The delayed introduction of new rules to clamp down on “disguised” employees has already led to a trickle of contractors leaving the market, a leading Scottish recruiter has warned, but the full impact will come later this year as pandemic restrictions ease.

Changes to IR35 – shorthand for UK tax legislation designed to identify contractors and businesses which are avoiding paying the appropriate tax by hiding their true employment status – that come into effect in three weeks’ time were initially due to be introduced last year, but were postponed because of the Covid outbreak. With the economy still reeling from the fallout from the pandemic, there was widespread hope for a further deferral that hasn’t materialised.

Charlie Wood, who is in charge of contractor solutions at Head Resourcing, said the visible result of these changes will be a “senior and technical talent drought” at a time when these people will be most needed to help kick-start the economy. Those who can will exit the market, leading to a greater talent shortage in the IT, digital, construction and pharmaceutical sectors.

Mr Wood said the combination of IR35 and Brexit had already led to “a handful” of contractors relocating to European destinations such as Ireland or France, though Covid-19 restrictions have so far prevented any “mass migrations”.

“We are aware of a number of contractors who not only sought EU citizenship if they could but also moved abroad ahead of both Brexit and the IR35 changes coming into effect,” he said.

The Herald: Charlie WoodCharlie Wood

“With existing talent shortages already present and mounting, particularly within the technology sector, there is a very real threat of exacerbating the situation further with additional ‘brain drain’ due to the combined Brexit-IR35 effect.”

Although the new IR35 rules have been a long time coming, there is still a good deal of confusion about what they actually mean, and who is affected.

When it first came into force in 2000, it was the responsibility of individual contractors to determine whether they were “inside IR35”, meaning they should pay the same National Insurance and income tax as an employee. The rules changed in 2017 so that in the public sector, the responsibility for determining status shifted from the contractor to the organisation engaging their services, who would also pay any penalties for mistakes in these assessments.

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It is primarily aimed at weeding out individuals who work long-term for the same client as a director of their own limited company. Under this setup, limited company contractors pay UK corporation tax (currently at 19 per cent) on their company’s profits, but can draw the majority of their income as dividends, thus avoiding higher rates of income tax. This set-up also reduces or eliminates National Insurance payments.

When the new rules for the public sector came in, most organisations defaulted down the “easy route” of placing all contractors within IR35, as this appeared the safest and most cost-effective approach. By HMRC’s own estimates, about 30% of contractors should have been put under IR35, whereas in reality about 80% were shifted over.

The upcoming changes affect private sector organisations, and will mirror those that took place in the public sector in 2017. Suspicions are that private businesses will take the same aggressive stance in putting the majority of contractors within IR35.

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Mr Wood said it’s likely that most jobs will be deemed subject to income tax and National Insurance, and with no signs yet of substantial upward movement in the rates on offer, contractors will have to absorb this in what will effectively be a pay cut. Most may grudgingly accept this model, but many will also be on the lookout for other opportunities.

And as more people exit the freelance market, Mr Wood believes rates of pay will have to go up, with evidence of this likely to begin emerging before the end of the year.

“Whilst there has been no reprieve [on IR35], given the current state of the economy, the fact that we are still in the midst of the pandemic and the additional pressures and uncertainties added by Brexit, it seems to me to be irresponsible,” he said. “It will add even more pressure to business and indeed to the majority of the contracting community who have already been massively neglected by the current UK Government’s Covid bail-out and support plans.”