating any risk on taking them on.
In another it is bad. It encourages the use of subcontractors who use limited companies over those who do not.
Companies are almost always a more tax efficient business vehicle (if you are keeping to a single structure). So, the consequences of making a risk assessment in favour of a corporate subcontractor is a decision that reduces tax payable overall.
Don’t get me wrong, this is not a tax motivated decision. It is a risk motivated decision about tax.
I have thought about what the best solution is to the conundrum of IR35. As I said, it is quite good in that it encourages the use of subcontractors (if a limited company) by eliminating risk. Repealing IR35 might see a massive hit to industries where contracting is prevalent. The increase in risk and uncertainty, combined with a reluctance to employ workers might see output reduced.
What about introducing a similar mechanism to IR35 for unincorporated businesses? It sounds crazy at first, but it evens the field in terms of preference for limited company subcontractors.
Of course, it’s a bit late to do this. We are where we are and we are unlikely to see a mass of disincorporations. Unless the proposed disincorporation relief turns out to be an incentive along with a simplified cash accounting system for small businesses.
What about introducing a mechanism for putting the PAYE onto the employer? Well, that is being discussed at present. The consultation document on the taxation of controlling persons hasn’t exactly received a warm welcome.
The main issue with that is the one raised by repealing IR35. It disincentivises the freelancer. But, for controlling persons that might not be such a bad thing. As long as the definition is clear and fair.
Anyway, If I’m doing this blogging malarkey, I’m going to have to get used to leaving ideas without having explored them fully. I normally have somebody make it sound sensible after the fact, so please feel free to correct/add below.
I don’t have an answer to IR35. And I think it indicates how anti-avoidance legislation can have the opposite effect. Rather like Pandora’s Box, once it has been opened, it isn’t simply a case of closing the lid on it.
Thoughts on the subject are always appreciated.