IR35: The impact on digital transformation

Philip White, founder and managing director of national software development company, Audacia, shares his thoughts with Business Leader about the impact tax changes have had on digital transformation projects.

By the time you read this, private sector anti-tax avoidance reforms, known as IR35, will have come into force, causing significant risk and disruption for businesses that rely on IT contractors for digital transformation initiatives and support.

What is the impact of the change?

From April 6th, 2021, every medium or large private sector business is expected to review its use of contractors and how their roles are classified under the IR35 legislation. It is designed to reveal ‘concealed employees’, who are lowering their tax and National Insurance contribution (NIC) liabilities by being paid by an intermediary company (a ‘personal services company’ or PSC), that has billed the client for their services. This practice also brings cost savings to customers, in the form of unpaid NICs and reduced payroll admin and employee liabilities.

The new rules apply to all companies who cannot demonstrate that they are not small businesses. To qualify as a small business, an organisation must meet two or more of these conditions:

  • Annual turnover is no more than £10.2m
  • A maximum balance sheet of £5.1m
  • Employ no more than 50 staff

If eligible, your organisation must decide whether each outsourced provider falls inside or outside IR35 – a task that was previously left to the contractors themselves.

If they are determined to fall inside IR35, your business is expected to deduct income tax and NICs from the contractor’s payments.

Learning from IR35 in the public sector

Using PSCs, public and private sector businesses have traditionally been able to reduce their wage bills – a useful way for them to control costs.

In 2017, though, all public sector bodies were forced to begin the process of classifying contractor roles as being either inside or outside IR35. Some jobs were made permanent with staff being taken onto the payroll. Other contractors were forced to join umbrella organisations who assumed responsibility for deducting PAYE and NICs.

The process was long and arduous and the tax loophole was eventually closed – but there were some unintended consequences too. A recent survey by Contractor Calculator showed that 76% of public sector departments lost highly skilled contractors – and that 38% could not be replaced. A quarter (24%) of projects lost at least half of their contractor workforce as individuals left for the private sector – or even moved abroad.

The public sector experience shows what private companies should expect with the new financial year and beyond.

Why has IR35 become such a headache?

IR35 will create problems for any organisation reliant on long-term contractors for headcount.

There will be an increase in costs because they will now have to spend time that they previously didn’t on the assessment process and will often need to pay additional Class 1 NICs, too. And as contractors find more of their salary disappearing under PAYE, they are also likely to face demands for rate/salary increases to cover the shortfall.

With Harvey Nash reporting that 17% of 1,100 IT contractors are raising their rates to mitigate against the tax increase – some by 13% – 38% to cover the difference – a stark rise on already large invoices is on the cards.

The reclassification of roles is likely to be highly contentious. Public sector organisations like the NHS faced a lot of time-consuming, costly disputes and push-back from contractors who felt that their roles had been classified incorrectly.

Eager to remain compliant with HMRC regulations, many businesses have taken a hard-line no-contractor policy. All big four banks in the UK – Barclays, HSBC, Royal Bank of Scotland and Lloyds – revealed that they will no longer engage with contractors who work through personal services companies and, instead, will employ individuals on a pay-as-you-earn (PAYE) terms or via an umbrella company.

The impact on digital transformation

More and more companies are continuing to promote and invest in digital-first strategies, especially after recent events during the pandemic, which influenced more than a third of 2021 tech budgets. Here, it was made abundantly clear how dependent we are on IT services for business continuity, enabling organisations to rapidly adapt and respond to customer needs throughout times of change.

As more and more sectors typically use contractors for development work to accelerate digital change, the broadening of IR35 now presents a high risk of these transformation programmes stalling, with a potentially devastating effect on outcomes.

Indeed, further research by Contractor Calculator revealed that 79% of public sector IT projects were delayed after IR35 came into force due to contractors leaving. This put a quarter of big government IT projects at risk, including the Home Office’s £341m Digital Services and Border Programme and HMRC’s £220m digitalisation of tax for business plans.

As IR35 changes hit the private sector, at least some of your most valued contractors will likely leave. In fact, a Personnel Today study last year found that 52.5% planned to leave immediately because of the IR35 changes – and another four percent intended to emigrate. A further 19% said they would stay on short term, while they evaluate their options.

CIOs in all sectors are now faced with a potential resource shortage because of the contractor exodus, just as the UK is ‘heading towards a digital skills shortage disaster’, according to the Learning & Work Institute. In March, the think tank reported that the number of young people taking IT subjects at GCSE has dropped 40% since 2015, while demand for AI, cloud and robotics skills is soaring. This makes the option of hiring permanent employees to replace contractors a challenging one.

What are client companies doing?

In response, many CIOs now see the contract renewal phase as an opportunity to revaluate delivery teams.

Given the complexity of reclassifying every role, as contractors up sticks, more and more commercial organisations are shifting from the traditional use of individuals, each one sourced separately, to using external corporate providers to accelerate their digital transformation initiatives.

Instead of manning internal engineering teams with a collection of disparate contractors, business leaders are considering commissioning technology partners who can provide embedded flexible teams to meet all current needs and are able to scale and adapt as priorities change.

This allows client organisations to deliver projects faster, without the need to increase headcount. It also avoids all risk and concern around IR35 as they would be engaging with a service delivery company with full time employees under a genuine management structure. In addition, they could tap into a truly multi-disciplined ‘technology hub’, with experienced specialists across many different business areas and industries to match staffing needs and keep pushing technology forwards.

Audacia works with businesses in a range of sectors to provide digital transformation services, from advisory and strategy development, to providing teams to deliver digital projects. Teams operate as an extension to client businesses, either based onsite, providing the benefits of contractors or internal hires, or offsite, an approach that has only strengthened as businesses continue to work remotely and online collaboration continues to excel.

This reduces the reliance on external contractors and ensures agility and efficiency for businesses; in current periods of continuous change, adaptability has become key to success. Small, agile, outsourced professional teams that avoid the cost and compliance headaches of IR35 enable organisations to rapidly deliver digital projects and focus on continuous improvement and innovation. This will be essential for businesses to respond to customer needs, improve service thresholds and scale.