Why contractors should mind the tax gap

This year’s ‘tax gap’ - due to be disclosed on Thursday - is too often regarded as just another HMRC update. In reality, the gap is why contractors are being attacked by legislation on multiple fronts. The gap was even nodded to in the IR35 ‘discussion document,’ writes Graham Webber of tax investigations firm WTT Consulting. 

Before pinning down the significance of the tax gap and why it matters, it’s important to explore how much it is (without wanting to steal HMRC’s thunder ahead of Oct 22nd), and what it is.

Ghosts and Moonlights

To quote HMRC, the tax gap is “the difference between the amount of tax that should, in theory, be collected” versus “what is actually collected.” In 2014, HMRC estimated the value of the gap to be £34billion. Of this amount, individuals contributed £4.6bn with the majority of that (£3.4bn) being attributable to “ghosts and moonlights”.

The gap as a percentage of the tax that should be collected is around 6.8%. This is a figure that HMRC is proud of. In fact, the department says that the tax gap has reduced since 2005/06 to the most recent measure by around 2%. Given that the ‘gap’ was not a measure used in 2005/06 and the difference is arrived at by guessing at what it would have been 10 years ago, this narrowing can at best be seen as indicative rather than real. 

MPs minded the gap more than the Revenue

Today, there can be some admiration of HMRC because it has managed to spin into a success story what it once regarded as an onerous measure, given that it was actually MPs on the Public Accounts Committee who foisted the ‘gap’ onto the tax authority as a criterion. But I do wonder; is asking HMRC to police itself in this way (it updates us each year on how much the gap is worth) ever going to give an answer that can be trusted, implicitly?

There have been more fanciful measures of this gap. In particular Richard Murphy, a campaigner for tax equality, produced his own report which values the tax gap close to £120bn; quite a big pinch above HMRC’s £34bn. If we are going to be wary about the selective use of statistics, there is no direct comparison from Mr Murphy’s report to the values HMRC puts out, other than to observe that the majority of the gap here is from fraud, evasion and corporate avoidance. And with those three areas, the usual suspects are rolled out. Their alleged avoidance is measured by Mr Murphy’s outfit, Tax Research UK, with ease whereas frustratingly, HMRC is unable to do the same or take action. More informed sources than I have looked at the figures here and reached a conclusion that the value of the gap is at best hopelessly optimistic. (As an aside, it’s worth remembering that most commentators have their own reasons for supporting/denying the official figures on the gap).

Why the tax gap matters

Firstly because the measure has become a key metric against which HMRC is measured. As such, they can be expected to try to improve their performance. This may be hidden behind HMRC sound-bites such as “instilling confidence in a fair tax system”. The more likely reason is that, like most organisations (and especially an oft-criticised government organisation) it wants to be seen to be doing better.

Within the tax gap numbers (whoever’s set you favour) there are some easy targets. These tend to be those taxpayers who have inadvertently strayed into what is now classed (and frowned upon) as tax avoidance. These unenviable individuals stay visible to HMRC and are typically active in trying to resolve their situation, even though they might not necessarily have deep pockets to obtain the advice they need.

The multinationals in the coffee, internet and logistics sectors are, by contrast, far from being easy targets. From dealing with these giant companies and how they teem and lade profits (and taxes) between territories in order to be ‘efficient,’ I can vouch that this is a massive exercise involving dozens of people and incurring hundreds of thousands of pounds in professional costs. I can’t imagine the job is getting any easier. Yet I can easily imagine that the resources available to large corporations and HMRC are not in parity.

The second reason why the tax gap matters is because the metric has found its way into the thinking and justification for a number of changes proposed for the tax system. The recently closed ‘discussion document’ on IR35 contains on page two a summary of reasons why change is needed. One of these is the fact that the rule is not working “as effectively as it should be”. That sounds like a target has been set and as the revenue is less than said-target, there is a ‘gap.’ Given that the group of individuals against whom the rules are aimed (contractors) falls into the contingent who are easy to find- not least because they are still working and are able to pay (allegedly), these freelance professionals are certainly easier for HMRC to extract funds from than multinationals or those earning but not in the system at all. So yes contractors, to HMRC you are invariably deemed to be low-hanging fruit.

The third reason why the tax gap matters is that reducing opportunities for legitimate tax planning, as the government is doing, will reduce the gap. While there is lip service paid to the impact small businesses make to the economy from all sides of the political spectrum, and claims from officials that traders can structure themselves as they wish, the reality is different. We are being proposed changes to the way dividends are taxed (despite an election promise not to raise income tax), as well as changes to the way expenses are to be taxed (despite the July Budget’s rhetoric about ‘recognising hard work’). The government’s scrutiny and implied distrust of companies used to sell the skills of individuals (also referred to umbrella companies) meanwhile pervades, notably since its peak at Autumn Statement last year.

IR35 is about to pale into the background

The next 6 to 9 months is going to see a revolution in how contractors organise themselves and are taxed that will make the original introduction of IR35 pale into the background. It is my personal opinion that reducing the tax gap is the key driver to all of these measures and unless (and until) that measure is abandoned, it will remain a powerful and driving force of legislative attacks against contractors.

Unfortunately for hard-working individuals operating on their own as a contractor or consultant, the measure that is the tax gap is here for a decade or more – at least according to my best estimation. Figures for the gap were seized upon by Jeremy Corbyn in his recent victory in the Labour leadership contest and became a plank of his anti-austerity message. The figures continue to surface in the rhetoric of John McDonnell, the shadow chancellor. The message from the Labour side suits the Conservative agenda well, so this measure seems set to be a political football, of sorts, with the kickers in Whitehall being able to bend it into whatever shape helps their arguments best.    

Future-proof yourself for a potentially torrid time ahead

For contractors, the implications are therefore clear. For some time to come, treat with extreme caution any off-the-shelf ‘solution, ‘arrangement’ or ‘plan’ that promises high percentage (over 75%) retention of earnings. Such offerings will almost certainly be non-compliant with the tax gap measure that is now an easily understood number that has the advantage of being both part of the public imagination and capable of meaning whatever you want it to. 

So our recommendation to contractors is this: plan to operate within the new rules on dividends, status and expenses; don’t wait. Review your present arrangements and consider getting some advice on how you should be operating in 2016. Oh, and one more thing we won’t shy away from strongly suggesting – takes these steps NOW.