The taxman cometh
The IR35 directive is part of the government's crackdown to net tax dodgers. But Tracey Caldwell discovers that the law could drive freelance IT contractors away from the UK.
Government moves to abolish the tax benefits enjoyed by computer contractors have unleashed howls of protest from contractors. Further up the chain, many resellers employ freelance contractors to swell their workforce or extend their skillsets temporarily, but few have had a chance to assess the impact the change might have on their business.
The controversial legislation, known as IR35, is part of chancellor Gordon Brown's proposed move to combat an annual shortfall in National Insurance payments. But contractors paint a picture of doom. They believe the acute IT skills shortage will worsen as contractors are forced to move abroad, leaving no pool of ad hoc skills to tap into. Susie Hughes, chairwoman of the Professional Contractors Group, which was set up to fight the legislation, declares: "This will close down 66,000 small businesses."
Even more dramatic figures are provided by the 360 Group, a firm of accountants that set up the IR35 Consultation Group with members ranging from professional bodies to corporate employers of contractors. Ian Sutherland, co-ordinator of the IR35 Consultation Group, says: "There will be an additional cost of £2.1bn per year on the cost of employment if the measure goes through."
The 360 Group is seeking a compromise situation. It acknowledges there is some abuse leading to a shortfall in National Insurance payments. Sutherland claims the delay in issuing final proposals and guidance is already leading to concern over the effect on contracts being written at present. "Many companies are spending considerable time and effort in reviewing their positions and seeking legal opinions as to the various likely effects."
A spokesman for one leading company states: "We are already spending 40 per cent of our legal and tax budget on this subject instead of getting on with business."
When the 360 Group asked a number of leading UK companies whether they supported the chancellor's move, 72 per cent disagreed, 14 per cent were not sure and only 14 per cent supported the directive.
Sutherland believes companies that are forced to take on more staff because they are unable to use contractors will appear less efficient on the balance sheet - with more employees, they will have a lower output per head. Previously, there were concerns that firms were manipulating their value by using contractors. Big package providers would need to prepare for searching questions from shareholders.
Richard Todd, formerly senior contractor at Eagle Star and Misys, believes the long-term result of the measure will be increased costs but, in the short term, there will be a period of chaos as resellers struggle to grasp whether or not the freelancers they employ will be affected by the rules.
In the face of many grey areas, the onus will be on resellers to decide.
The reseller will be penalised if it employs an individual with company status. "There is also the issue that firms' accounting systems may have to be amended to show a company's exposure relative to IR35," says Todd.
However, he believes the small reseller might turn out to be the sole beneficiary of the law. "The only organisations I can see gaining are those that aren't very big. Their competition is disappearing and they will have a clear field.
"But the service industry tends to be based on individuals, and when there's someone others can work with, people tend to follow them from company to company. What will happen is that customers will take the option to move with that person," Todd adds.
Richard Lander, managing director of Analystic, an independent service company operating in the PC market, describes the directive as fair. "I don't think it will have a direct negative effect on us if it goes through. It will help to differentiate between real project contract companies and temporary staff."
Keith Birch, managing director of Suncentre Touchstone Computers, says: "It won't affect us in a negative way. If there is a big freelance market, it tends to have an impact on sales costs. Suncentre is a public company, so we will have to take a stance on our dealings with freelancers. If they put up their rates, we will have to declare them uneconomical."
But Birch doesn't expect this to happen. "I'm sure they will wake up and smell the coffee. However, firms that use a large percentage of external staff will judge it differently," he adds.
Derrick Bates, director of the infrastructure division at network reseller CNS, declares that the proposed changes would make him think twice about taking on contractors. The 60-strong company employs only a handful of contractors. "If employers are deemed responsible for payment, I would be put off."
He believes that if the chancellor enforces draconian rules for contractor employment, it would have a detrimental effect on contractors' wages. "The government might declare that if we employ contractors for more than 30 days, then we'll be responsible for their National Insurance payments.
"We might also have to notify the Contributions Agency if we employ a contractor so that it can monitor the situation. Employers would have to reduce rates to cover the fact that we have to pay their National Insurance."
As contractors threaten to put up rates to cover their increased outgoings, the potential for conflict is great. Bates heads a team of consultant network engineers who are in the front line. "These are the very people who would become contractors - we lost two recently to contracting. They are all very much aware of IR35 and they see it as limiting their options.
"The directive would help prevent my losing staff in this way to contracting, but I don't necessarily welcome that. Staff always have the option of moving on anyway. At the end of the day, that's the name of the game," he adds.
Bates believes that if the tax changes come into force, he will not take on contractors simply because of the time it would take to understand the legislation and to monitor any changes in the way it could be applied.
"As an employer who might take on contractors if IR35 was in force, I would have to know intimately how it worked and that would seriously limit me. I will be watching very closely the outcome of any challenges to this legislation in court."
Few resellers will want to admit to a heavy reliance on contractors for various reasons, including the fact that it's likely to put up their prices.
Services company Partners In IT (PIT) markets its dearth of contractors as a positive aspect in its price transparency drive. The firm charges its customers for the itemised costs of a service - plus 10 per cent profit - and needs to keep its staff costs within control.
Paul Cash, co-founder and director of PIT, is tracking the IR35 arguments closely. "Ours is a services company, so the issue is not about the definition of the changes. It's more about choice and investment in staff. Small firms such as PIT struggle due to the strength of the contract market.
"It means some companies are afraid to train staff as they will be lured away by the large number of agents. Firms have to put together very creative packages to retain staff and it's a big issue," he says.
PIT was set up with the staff retention issue at the heart of its approach.
Staff are permanent and hold company shares and a share option, and the firm is also fully privately-owned, Cash states.
"We think very hard about our management structures and make sure we have the right training for the right people. The company has a full-time staff member for human resources and recruitment. That is quite a commitment in a workforce of about 50 people."
He adds: "We're not saying that there's no place for contractors. Most companies need external resource during growth periods and the argument that contractors will disappear is relatively emotive. But the market has been distorted by tax and legal loopholes."
Staff retention has always been a big issue in the IT industry and anything that stabilises the labour market and curbs the incentive for staff to be lured away to become contractors might seem a good thing for resellers.
According to Nigel Davies, project manager at Analystic, the job market has matured beyond this issue. He believes employers are questioning the benefits of taking on contractors and see permanent staff as less likely to be lured away by the big money of contracting.
He says: "People in permanent jobs are realistic about it. Contractors chase big money but remain static in skills. They grab the cash, whereas permanent staff evolve through their careers towards it.
"Also, the pay disparity is not as great as it used to be when people include employment benefits such as private medical insurance - except perhaps in the City."
Ian Brookes, managing director of reseller IB Business Solutions, believes the move will probably stifle many small business start-ups. "I think it is highly unlikely that companies would take on their contractors permanently. I hope we can continue to get people in when needed and that there will still be a skills pool."
Mike Regan, internetworking business manager at reseller Memorex Telex, says: "The one clear downside is the loss of the consultant with a high level of skills - the genuine expert who sells specialist skills at a high price. These people are essential - their skills are so niche and yet you can't afford to employ them if they are only used five times a year."
He adds: "One company can't keep them fully employed if it is only going to use them five or six times in year. However, I sometimes wonder where they will end up - maybe at a large firm of consultants where their price will be even higher."
Marianne Kolding, services analyst at research company IDC, declares: "It's the small service providers that will be hit hardest. They can't afford to have a full complement of skills."
She believes the answer is for resellers to partner other service providers that complement skills or specialise even further. "There will be many large firms and smaller, specialist companies that will have to work together.
They'll have to establish formal and informal networks on the basis of skills and location to cover their needs."
The government has positioned the IR35 clause to support SMEs and to back genuine entrepreneurial activity. But in the eyes of many firms, its proposals could have the opposite effect.
UNVEILING THE TAX WRAPPER
IR35 is tax legislation first proposed by chancellor Gordon Brown in his Budget last March. It is aimed at countering tax avoidance among individuals setting themselves up as a service company purely to obtain corporate tax benefits while working in what is, in fact, disguised employment.
At present, a permanent employee can leave a company on a Friday, return on the Monday and do exactly the same job - but this time engaged as a consultant, paying reduced tax and National Insurance.
This reduction is achieved by contractors drawing most of their income from the company in the form of dividends and paying little or no salary, so avoiding employer's and employee's National Insurance on that salary.
This affects a number of industry sectors, but IT contractors have been most vocal in campaigning against the move.
At the time of the Budget, it was announced there would be time for consultation, but in a surprise move, the government incorporated the clause into the Welfare Reform and Pensions Bill unveiled on 17 May, which passed through the House of Lords on 10 June - with IR35 included.
The IR35 clause will pass into law in the Finance Act (2000) unless the government is persuaded to change its mind before winter.