The Challenges of Taxing Employment (II) False Self-Employment

A consistent focus of UK Governments stretching back to, materially, Roman times has been an avowed desire to ‘clamp down on  false self employment’. Last week the Social Security Advisory Committee released a report identifying this as a phenomenon which:

occurs where employers (re)define their employees as being self-employed, which would not be appropriate if they effectively work for the ‘employer’.

This followed hot on the heels of the Consultation Document on the Onshore Employment Intermediaries provisions (“OEI”) in the Finance Act 2014. In his foreword, David Gauke, then Exchequer Secretary to the Treasury, said:

1.5 There are many legitimate reasons why a worker is engaged on a self-employed basis. The Government strongly supports enterprise and welcomes the contribution these entrepreneurs make to the economy. They recognise the additional financial risks someone who is genuinely self-employed takes and believe this should be recognised in the tax system.

1.6. However, there are times when someone who should be an employee is engaged on a self-employed basis. There are a number of benefits of engaging someone on a self-employed basis to the engager. The engager does not have to pay 13.8 per cent employer NICs and has none of the other costs associated with being an employer, including those associated with employment rights such as pensions contributions, redundancy pay and sick pay. The worker may benefit from a small increase in pay in the short term but this is at the expense of longer term benefits and protections such as employment rights.

And in 2009 the last Labour Government consulted on proposals which described the problem thus:

1.2 False self-employment occurs where workers are treated as self-employed for income tax and National Insurance (NICs) despite the fact that the way in which the work is carried out on a day to day basis demonstrates that there is an employment relationship.

And this Labour opposition has pledged, should it regain government in 2015, to introduce proposals similar to those it consulted on in 2009. And it’s not exactly as if the current legislative code ignores the issue. The Income Tax (Earnings and Pensions) Act 2003 contains (in addition to the Agency rules  revised in the Finance Act 2014) so-called ‘IR35’ provisions and ‘Managed service company’ provisions.

Because the line separating employment and self-employment is “blurred and shorn of logic and economic principle“; because the difference in tax rates (for those who recognise a rose by other names) is huge; and because there is fiscal advantage for both workers and engagers (to adopt two neutral expressions) in classing workers as self-employed, there is every incentive to arrange matters so that that which might be the one is taxed as the other.

Even so. That one might need (presently) three – and with a contemplated fourth – sets of statutory provisions to tackle a single issue might cause even us benighted professionals plying our trades in the field of tax to raise a wearied eye. How has this come about? And does the contemplated fourth provide reason to cast off the pessimism of experience?

An informed walk through the story above reveals three discrete but related issues.

First, there is a remarkable lack of clarity about the problem. None of the papers referred to above define (or define better than the quoted paragraphs) what false self employment is. Now, it is undoubtedly true that there are some workers who are wrongly treated for tax purposes by their engagers as self-employed when they are employed. But that is not a problem that requires legislative solution: the Tax Tribunal is perfectly able to address it without recourse to any of the provisions set out above. All the Tribunal need do is ask whether the worker is employed or self-employed.

The real problem (in this context) with the Tax Tribunal – as we know but do not say – is that the assessment of a worker as employed or self-employed is a fact rich one. In consequence, it is usually disproportionately (compared with the value of the arbitrage) resource intensive for HMRC to tackle the question worker by worker. The legislative solution that is offered is to substitute a less fact rich assessment. But this is, of course, a solution to a different problem (resourcing rather than wrongly characterisation). And these solutions create a different issue: that of false employment.

Take the on-shore intermediaries provisions, for example. They eschew the multi-factorial assessment of the Tax Tribunal for a focus on a single question, that of supervision, direction or control. Fail this and you’re deemed to be – and taxed as – an employee. Even if, having regard to all the relevant features, you would be deemed to be self-employed.

Second, there is, as I have stated above, a lack of clarity about the reasons for the difference in tax treatment between these categories of employed and self-employed. None of the papers cited advance beyond David Gauke’s rather imprecise observation about ‘risk-taking’. The tax code pays no mind to the differences between dynamic and steady state businesses; between those where capital is and capital is not being risked; and between those who do and do not employ. It has no regard at all to the huge value for the economy as a whole of having a flexible labour market. It’s a difference likely without any – and certainly without any articulated – rationale.

What the papers referred to above also reveal is a (largely unspoken) frustration with the fact that it is often possible to toggle the tax status of a worker through adjustments to the drafting of his or her contract. That workers in economically similar situations might be taxed so differently (with distortive effects on the ability of engagers to compete on price) might seem surprising. But it is a natural – indeed, it is an inevitable – consequence of the fact that the relationship of employment – and hence the incidence of taxation – is a function of contractual terms.

Third, there is an apparent lack of understanding about how the problem should in practice be tackled.

The OEI provisions contain an excellent example of such a short-coming. It’s all very well creating a liability to tax on a person. But this is meaningless unless you can in practice collect it. These provisions (immaterial exceptions aside) put the liability on a third party – neither the engager nor the worker. And they create a situation where both engager and worker are largely indifferent to whether that third party meets its liability. We – taxpayers at large – have long and bitter experience of such circumstances. The practical reality is that the third party too – invariably a barely capitalised corporate – will itself be indifferent as to its liability. Its owners will remove its income, let the corporate fail, and then (in a practice known as ‘phoenixing’) simply create another corporate.

Let me look at these issues in turn.

If one was honest about the real problem one was seeking to tackle – the problem shared by both HMRC and engagers of how to form a secure view of status – one might then more readily move to a sensible discussion of what fit-for-purpose legislative solutions looked like. But so long we pretend that the problem is otherwise, we remain handicapped in our ability to tackle it.

If we were clearer about the behaviour we wished to encourage through the differential in the rates between employment and self-employment we could more readily tax to encourage or reward that behaviour. At the moment it is difficult to discern a rationale beyond discouraging the contractual status of employment. And this – to me at least – feels like no rationale at all.

What is it that we really wish to encourage – surely it is not everything that is not employment? Might it be businesses that risk capital? Is it those that employ others? Is it businesses that seek to grow – as opposed to those that seek merely to remain in a steady state? Is it those who are prepared to commit to short term contracts to provide supply chain flexibility for their clients?

Legislators, compelled to avert their eyes from such considerations, are left to tinker about with aspects of the contractual definition of employment. This impedes their ability fiscally to grease the right economic cogs. Indeed, I would go further. It is – in my opinion – very likely but quite inadvertently to have the effect of removing fiscal incentives from behaviour that, clear-sighted, we would undoubtedly wish to encourage in our economy.

And as to the third? Beats me. If you have the answer, do let me know. Certainly shooting from the hip at politically expedient targets can dis-incentivise business from engaging in developing workable solutions.

I should note, finally, that I will return to consider the role of intermediaries in the labour market in more detail in a later post. For now it is enough for me to note that they are a feature of this landscape but not one that alters the analysis set out above.

37 thoughts on “The Challenges of Taxing Employment (II) False Self-Employment

  1. I tentatively venture that some justification for the higher taxes on employment might be that the employee is receiving more for their labour than simply their salary – they are receiving the full protection of UK employment law (maternity rights, protection from wrongful dismissal via the courts etc etc).

    After all, if employment income and self employment income were taxed in the same way, who would ever choose to be self employed?

    This is just a thought, and not one that I have fully explored, but I wondered what your view might be.

    I would say that false self employment is a situation whereby the worker is not subject to tax as an employee, despite working in circumstances which would entail him or her employment rights if wrongfully dismissed (there was a tribunal case a few years ago, I forget the name).

  2. that would be so to such extent as an employee receives those things from the state – to whom the taxes are paid – but it’s less obviously so where that person receives those things from their employer.

    history suggests – at least I’ve been told it does by a prospective guest blogger – that one explanation for the differential in rates lies in the fact that the employed used to get more back from the state. however, apparently, that’s much less clearly the case now.

    I think your definition of false self-employment is fairly close to the one I posit – it’s people wrongly characterised by their employer as self-employed. but if that is the real problem then, as I say in my blog, we don’t need any special mechanisms to address it…

  3. “that would be so to such extent as an employee receives those things from the state – to whom the taxes are paid – but it’s less obviously so where that person receives those things from their employer.”

    I appreciate that I am clutching at straws a bit here, but perhaps it could be that the state provides the means of redress (ie the court system)?

    Anyway, this is heading off topic. Sorry.

  4. were my blog supremely established, I’d meanly point out that the state provides means of redress for employed and self-employed alike. but as I’m just getting going i’ll confine myself to observing it’s an interesting thought 🙂

  5. Roman times? Go on: I am all ears. And “fiscally to grease”?

    Anyway: I think you need to distinguish at least two situations.

    First, if a person is setting up in business, they could reasonably ask, should I set up as a self-employed sole trader or should I trade through a small company, taking a small salary and dividends? Various considerations, such as tax (that is, how much of the business’s earnings will the business and its owner keep) and potential legal liability to third parties, might well push a person taking that decision towards setting up as a small company.

    Second, if an established business needs to engage a person to perform a task, they could either engage the person as an employee, or contract with a self-employed service provider (or indeed company) who will arange for that task to be done. Various considerations, such as tax (that is, cost) and potential legal liability, might well push the business towards preferring to engage with a self-employed service provider. Most individuals don’t have a sufficiently strong bargaining position to demand that they are engaged as an employee.

    Stepping back, isn’t the question to ask: why are employees, and the self-employed, and persons trading through a small company, taxed in radically different ways? For example, my understanding is that in the US, a person would be taxed in a similar way, however they established their business.

    I suspect there is no proper policy rationale for the lines that the tax system draws, or for the encouragements offered to structure one’s affairs in one way or the other. If there were a policy rationale, surely it should be either to encourage entrepreneurial risk taking, or to encourage taking on employees, or both.

  6. “materially” to Roman times. But I do agree with your question.

  7. Sorry, this is off the main topic, and perhaps I am being thick, but I still don’t understand what you meant by “stretching back to, materially, Roman times”. Wealth taxes, poll taxes, land taxes, customs duties, yes, but false self employment?

  8. It was a feeble attempt at a joke (I am compelling to take them where I find them). Read it as “for as long as we’ve had different rates of tax on employment and self-employment income”.

  9. Is the answer just the boring one that there is no rationale basis for the differential tax treatment, but this is just where historical accident and political expediency have taken us?

    In other words, employer NICs is a politically handy way of having an effective tax rate in excess of the headline rate of income tax, in a way that isn’t immediately visible to employees. But there is, of course, no way to levy such a “hidden tax” on the self-employed.

  10. I suspect your account of how we got to where we are is accurate. A guest blogger is going to write on this issue. But it’s interesting to note that politicians – see for example David Gauke’s comment referred to in the post – do now seek to support the differential as being grounded in some difference in substance. And they might – might – be right. But, personally, I’d like to see the case that they are.

  11. Oh, just me being thick then 🙂 I hoped you might have an interesting anecdote about freedmen being subject to the poll tax, but not slaves, or some such.

    Perhaps we could go back to the Duke of Westminster case – a payment of wages was not deductible, but payment under a deed of covenant was – as a loose parallel to avoiding employer NICs?

  12. I rarely miss the opportunity to offer up an interesting anecdote.

  13. One point not explicitly covered in your post is that of LLPs. Here the situation seems even more perverse, the creation of a new entity type at a time when the knowledge of false self employment was well established with a specific reference to confirm beyond all doubt that members would always be self employed, then many years later, after the boundaries are pushed (without challenge) on a wholesale basis, the response of government with shock that this could ever have happened.

    Then the worst consultation process I can ever recall, with so many changes and repositioning throughout. What was more bizarre was the mixed membership aspect missing the entire point about one way transfer pricing abuse (suddenly noticed, again to the great surprise of the treasury, which was incredible in itself) and a rushed through piece of legislation that will doubtless be fundamentally rewritten in two years time when it is realized that the gateways available mean that the recovery of tax and NIC will come nowhere near the amount provided in the budget press release.

    As a tax advisor, I plead any government to take the time, and formally wrap up all these poorly targeted legislative aspects into one single definition of employment for tax purposes, similar to how the statutory residence test achieved at least some form of certainty. I’d boldly suggest bringing OMB dividends into the NI net in some form. There would be winners and losers, sure, but more importantly, clarity of policy and certainty for the taxpayer.

  14. Thanks.

    Interesting to test the mixed membership provisions against the possible reasons for favouring self employed status given in my post. Often growth businesses and usually employers. But ‘salaried’ partners take less risk, don’t provide flexibility to employment market, and don’t usually ‘run’ businesses. What do you think?

    Certainly would be nice if we’d been told why the dividing line criteria were adopted.

  15. There were some blatant abuses of LLPs, both in Mixed Memberships and Salaried Partner rules. The ‘Transfer Pricing Trick’ was so incredibly simple in its application (and transparent, if one reviews the accounts of a company/LLP that applied it). However all were permissable legally under the rather poor way in which the enabling legislation for LLPs was drawn up. No doubt closure was required. I’ll also add that I had no part in any of these structures!

    However, the door slamming shut has given two consequences affecting what may be considered ‘non abusive’ LLPs (I hesitate to say traditional as it would imply I’m trying to protect my own profession). Junior partners on the stepping stone up to full equity, an acceptable salaried partner position for many years now have a choice to be classed as employees (whereas under any other structures they would not be – see companies and dividend extraction or non LLP partnerships) or engage with an arguably artificial introduction of capital to ‘fail’ the capital test. We now see LLPs with excess cash calling in capital contributions to (apparently legitimately) fail the salaried member test.

    How can this be a logical approach in dealing with the issue by attacking one single line of abuse in one area without actually statutorily defining an employee for the purposes of all taxes?

  16. Um. Important question, JoIyon.

    Why are your dates written in American?

  17. Not sure I have a ‘written in English’ option.

  18. Flattered you’re reading it so closely!

  19. I don’t know anything about the transfer pricing thing. But you are right, of course, to point out that it is another, query well thought through, attack on ‘false’ self employment

  20. The principle is that earnings on capital should be taxed at a lower rate than earnings on labour, because capital has greater mobility than labour. You can spirit away your denarii to a Swiss bank account with one quick phone call to your banker, thus depriving the taxman of revenue: whereas your labour is stuck within commuting distance of home.

    This naive view may have been true in the past, but it hasn’t stood the test of time. For one, individuals are taxed on worldwide investments: by law I must declare any interest earned on my Swiss bank account, and I pay tax on it in the UK. Secondly, labour is surprisingly mobile: the last decade of heavy inward migration from the former Soviet Union has proved that. A purely rational (but evil) tax system would offer lower income tax rates to footloose single childless renters, and a much higher tax rate on married child-rearing homeowners, on the basis that the latter are stuck there anyway. (Norway almost does this: if you work for under two years you don’t have to pay their equivalent of NI, some 10% of earnings).

    Here’s a recent paper which debunks much of the capital-is-mobile taxation theory:

  21. One could levy the tax on the self-employed by increasing Class 4 NI to 24% or so, with an upper rate of 14% (can’t be bothered to do the exact maths at the breakfast bar). It wouldn’t be a “hidden” tax, but it would function the same as primary + secondary class 1: the self-employed person would pay 12% or 2% in his capacity as self-employee and 12% in his capacity as self-employer.

    It would of course make incorporating a *complete* no-brainer… 🙂

  22. Don’t get cocky.

    It onIy means I’m reading the dates carefuIIy.

    What are the articIes saying?


  23. Certainly one could use Class 2 NICs or an equivalent to secure that the low paid did not miss out on contributory benefits through raising the UEL.

    As to whether NICs should be equalised between E and SE, I think that’s a question the answer to which depends on whether you think they are in a materially identical position. Some – ie Judith Freedman – think they are. My own view for what it’s worth is that the case for equalising is unmade. Likely the evidence will showboat some SE are and some SE are not. A well designed NICs system would recognise that difference.

  24. In general terms it seems to me people get b*gger all for NI these days. After all it’s possible to have a qualifying year for contribution purposes without paying any NI at all.

    All of the services referred to elsewhere (employment tribunals etc) are available whether or not NI has been paid.

    Employers’ NI is the ‘tax’ that causes so many people to change behaviour but it brings too much money in for the government to consider serious reform. It’s all very well Cameron banging on about an extra 1% on employers’ NI being a ‘tax on jobs’ but if an extra 1% was a tax on jobs, what does that make 13.8%?

    Of course employemnt/self-employment involves more than tax, there are legal protections as well and a number of cases used in the employment/self-employment library of arguments weren’t tax related, which makes the whole area even more complex.

    Just make sure you have a ‘right of substitution’ clause in the contract and that it’s occasionally actually acted on.

  25. Sorry, should have added anti-avoidance legislation came into effect 25 Oct 2013.

  26. That would of course be ineffective if there’s an agency in the loop…

  27. A counter-argument might be that a well-designed tax and benefits system should eliminate the difference 🙂

  28. Only if you ignore – which I don’t – the fact that E and SE might do different things in the economy some of which the fisc may wish to subsidise through lower taxes.

  29. What sort of “different things” are you thinking of?

    Certainly HMRC seem to regard them as being functionally pretty much identical in many ways.

    If you take the VAT concept of supplies as a starting point, I can see something of a difference between people who supply their time and expertise, and people who supply other things (goods, most obviously; or the time and expertise of others). The former would include employees plus some who are currently regarded as self-employed, whereas the latter is pretty clearly self-employed only.

    Not being an economist, this is the sort of area in which I tend to listen and learn from those with more experience than I 🙂

  30. See paragraph beginning “What is it that we really wish to encourage…” in my post which covers what will sometimes be differences and could be said to be material.

  31. “Certainly one could use Class 2 NICs or an equivalent to secure that the low paid did not miss out on contributory benefits through raising the UEL.”

    Would it be pedantry to point out that it’s raising the LEL that would mean the low paid missed out?

    I know it’s probably a typo but some reading this might end up with the wrong impression.

    I once saved a client a small fortune in tax because a simple typo in an HMRC letter meant they opened a tax enquiry into the ‘wrong’ year and by the time I pointed this out to them the time limit for an enquiry into the correct year had passed.

  32. Fair point.

  33. The transfer pricing “wheeze” was to have a company as one of the members of your LLP, and employ all your staff via the company. The company would then recharge the LLP for the staff time at below a market rate. The company and LLP would voluntarily apply the transfer pricing rules and so additional profits would be taxed in the company at 23% and then be available to be withdrawn from the partnership tax free.

    It was a pretty appalling scheme, but not obviously wrong in law. It was pre-GAAR too. I saw it several times, and I’m aware of some Northern accountants and law firms packaging it and selling it in bulk. We never did it, but our Yorkshire office lost a number of clients to competing firms as a result.

  34. Of course 🙂 Sorry, my fault for following the comment chain without referring back to the original article 🙂

    My preference, if tax incentives are to be used, is to have the tax impact directly on the thing you’re trying to encourage rather than indirectly. So for example if you want to encourage SMEs to employ people, I’d rather tinker with the taxation of the employees than the taxation of the employer. If we can only look at the employer, then look at the costs of the employees rather than the income of the employer.

    With a self-employed person, if we want to encourage them to take on employees then I’d muck about with the secondary NI in the first instance (Employment Allowance fits in here). Playing around with the proprietor’s Class 4 NI in order to encourage them to take on employees seems a bit indirect (and complex).

  35. Elegant: and the ones that work usually are.

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