One-man bands take on the Revenue

'Service' firms are going to court over new rules that will increase tax bills,

Although most of us feel we pay too much tax, few will take the Inland Revenue to court on the grounds that its tax regime is not only unfair but illegal. Yet last week the Professional Contractors Group (PCG), representing the IT industry, did just that, arguing that the new IR35 tax rules are against European law and a breach of human rights.

Although most of us feel we pay too much tax, few will take the Inland Revenue to court on the grounds that its tax regime is not only unfair but illegal. Yet last week the Professional Contractors Group (PCG), representing the IT industry, did just that, arguing that the new IR35 tax rules are against European law and a breach of human rights.

Mr Justice Gibbs agreed that the PCG has an arguable case, so the Government will be forced to defend the new legislation in court. But the Revenue is confident of victory. Its defence is that, far from being illegal, IR35 makes the tax system fairer by blocking a widely used loophole involving "one-man" or "service" companies.

To understand who IR35 is aimed at, imagine two people, Jack and Jill, each carrying out similar work for Telecom Ltd. Jack is a Telecom employee, but Jill has her own company, Jill Ltd. This company signs a contract with Telecom Ltd to supply Jill's services, and so Telecom Ltd pays Jill Ltd instead of Jill. Until April this year, the use of a service company allowed Jill to minimise her national insurance contributions (NICs) and tax costs.

The Inland Revenue estimates that she would have paid only 21 per cent in tax and NICs, while Jack would have paid 35 per cent. IR35 corrects this imbalance so that Jill will pay almost as much tax and NI as Jack. This doesn't sound unfair, so why did Mr Justice Gibbs agree that the PCG could take the Inland Revenue to court?

The IT contractors argued that the legislation was contrary to European law in three ways:

* In practice, the new rules only apply to very small companies. However, larger groups may also supply contract staff to clients, but are not subject to the same heavy tax burden. The PCG argued, therefore, that IR35 is anti-competitive and constitutes illegal state aid to larger companies.

* The new rules are based on existing tests used to distinguish an employed person from one who is self-employed. The PCG argued that these tests are too uncertain and act as a barrier preventing people from other European countries doing business here. This is therefore a breach of the EU's Right of Establishment.

* Although governments are allowed to tax their citizens, unfair taxation can amount to illegal confiscation of property - a breach of human rights. The PCG contended that IR35 is such a breach.

As the judge held that the IT contractors have an arguable contention on all three grounds, the case will be heard in the High Court early next year.

What does this mean if you are affected by IR35? Well, the PCG will not necessarily win. The judge's ruling is only the first hurdle, and the court case will be a much greater challenge. Contractors should assume that IR35 will survive and take whatever steps they can to minimise the consequences. These include:

* Reviewing your working arrangements to see if some or all of your contracts can be restructured to fall outside the new rules.

* Maximising pension contributions, reducing both the tax and NICs payable under IR35.

* Ensuring you take full advantage of the travel rules, which give more generous tax relief to personal service companies than to employees.

* Managing the company's cash flow so that there is enough money available to pay tax and NICs when due. You will have to pay interest on late payments.

* Reviewing your company year end. Some dates, such as 31 March, may mean that tax is in effect paid twice on the same income.

* Once the company has paid the tax and NI due under IR35, the net amount should only be taken out of the company as a dividend. If it is taken as salary, further tax and NI is payable. This is a nasty trap that could catch many unawares.

If contractors assume that the PCG will win, and do nothing, they may face a big tax bill on 19 April 2001. This is the date that the first tax and NI payments are due under IR35. Taking preventative action now is like carrying an umbrella: it may not rain, but if it does, you won't get soaked.

* Anne Redston is a chartered tax adviser and partner at Ernst & Young. Her book 'IR35: Personal Service Companies' is published this week at £49.50. For a copy, call 020 7920 8991.