Lords rule out transferring responsibility for compliance with IR35 service company tax rules to end user

The conclusions of the committee, convened to consider the use of personal service companies, would come as a relief to the many businesses which contract labour through these companies, tax expert Chris Thomas of Pinsent Masons, the law firm behind Out-Law.com, said.

"The suggestion, made by ICAEW amongst others, of putting the responsibility on end users was highly controversial and would have placed a substantial burden on businesses, requiring a wholesale review of their terms of engagement and considerable 'due diligence', which they would often not be well placed to carry out," he said.

"In our experience, a lot of contractors choose to operate through personal service companies and are content to take the PAYE risk in return for the wider advantages that they enjoy by contracting in this way," he said.

The report said that transferring the responsibility for the tax to end users would "place significant administrative pressure on engaging businesses" and the majority of the evidence the committee received in relation to a public consultation did not support "placing the onus on businesses to make judgments about whether contracts fall within the IR35 rules".

The committee also concluded that HM Revenue and Customs (HMRC) had "failed to demonstrate a sound basis" for the £550 million in tax and national insurance contributions (NICs) that it claimed would be at risk if the legislation, known as IR35, was to be abolished. The committee recommended that HMRC publish a "detailed assessment" of this estimate to show that the benefits of the legislation outweighed the compliance costs, as well as produce better and clearer guidance to those affected by the provisions.

"During the inquiry, it became clear to us that there is an increasing use of personal service companies by freelances and contractors, who are part of the UK's flexible workforce," said committee chair Baroness Noakes. "There are many reasons for the use of personal service companies, including the possibility of reducing tax and national insurance bills. The government's anti-avoidance legislation, often referred to as IR35, is complex and raises its own problems."

"We have also received evidence that low-paid workers may also be employed via personal service companies and that they may not be aware that this means they have fewer employment rights. We believe that this is something which needs to be thoroughly assessed by the Low Pay Commission," she said.

The report also recommended that HMRC revise the 'business entity' test, introduced in May 2012 as a way for contractors to assess their risk of being caught by the legislation; and suggested that the government "re-examine the longer-term case" for combining income tax and NICs into a single employment-based tax.

First introduced in 2000, IR35 is intended to stop contractors in 'disguised employment' from using limited companies to avoid paying tax and NICs. It ensures that contractors have to pay tax and NICs as employees, even when they are working via a personal service company – typically a limited company of which the worker is the owner and sole director, contracted to supply professional services such as IT or in the oil and gas sector.

According to HMRC estimates provided to the committee, there are around 200,000 personal service companies operating in the UK and the number has more than doubled in the past decade. However, the committee said that there was a "general lack of information" about how widespread the use of such companies was, "due, in no small part, to the absence of reliable information collected by HMRC".

The report noted that the legislation did not tend to cause significant issues for businesses that used contractors, but that it could "arouse considerable hostility" from contractors themselves. It recommended that HMRC reconsider whether the questions it asked on tax returns were necessary and, if so, make it clear that compliance was essential in order to increase certainty for taxpayers.

On national insurance more generally, the government has confirmed its intention to introduce a targeted anti-avoidance rule (TAAR) for NICs at the next available legislative opportunity. The TAAR will have retrospective effect from 6 April 2014 and is aimed at reinforcing the new rules clamping down on the use of onshore and offshore agencies to avoid employment taxes which came into force on the same date. The TAAR will be drafted in a similar way to the income tax TAAR  currently in the Finance Bill, but will have to be included in the next Social Security Bill as national insurance is not technically a tax.