Tax rule may start new brain drain

Next week a band of computer experts will trudge along to the High Court in London to contest a tax rule which they say leaves them paying tax at more than 50p in the £1.

They say the new rule - known as IR35 - has forced the country's brightest talent to leave in their thousands for the continent and the US rather than pay excessive amounts of tax.

Computer programmers, software developers and other IT specialists who supply their skills to big companies are at the heart of Britain's technology boom. Without them, they argue, Tony Blair's dream of a nation full of energetic, independent techno wizards driving the economy forward will to be an interesting idea and not much else. Many of them hoped the Chancellor would scrap the rule in the Budget this week, but it seems there was never any intention on the government's part to step away from next week's confrontation.

The Professional Contractors Group represents a large slice of disgruntled computer specialists who are caught by the tax rule. Gareth Williams, the group's chairman, says he was disappointed that almost two years of concerted lobbying had failed to change the government's mind.

"The government has been universally condemned for introducing this misconceived measure. This Budget gave the Chancellor the last opportunity to right the wrong before the PCG's legal action," he says. "There is little point in him making token gestures towards small businesses when many of those small businesses will have either closed or moved overseas." The contractors' group keeps a running list on its website of members that have already left the country. A glance at the list shows that most have gone to places with favourable tax schemes. Holland is a top destination as is the US and Germany.

Anywhere between 50,000 and 100,000 IT people could be affected by IR35. The rules are devised to stop what Inland Revenue officials had come to see as a widespread tax scam. The Revenue claims that during the mid-90s it began to see large numbers of people who provided services, set up limited companies that employed one or two others.

A limited company was better than self-employment for several reasons, but mainly to save on National Insurance payments. If the income of the company was in the region of £50,000, the usually male employee would be paid £4,000-£5,000 tax-free (roughly equivalent to their personal allowance entitlement). Another £4,000-£5,000 would be paid to their non-working wife.

Meanwhile large amounts of domestic costs along with business costs like new computers, software and training would be charged as expenses, depressing the amount of taxable income. The difference would be paid out in dividends, which are eligible for income tax but not National Insurance.

In this way, someone with a large income could use a limited company to their advantage. The Revenue says a PAYE employee earning £50,000 would pay, on average, 35% of their income in tax while the computer contractor sitting next to them was paying 21% of their income in tax.

John Birt, the former BBC director general, made the perfectly legal practice famous when it was discovered that he was not a BBC employee despite taking on the top job but, instead, used a limited company that charged his services by the hour.

A senior Revenue official told Jobs & Money that computer contractors and other business people in the service industry were encouraged by accountants to use limited companies to avoid paying tax. The Revenue believed it was losing millions in unpaid class one National Insurance contributions as the computer industry grew and the ranks of contractors swelled.

IR35 says contractors and other workers must behave like self-employed people and work for several employers. Long projects for one employer will mean they are employed by the client. If they manage to fit the self-employment rules, the contractor's company is prevented from retaining company profits for investment, which depresses taxable income. National Insurance will be applied to the companies' income and expenses must be limited to 5% of income.

But the PCG denies that its members used limited companies as a tax avoidance device. It says clients who bring in contractors want them to work under the umbrella of a limited company, which must take responsibility for any mistakes. If the contractor were self-employed, the client would be liable.

The contractor will often employ people to help develop software and work on projects, which is easier to manage and with more legal safeguards in a limited company arrangement.

And it says there is no justi fication for comparing contractors with employees. They qualify for sick leave, holiday pay, pensions, share options and a degree of job security.

Even if they had an equivalent status, under IR35, contractors will pay much more tax than employees without any of the benefits, it claims.

The Revenue official said: "Ministers do not accept that people who work in the IT in dustry are a special case. The government is very keen to support the IT industry, but not by allowing a certain class of people to pay tax in a different way to other employees."

IR35 helpline: 0845-303-3535 or www.inlandrevenue. gov.uk/ir35

Also leaflet IR2003, Supplying Services - How to Calculate the Deemed Payment