Regulating the Demon
Overview
So far, this book has focused on exposing the nature of a particular type of human experience. Employment is the relinquishing of individuality and identity at work. The task of the common law is to discover whether individuality and identity have been relinquished; if they have, then the work relationship is governed by a particular form of legal contract known as the employment contract or contract of service.
The contract of service reflects, identifies and governs the way the employer and the employee interact. Employment is mostly governed by the common-law processes of the courts. During the twentieth century, however, and particularly since the Second World War, common-law oversight has become overlaid by a complex mass of statute law that has its roots in the thoughts of Karl Marx and current generational devotees. Marx objected to the unequal power inherent in the relationship between employer and employee, calling it wage slavery. Regulation has as its heart one basic assumption: that the human inequality inherent in the employment contract is bad. The state assumes that it has a duty to regulate the employment relationship for the purpose of protecting the legally powerless employee.
The intention is noble, but the process of regulation is flawed. The power of the regulators has expanded to the point where the regulators themselves have become oppressors of both employees and employers. The forms of regulation developed have seriously distorted human behaviour. Inequality of power has not been diminished; on the contrary, it has been expanded and shifted.
How this has occurred, how it is occurring and how social regulation creates inequality can be understood only by looking at the detail. And there's lots of detail to look at. The first is tax!
CHAPTER 3
The Tax Commissioner may (a) treat a particular event that actually happened as not having happened and (b) treat a particular event that did not actually happen as having happened.
-- The Australian Goods and Services Tax Act (165-55), 2000
In perhaps no area does the state choose to give itself greater power than in tax. The state is prepared to hand legal powers to taxing authorities that defy the laws of nature and common sense. In Australia, legislators have been prepared to give the chief tax officials authority to change reality. On a whim, tax officials can declare that a person travelling north is actually travelling south, that a war that occurred did not actually occur or, more likely, that an expense that an income earner incurred did not actually exist. Tax officials are granted powers that are granted to no other. Thus it has always been and thus, regretfully, it always will be.
And with this all-powerful authority, the attitude of tax officials to employment since the Second World War has been the most important regulatory influence on working relationships. It has been all-important for one simple reason: that the power of tax agencies to collect income tax at source, at the point of payment, has been legislatively tied to common-law employment. Where people have worked but not been employed, tax authorities have not had the authority to require the payer to withhold tax from the receiver of the payment and to send the withheld tax to the tax authority. This legislative model for the collection of income tax at source has been used in the USA, UK, Canada and Australia, to name just some countries. It is the "at source" income-taxing model used by most developed and developing nations.
In effect, the common dependence of income-tax collection systems and labour regulation on determinations of master-and-servant employment has, over time, caused tax-collecting authorities to become allied with labour regulators. The two authorities with outwardly different agendas have found themselves in the same colluding bed. Tax-collection powers have been of key importance to the powers of labour regulators.
This outcome has corrupted the integrity of tax collection systems.
To understand how this occurred and how it exists, the historical background is important.
HISTORICAL BACKGROUND
With some regret, one of the giants of the post-Second World War economics profession, Milton Friedman, (1) describes his role as one of the architects of the income-tax system in the USA -- a system replicated in most Western countries and now being transferred to developing nations. Friedman says that US federal income tax was meant as a temporary measure to overcome the problem of funding the Second World War. In the 1940s, the US Treasury was concerned that massive debt funding of the First World War had been a major contributor to the Great Depression, and feared that if the Second World War were also funded by government debt, then the seeds of a second great depression would have been sown. The solution was the income tax system. This now familiar tax system imposes tax on each individual income earner. A key part of the system is that it requires "withholding" -- a person making a payment to a worker must take out tax and send it to the tax office. This gives government a steady, reliable and continuous stream of money. Government can spend without resorting to debt, so long as it keeps its spending in line with tax receipts.
Milton Friedman bemoans how temporary measures become permanent and grow when government has its hands in the public's purse. Income tax has become huge and is a dominant source of government revenue. Here, then, is one of the sources of the "employment" problem, because "at source withholding" was and is legislatively dependent on the existence of common-law employment. No contract of service means no income-tax withholding!
In the 1920s, '30s and '40s, the legal master-and-servant employment model was perhaps at its height as the method for organising business in capitalist societies. It was understandable that, in designing income tax systems, tax legislation should tie the power of tax officials to collect income tax at source to common-law employment. In the mid-twentieth century, common-law employment-dependent tax powers had caught nearly the entire working population in their net. However, things began to change.
Around the late 1970s, significant shifts in legal work engagement methods began to emerge and have since accelerated. People started to desert the master-and-servant, wage-slave model for reasons unrelated to tax. But as a consequence, tax officials feared that their legislative reach was diminishing.
The scale of the social movement away from wage slavery has only recently been authoritatively identified. In Australia, for example, the first survey on this issue was undertaken by the Australian Bureau of Statistics. (2) It found that, as of August 1998, 20 per cent of the workforce identified themselves as self-employed and only 59 per cent of the workforce identified themselves as working in full-time employment. Significantly, 28 per cent of the private-sector workforce were identified as working without being "employed". The best available surveys in 1989 put the Australian self-employed figure at somewhere around 3 per cent, (3) indicating the large and rapid scale of the growth of the independent contractor sector in little more than a decade.
In many other English-based legal systems, such as the USA and Britain, the trend away from employment has been even more marked. There are some indications that, in the USA, perhaps more than 40 per cent of the working population have deserted employment and work under independent contractor-type arrangements.
These trends have alarmed tax authorities in USA, the UK and Australia, to name just some. Many tax commentators and designers have not understood or accepted the social movement away from command employment, but have instead interpreted the movement as a tax-avoidance scam. From their perspective, it is perhaps tax avoidance; but, if it is not avoidance, the decline of employment certainly presents tax officials with an administrative problem, since their job is to ensure revenue for government. When that revenue is diminished, they come under pressure from their political masters.
The response of most tax authorities to the diminution of their collection powers has been a combination of accommodation and aggression. The aggression has come in the form of co-ordinated attacks against independent contractors by tax authorities, certainly in the UK, Australia and the USA. Ultimately, however, the movement away from employment cannot and should not be stopped. It is occurring for reasons unrelated to tax and is being pushed by new attitudes to the nature of work relationships: part of a redefining of the nature of control in social and economic structures. Aggression by tax authorities will only bring them into conflict with vast sectors of society and damage the effective working of economies. Tax authorities will not win by trying aggressively to enforce a tax collection regime that was designed in the mid-twentieth century. Yet tax officials can successfully accommodate the emerging social movement away from employment, and they have largely done so in Australia in the 2000s. It is a lesson that developing economies should heed.
First, however, it is necessary to understand the problem from the tax system and tax officials' perspective. Tax officials are charged with a legislative obligation to collect tax. From an administrative angle, the most effective tax systems are those in which voluntary compliance is maximised and in which tax is collected at the time a payment is made (at source). Tax auditing and compliance are expensive, not cost-effective, and something which tax designers seek to minimise. Voluntary compliance is a key objective.
In most nations, pay-as-you-earn (PAYE) arrangements have evolved as the primary "at source" collection system. It is the system in part designed by Milton Friedman. It is around PAYE that the tax authorities' administrative systems are constructed. But, commonly, PAYE legislation gives the tax authorities power to collect an individual's income tax at source only if the individual is in a common-law master-and-servant employment relationship. The normal legislative wording requires "employers" to deduct instalments of tax from payments of salaries or wages to "employees" and to send the proceeds to the tax authority.
Industrial and post-industrial societies have largely been constructed around big businesses employing large numbers of people. The legislative process of requiring businesses (employers) to take tax from their employees and send it to the tax authorities has made for comparatively simple tax-collection systems. Income earners have been legally liable for income tax, but employers have been legally liable for collecting it. It has been much easier for tax authorities to administer the collection of income tax from tens or hundreds of thousands of employers than from many millions of individual income earners. The master-and-servant arrangement has well suited the administrative taxing systems of the nation-state, particularly before the onset of the IT revolution.
But when large percentages of people leave employment, this challenges the established taxing authority of the state. The shift from employment to contracting has seen large numbers of businesses continuing to employ many persons but "engaging" many others through independent contracting. Consequently, and in relation to contractors, businesses no longer have a legislative obligation to withhold tax. In fact, to withhold any amounts from the contractor without the contractor's consent would breach businesses' common-law commercial contract obligations.
The response of the tax authorities to this community shift has largely been one of aggression, as reflected in the choice of language tax authorities use when referring to contractors. Independent contracting has been termed "disguised employment", contractors are said to "exploit the fiscal advantages offered by a corporate structure" and to engage in "means to avoid paying a fair share of tax", (4) and tax authorities are said to need to establish "rules to tackle tax avoidance" and to have a moral obligation to "ensure that they [contractors] pay a fair share of [tax] compared with those directly employed." These quotations come directly from press releases issued by the Internal Revenue Service in the UK. (5)
In short, the tax authorities have sought to demonise independent contractors in the court of public opinion in an effort to justify the tax authorities' aggressive push beyond their legal limits. It amounts to officers of the state using the power of the state to engage in crass bullying. It allows officers of the state to assume they have a moral responsibility to collect income for the state beyond the legal powers delivered to them.
In an important test case in the UK referred to in Chapter One, (6) the presiding judge referred to this sort of language from the tax authorities as "wholly regrettable and unnecessary". The judge offered the view that the language indicated a bias and predetermination of outcome on the part of the UK IR. The judge said, "It seems to me to have been assumed without any or any adequate research, that all service companies [contractors] fell within that category [employment], simply by reference to the use in the initial publicity of words ..."
This evidence of the taxing authorities' determination to impose employment is a clear demonstration of the overstepping of the authority of the state and how the state, through the detail of regulatory administration, can become an oppressor of its citizens. Further, it demonstrates that regulators should not be the determiners of employment, since they have a vested interest in a particular outcome of any investigation.
AUSTRALIA
As in the UK, the Australian tax authority (the Australian Taxation Office, ATO) has a long history of aggression against independent contractors. But the situation has rapidly improved thanks to a redesign of tax administration and collection.
In an effort to overcome independent contractor leakage from PAYE during the 1980s and 1990s, the ATO argued that the legislative powers under section 221A(1) of the Tax Act extended the Commissioner's powers beyond employment to include contractors.
The ATO sought to enforce this extension of its legislative powers. Australian courts, however, consistently disagreed with the Tax Commissioner. During the late 1980s and 1990s, the High Court of Australia (the court of final appeal) on 10 separate occasions rejected the Tax Commissioner's view that PAYE legislative powers extended beyond common-law employees. The Australian courts applied a strict common law definition to the word "employment" and consistently held that independent contracting was not employment. Yet even when a large number of legal decisions went against the ATO, it continued to take aggressive legal action against individual independent contractors. As of 2005, this remains the situation confronting independent contractors in the UK.
Naturally, the tax authorities can fund their side of these highly expensive legal cases from the public purse, while individual defendants have to pay for their defence from their own pockets. In some cases, determined to be test cases, the tax authorities will offer to pay the defendants' legal expenses, but not their accounting and personal expenses. In such cases, the individual taxpayer always suffers significant financial loss. Tax authorities, with the wealth of the state at their disposal, practise commercial intimidation against the citizenry. In this area, tax officials in many nations have a history of achieving their preferred outcomes simply because the individuals they target cannot afford the legal or personal expense of a defence.
But it is a situation that defiles the rule of law and reduces community respect for the instruments of the state. Ultimately, a community can come to see the state as akin to a robber baron who ignores justice and the law. This encourages a widespread belief that it is legitimate for the people to steal from the state because the state steals from them. If taxing authorities do not comply with the law, or seek to manipulate the clear meaning of the law, they inevitably encourage blatant tax avoidance.
It is of course a fine balancing act, because tax authorities have plenty of experience of individuals using legal loopholes and aggressive legal action to thwart legitimate taxing authority.
As well as aggression, another approach tried by the ATO in 1994 was to change income tax legislation so as to bring independent contractors into the income tax withholding net. The amendments, known as Taxation Law Amendment Bill No. 5, were, however, dropped in 1998 after significant turmoil and a change of government.
Amendment Bill No 5, like other attempts to apply income-tax deduction at source to all contractors, declared contractors to be master-servant employees. In effect, it sought to outlaw independent contracting. As one judge said, it amounted to legislatively calling a chicken a duck even though a chicken is still a chicken. It was an approach with parallels to the Queensland Section 275 legislation discussed in Chapter Two. Had these tax amendments succeeded, they would have turned the Australian Tax Office into an instrument of the labour regulators and would have put the ATO on a collision course with a broad social movement interested in freedom, equity and justice. Bad for tax collection and bad for society!
The problem with the ATO's approach is that it defies the common-sense, common-law reality that contracting is still contracting. Legislation does not change reality -- even if governments give tax officials the power to pretend to do so.
Another approach taken by the Australian Tax Office was to create an administrative tax collection system at source for contractors. This was called the Prescribed Payments System (PPS). It was designed largely to create an "at source" tax collection system for the Australian housing building industry, which is almost exclusively structured around independent contracting and is politically powerful enough to resists attempts by the ATO to impose employment on it. PPS existed between about 1983 to 1997 but was always seen by the Tax Commissioner as administratively messy and at best providing only a temporary plug for an expanding hole.
In Australia, the union movement conducted fierce scare campaigns against PPS, denouncing it as illegitimate and a source of tax evasion. But its real concern was that it provided a measure of tax legitimacy for independent contractors. A legitimate and safe legislative tool for collecting income tax from contractors does not suit the industrial objectives of the Australian union movement, which relies on the state enforcing command-style employment so as to sustain the "class war" mentality upon which unions' claims to moral authority rest. Any taxing system that caters for contractors threatens union power.
THE UNITED KINGDOM
The Internal Revenue Service (IR) of the United Kingdom has similar concerns with independent contractors. As noted earlier, the UK IR has acted aggressively against independent contractors. It has been involved in the at-source deduction issue, but has equally been concerned that independent contractors access lower levels of tax than employees.
The specifics of the issue are as follows. As in most income-taxing countries, tax is imposed on any entity that earns income. Employee income is usually taxed on sliding scales so that people who earn less pay a lower proportion of their income as tax than do high-income earners. This is considered an important tool for reducing income inequality in the community. Employees are allowed comparatively few income tax deductions because it is considered that employers pay for the non-labour costs of production, which are not costs employees must bear in the course of earning income.
Businesses, usually thought of as employers, are also taxed on their incomes, but the method of calculation is more complex than with employees. A business has large expenses and is taxed on profit (net income), not revenue. To calculate profit, business expenses must be deducted from sales revenue.
Most arguments over tax evasion relate to the business tax area rather than to employee tax, since tax authorities disallow deductions on costs they do not consider to be true business expenses. In addition, tax authorities spend considerable resources chasing accounting-type scams whereby businesses may attempt to transfer expenses from one business unit to another, hide income, claim personal living expenses as business expenses, and so on. Huge sums can be involved and the accounting and legal scams can be highly complex.
The issue of the taxation of the income of independent contractors, however, is not at its core one of illegitimate tax deductions or the hiding of income. The primary issue is that of a cross-over from employee to contractor. If a person is an employee, the administration of their tax is comparatively simple. If a person is an independent contractor, their tax is and should be treated within the more complex business-tax framework.
The issue is one of both practicality and law. An independent contractor, by virtue of the way she works, will tend to incur expenses that an employee does not. An independent contractor is the same as a business. Before an independent contractor's tax can be assessed, her business-related expenses must be deducted from the revenue to find the true (net) income. In law, an independent contractor works under the commercial contract for services, like any other business, and should be entitled to business-tax equity.
The conceptual problem that tax authorities in most countries cannot seem to cope with, as reflected in the UK IR approach, is that a single person can be a business. Tax designers seem to have collectively concluded that the idea is preposterous. They can conceive of a plumber, for example, being self-employed and running his own business and being entitled to business tax deductions. But they have particular difficulty conceiving of a person whose main business activity is the application of brain-power running his own business and being self-employed. They have even more difficulty thinking of independent contractors working in areas where employment has been traditional and dominant, for example, in factories. Tax authorities have additional and huge conceptual difficulties where individuals set up company structures and where such individuals work principally for a single client. They seem to be convinced that independent contracting must be a tax scam of some sort and go to extraordinary lengths to deny contractors their commercial status. Their suspicious attitudes are evident in their aforementioned aggressive language.
In the UK, this contractor-denying strategy has manifested itself in "composite legislation", known as IR35 after a UK Internal Revenue press release. IR35 is an administrative tax measure that gives UK tax officials the power to investigate individual independent contractors and to make a determination as to whether they are employees or independent contractors. IR35 has caused uproar in the UK independent contractor community because of the ad hoc and selective denial of business-tax status to independent contractors. As a consequence, an independent contractor association was formed in the UK in 1997 (the Professional Contractors Association) (7) specifically to fight the measure, and within four years it had over 14,000 members. IR35 has strong similarities to anti-independent contractor legislation in other countries.
What is extraordinary about IR35 and other similar measures is the denial of natural justice in the tax attack. The determination of employee or contractor status has always been the preserve of common-law court processes. Independent judges hear evidence and make rulings based on the individual facts of each case and in the light of case law principles established over hundreds of years. Contractor status is not some glib, light foolishness. It is a reflection of conscious contractual relationships into which people choose to enter and around which they organise their work. Tax authorities have a financial vested interest in the outcome of a contractor or employee determination, and IR35 gives the applicant (the IR) the roles of prosecutor, judge and jury. More than that, they are the potential beneficiary of any decision they make.
But what is the core concern of the taxing authorities? And do independent contractors avoid tax? In the major test case of the legalities of IR35 introduced earlier, the ruling judge explained the general circumstances, which are common to contractor-tax issues in all countries where the "concern" exists.
People who wish to cease being employees commonly set themselves up under a company structure (service companies) or even operate as a partnership. The company typically has one or perhaps two employees, who are often the directors of the company -- it is a structure commonly used by self-employed independent contractors. The company invoices its client or clients, and is paid. The company takes on the risk of bad debt. The company has expenses that are a necessary part of operating the business. The company pays the owner or owners as employees and sends PAYE tax and, in the case of the UK, National Insurance Contributions to the IR. If, after deducting all their expenses, the company makes a profit, the profit is taxed at company tax rates.
If people using this structure run a shop, the tax authorities accept the business-tax status because a shop is a business structure that tax officials see in their daily lives. If the business employs a few other people or even tens of thousands of people, the tax authorities accept the business status. But if the company is the smallest of small-business structures, namely a one- or two-person self-employed entity, supplying services such as, for example, IT, tax authorities become suspicious. Why?
Tax authorities argue that, by purporting to be independent contractors, people who should be taxed as employees are able to reduce their tax liabilities through the service company. For example, in the UK, the IR promotes the view that people take advantage of the sliding scales of PAYE tax -- that is, lower rates of tax for small companies -- and do not have to pay National Insurance Contributions on dividends (which the IR sees as disguised employee income). By juggling the declaration of employee and dividend income, individuals can minimise their tax.
Does this occur? Probably yes. But is it illegal or illegitimate or immoral? No!
People have a right to decide how they wish to work and how they wish to manage their lives. In relation to tax, "the problem" that the tax authorities think they are facing is not that people are rorting the tax system but rather that the world is changing. And that changing world does not fit the neat employment view of society around which tax authorities have structured their administrative processes and their personal working lives. The problem is not that of contractors rorting tax but rather of tax authorities failing to respond to new social trends or failing to redesign their tax systems to reflect emerging community practices.
The fact is that, in the UK, lower tax rates are available for small business. This is not of independent contractors' making but a decision of government. An independent contractor is the smallest of small businesses and has a right to access tax regimes created by government. If there is something wrong with the tax regime, the tax officials' appropriate response is to seek to redesign the regime, not to impose a selective view of the system's application. Tax authorities do not have the moral right or a right under common law to decide who is or is not allowed to be self-employed. The decision is always that of the common-law courts and the most that tax authorities have ever achieved is an administrative power under statute. Tax officials have a duty to collect tax. This does not confer on them the authority or right to decide the social and legal structures that people use in a society.
The great concern is that the law sets up the UK tax authority as a sole arbitrator of what is or is not a legitimate business structure. Yet the UK IR has a vested financial interest in the outcome of determinations. They are not qualified to undertake the consideration or make the decision. Only the courts can do that.
This was demonstrated in the IR35 test case (8) in which the judge cited the failure of the IR's tax inspector to apply contractor determinations accurately and consistently. The judge observed that "... two different inspectors wrote, quite independently to the accountants a month apart, without reference one to the other, giving entirely inconsistent answers: the one who gave the answer that IR35 would apply relied upon an entirely erroneous construction of the contract in question."
The simple fact is that there is a clear legal distinction between the status of employment and the status of independent contracting. Independent contractors are self-employed business people subject to common law and legislative commercial regulation. They are not by nature, nor should they be, within the jurisdiction of labour laws. It is simply not possible within common law for a person to be a contractor and a "little bit an employee". Yet legislatures give the instruments of the state the power to perform acts of legal nonsense. When the state is both the lawmaker and the financial or other beneficiary of the law, the bounds of common sense and legal principles seem not to prevail, or at least are distorted.
This appears to be the case with the UK IR35. The tax authorities believe that independent contractors are tax rorters and legislatures have given the authorities total discretionary power on the basis that "you can trust us". But do independent contractors legally set themselves up just so they can minimise tax? The answer is that there is no general answer. It may be the case or it may not. Take the following simple but real-life example.
INDEPENDENT CONTRACTORS AND TAX DEDUCTIONS
A company needs an information technology specialist. The company can either employ the person or take him on as an independent contractor. Assume that the job will last 18 months.
If the company takes him on as an employee, it takes on a complex series of employer responsibilities. In most countries, by employing a person for 18 months the company enters a situation where labour laws assume that the person is full-time and effectively has ongoing ownership of the job. The company must factor its "employer" responsibilities into its arrangements. When the company pays the person as an employee, employment regulation determines that the "employer" must deduct certain items from the payments to the employee. This includes amounts to cover holiday pay, sick leave and other leave requirements. In Australia the amount that has to be deducted amounts to about 18 per cent of the employee's income. The employee does not see this money until he takes leave, for which he is paid although he is not working. The employer must keep detailed records of these deductions to ensure that the employee eventually receives back the money deducted. The withholding of money from the employee by the employer is, in effect, a forced loan from the employee to the employer. The system is disadvantageous to the employee and costly to the employer to administer, but it is all part of the complexity of the master employer-servant employee contract.
If the company takes the IT specialist on as an independent contractor, it does not take on any of the complex employer-type arrangements. The payment system is very simple. Nothing is withheld from the contractor for the purposes of holidays or leave, and the contractor receives total payment for the periods he works or the job he performs. When the contractor decides not to work, he does not get paid for not working. His holidays are his own choice which has nothing to do with the person paying him. Consequently, the payments made to the contractor are higher and the contractor takes on the responsibility of looking after himself. The contractor will often incur expenses that an employee will not. For example, a contractor is likely to take out personal income and public liability insurance, have self-training expenses and supply tools and equipment that are appropriate to the work he does. These additional costs incurred by an independent contractor will be reflected in the fee that he will charge, which is therefore greater than the wages that he would receive if he were an employee.
For example, an employee doing an IT job might receive $35 an hour. When on holiday he is still paid. An independent contractor doing exactly the same job but engaged in a completely different way might receive $50 an hour or more. This difference reflects the significant costs that a contractor incurs before a true comparison with the employee's remuneration can be made, such as the costs of taking a holiday.
Travel expenses are another example. With employment, employers normally provide their employees with work-related travel facilities. An employee arrives at work and takes a work car to go out and do her job. While the employee cannot claim the travel as a tax-deductible expense, the employer can claim it as legitimate business expense. A contractor, in contrast, has to charge her client a fee that is higher than the equivalent employee's wage in order to cover her travel expenses, for which she is solely responsible. The contractor can rightly claim the travel expenses as a legitimate tax-deductible business cost. The same arrangement holds with home office expenses: whereas employees are normally supplied a work station, the expenses of which are covered and claimed as a business expense by the employer, contractors, particularly in the IT industry for example, often work from an office at home, whose expenses they have to cover from their fees and which are legitimately tax-deductible.
On the surface, the contractor may appear to be earning more than an employee, but in truth may simply be receiving more in the hand because the contractor receives the "employee benefits" in a cashed-out form. Whether this is true depends on the circumstances of each case. No one answer fits all cases and many other factors come into play that may complicate any calculation.
In traditional industries, it may be possible to calculate the difference between contractor and employee rates. But information technology -- to take a relevant example -- is a new industry that has grown up and is near wholly structured around independent contracting, making comparisons with employment virtually impossible.
The point, however, is that for tax purposes the payments an independent contractor receives are exactly like the payments any small business receives. Business expenses must be deducted before the business's "profit" or true income can be calculated. The tax authorities' attack on independent contractors ignores these expenses and clearly seeks to disadvantage independent contractors. By insisting that independent contractors be treated like employees, tax officials impose higher rates of tax on independent contractors than those imposed on employees. A natural reaction of independent contractors would be to abandon independent contracting because of financial intimidation and to seek employment. By not being prepared to accept the business legitimacy of independent contracting, tax authorities become enforcers of employment.
When they adopt this stance, tax authorities are determining the nature of relationships in the work environment. Employment is about one person controlling another. The way people are paid is part of the control issue. Money is withheld from employees for holidays as a controlling mechanism. Employers want employees to work when and where the employer wants, at the employer's convenience. Holiday and leave pay is used by employers as a bargaining chip. With independent contracting the situation is completely different. No money is withheld and so no such control can be exercised. Negotiations over when a contractor takes unpaid holidays are done on an equal basis and are resolved in the normal businesslike way by finding commercial common ground between the parties. By insisting on employee taxation, tax authorities enforce inequality of employment bargaining.
Another complaint made by the UK contractors was that the IR ruling took away certainty of contract and was discriminatory. Before IR35, contractors knew that they enjoyed a business-tax status and could plan and operate accordingly. But when the IR sought to impose on them an employee status for tax purposes, the contractors considered they were being subject to state-imposed discrimination. Further, the actions of IR35 breached important principles of commercial activity in which "A norm cannot be regarded as a 'law' unless it is formulated with sufficient precision to enable the citizen to regulate his conduct; he must be able ... to foresee to a degree that is reasonable in the circumstances the consequences which a given action may entail." (9) Through the mechanism of IR35 the IR has created contractual uncertainty. People engage in business only if they know that, when they strike a deal, it will hold. IR35 creates an environment where the contractor's individual commercial contract is subject to retrospective bureaucratic destruction based on arbitrary processes that contravene the very common-law principles upon which commercial contracts are based. Note, too, that the IR applies such judgements only to individuals, never to big business: a practice that is clearly discriminatory!
IT'S AN ISSUE OF ATTITUDE AND CHOICE!
Sometimes the imposition of employment stems from disbelief that anyone would not want to work as an employee. Tax bureaucrats come from employment environments. They have been raised and educated to be "employed". They spend their careers as employees in generally secure government jobs, fight their way up the employment career ladder, mix and socialise with employees and most often do not have professional life experience outside the restrictive employment paradigm. Personally, they are taxed as employees. It is no wonder that they do not understand independent contractors, who do not fit into their experience of the world and may even seem strange or sinister to them.
But independent contractors do not see the situation in the same light. Employment "benefits" are not seen as benefits at all but rather as restrictions. Independent contractors genuinely seek freedom, independence, flexibility, the capacity to control their own destiny and, above all, the ability to control their own money. They seek to manage their own financial affairs rather than have an employer manage their money for them. They don't want holiday pay withheld from them but rather want the money paid up front. They want to work at a time of their choosing, or even not work if that is their desire. Stories of people choosing to work for six months then not working for several months are common in the independent contractor community. Sceptics say that this cannot be true and that the whole contractor thing is an employer-orchestrated scam. But it is true and the sceptics simply do not want to confront the reality that the near-total dominance of employment is being challenged by the people themselves. This is a "people movement" to which tax authorities must respond in a positive manner.
Further evidence of the genuine nature of the independent contractor movement can be found in investigations undertaken by tax authorities themselves. Such investigations have been limited. Unfortunately, most tax measures relating to contractors have been enacted on the basis of assumptions rather than facts. In Australia, however, the ATO's obsessive belief that independent contractors structure themselves in order to avoid tax was put to the test by the ATO itself in the late 1990s, by investing considerable resources in significant tax audits.
During 1997 and 1998, the ATO conducted the so-called Alienation of Personal Services Project. A total of 65,000 Australian taxpayers were profiled for investigation as likely income-splitters. (10) This was a comparatively large selection of the 590,000 Australians who worked through self-employed company-structured entities in those years. (11) Notices were sent to 55,000 taxpayers initiating reviews of tax returns. A total of 5,403 taxpayers were specifically targeted for tax review, and 1,104 tax agents were visited by the ATO. The outcome was that only 714 taxpayers were issued adjustments notices, and the increases in tax paid varied from 1.9 per cent to 11.6 per cent per taxpayer. A significant but unreported number of taxpayers received rebates, indicating that they had overpaid their tax.
It is understood that the additional tax raised from the tax audit was below that expected from any random audit of general taxpayers' returns. It is known that the project was wound down because the additional revenue raised did not cover the cost of the audit. Most importantly, the independent conclusion of the audit was that the vast majority of people structure for legitimate business purposes and not for tax purposes. The audit proved that tax officials' allegations of tax rorting by independent contractors were false.
This audit should have been used as a major element in the independent contractor tax debate that raged in Australia between 1998 and 2001 when the government was redesigning the tax system. But the audit was for all intents and purposes suppressed -- thereby raising questions about the genuineness of the Australian tax authorities' devotion to the truth. In 2000, the Australian government commissioned a major public review of business tax in which the issue of independent contractors featured strongly. But the 1997-98 ATO audit was not highlighted and did not feature in the government-commissioned review and report. The findings of the business tax report (the Ralph Review) read as if the 1997-98 audit had never happened. An aggressive anti-contractor stance was maintained in the report and simply reinforced the predetermined ATO position that independent contractors "split" income.
Income-splitting is one of those issues that everyone seems to think everyone understands, but when it comes to precise definition there is mute silence. Those who make accusations of income-splitting have a responsibility to define precisely the point in a transaction at which a payment to an individual from an entity ceases to be an expense in earning an income and becomes a tax dodge. This is never specifically addressed.
In a typical example, if the spouse of a carpenter contractor is a partner in the contractor's business, at what point do payments to the spouse cease to be legitimate partnership payments and become income-splitting? Are partnerships to be disallowed? Are two-person companies to be abolished? This seems to be the desire of most tax authorities, yet tax authorities' personal views cannot be allowed to determine tax policy. Policy can and should operate only on clear principles that apply equally across the entire community.
CLEAR LEGAL PRINCIPLES
In relation to contractors and employees, the facts are simple and clear. The status of employment and independent contracting are distinct and separate. There is no grey area at common law between the two.
As a consequence, independent contractors fall within the business-tax paradigm, which they access with all the advantages and disadvantages that apply in each country. Independent contractors are denied access to any alleged benefits available from employment regimes and avoid the disadvantages of employment. It is not for the instruments of the state to impose work status on people.
RESOLVING THE DILEMMA: THE AUSTRALIAN APPROACH
The contractor-tax dilemma as it stood through most of the 1990s in Australia was similar to that in most other countries. PAYE was being eroded and the tax office had developed tests to limit people exiting the PAYE system, but in effect the tests had become quasi-common-law rulings, a task for which the tax office had no expertise or authority. Because the quasi-common-law tax tests largely sought proof of contractor status on the basis of the existence of company structures, individuals had strong incentives to structure into companies or trusts. In the view of the tax office, structuring had enabled individuals to split income and claim deductions so as to avoid tax. Lurking in the background were the labour regulators, ever ready in their many chameleon disguises to use the tax dilemma to aid their own cause -- namely, to force people into PAYE wage-slavery employment.
In short, the linking of the Australian Tax Office's at-source income tax collection powers to common-law, master-and-servant employment relationships amounted to a serious mistake in times of vast social change. It corrupted the tax collection system, making it an instrument of the labour regulation system. It limited the right of people to free themselves from the inequality and injustice of the master-and-servant employment relationship.
With at least one in five of the Australian workforce not working in a traditional employment relationship, and with the trend showing rapid growth, the tax collection system was forced to modernise. The Federal Government's recognition of this was reflected in a Treasury document, produced in 1998, which established the principles and structures of the proposed reformed tax system and on the basis of which the incumbent Howard Government went to the 1998 election.
This key document said "Australia's core withholding system -- the Pay As You Earn (PAYE) system -- relies heavily on outmoded ideas of master and servant to define obligations. It simply has not kept pace with labour market trends and is falling further behind. Australia needs a modern, comprehensive withholding system for payments to workers." (12)
The backdrop to the modernisation of this aspect of the tax system was the highly politicised introduction of a Goods and Services Tax (GST) in Australia. Australia was one of the few OECD countries not to have a GST, and its introduction came on the back of a narrow electoral victory by the Liberal coalition government in Australia. The media focus was principally on the GST, but in many respects the real game was the complete redesign of the Australian tax administration system. And perhaps nowhere in the OECD had such a large-scale reform been attempted in one hit and within such short time-lines. The final key pieces of legislation were passed in November 1999, the starting date for the complete package being 1 July 2000. Almost no part of federal tax administration was unaffected by the changes.
As one of its primary objectives, the reform had to detach the Tax Commissioner's collection powers from common-law dependency. Exit the 50-year-old (plus) PAYE system with dependency on common-law employment! Enter the pay-as-you-go (PAYG) system, with legislation written not in common-law employment language but in new tax-specific language, much to the confusion of the accountancy profession!
Imagine the hair-tearing that went on in the accountancy profession which, as of 1 July 2000, had to process tax returns for the 1999-2000 year based on old language and abolished legislation, and then cope with the immediate administration of a new system. Imagine the challenge for the Australian tax office. Imagine the confusion and frustration of Australian taxpayers. Yes, the political fallout was huge and first hit the government in the face in early 2001 with a collapse of public support for it.
But other than the obvious political costs to a political party for reforming a nation's tax system, what are the long-term implications? Has the Australian tax system moved to reshape itself in line with a changed society? To answer the question, it is necessary to consider the legislation itself and the psychology of the tax collectors as reflected through the legislation.
The new tax legislation delivers powers to the tax office through three key planks. The first is the Goods and Services Tax. The second is the Australian Business Number (ABN) legislation which requires every business entity (trading above a certain yearly turnover), including corporations, trusts, partnerships and individuals, to register for and quote its ABN when involved in most commercial transactions. The ABN gives the Tax Commissioner the capacity to trace each and every declared commercial transaction in the Australian community. It is the primary tool in a Big Brother tax cross-reference system that facilitates computer-generated tracing of Australians' commercial activity. (Save for undeclared "black economy" transactions!)
The third plank is the PAYG legislation, which contains an instruction from the state to every business as to how and when it must remit tax. In all, the combined tax legislation stands 45cm high in five volumes, runs to thousands of pages and is printed on near "see-through" tissue paper. The legislation hardly passes one test of good government, namely, to provide legislation that can easily be understood, but it is successful when it comes to severing the link between common-law employment and the Tax Commissioner's power to collect tax. To provide proof of this is difficult, because proof is found in what is not in the legislation rather than what is.
The administrative outcome of the legislation is that common-law employees are clearly caught within PAYG under one set of legislative wordings. Independent contractors who work through labour hire are caught within PAYG under a different set of legislative wordings. Individual contractors who work direct and have an ABN can choose to be caught within PAYG by signing a "voluntary agreement", and this is described in a third set of legislative wordings. Contractors who do not wish to enter PAYG can remit their own income tax at source but will require an ABN if they don't want their clients to withhold 48.5 per cent of the value of their invoices. This multi-pronged process is designed to maximise pressure on all income earners to keep within the PAYG system. It successfully and broadly nets income earners no matter what their common-law work status and neutralises the interest of the tax office in being a determiner of common-law status.
In many respects, this multi-pronged attack may upset some Australian income earners who do not want to be caught in an at-source income tax collection system. But the issue is not whether at-source collection is good or bad. The issue is whether or not the system responds to social developments and whether or not it treats all persons in an equitable manner. On this score, the Australian tax designers deserve praise.
PERSONAL SERVICES INCOME
The residual tax issue for Australian contractors is the "alienation" issue. This is the view within the ATO that contractors divide their income with a spouse or other "associate", thus lowering their tax liability and claiming tax deductions to which they should not be entitled. This issue has been largely addressed in Australia, although not in as complete and certain a way as with the withholding issue resolution under PAYG. It is, however, vastly better than the UK IR35 and the tax discrimination that independent contractors in the UK suffer.
The resolution did not come easily and was the source of considerable political pain to the Australian government during 2001. Initially, the independent contractor legislation had strong overtones of UK IR35 -- in particular, the high level of discretionary interpretive power given to the tax office. In addition, the rules would have denied many independent contractors legitimate business-tax status and would have been applied inconsistently. It took some time for the independent contractor community to realise the extent of the problems with the legislation, but when that realisation sank in, a political storm erupted some six months away from an election. The government moved to quell the storm and amended the legislation to produce a much more reasonable statute.
The result is the Personal Services Income (PSI) legislation, finally passed in the Australian Parliament in late September 2001. The key to understanding the PSI legislation is that it applies a test for access to business-tax status that is essentially built around the common-law test for independent contractor status. With some qualifications, people who can clearly demonstrate independent contractor status have a higher level of certainty in receiving business-tax status than existed in the past. (There are, however, some unresolved issues which will not be discussed here.)
Principally, however, if an independent contractor passes the PSI legislation, she is entitled to be treated as a business for tax purposes and potentially can retain income in a company or trust and pay tax on the company or trust's income under company tax rules. Further, she can usually make payments to partners or associates who work with her and have those payments allowed as tax deductions from the business. In addition, she can claim certain business expenses as tax deductions. (This is predicated on the general tax avoidance provisions that declare that transactions entered into for the purposes of avoiding tax are disallowed.) In essence, these are normal tax rights and circumstances that every person in business has and reflect the commercial reality of how income is earned and expenses incurred when doing business.
For those with a technical interest, the final PSI legislation says that, to be allowed this business-tax status, four major tests are applied. First, a common-law employee cannot be treated as a business for tax purposes. Income will be treated as personal income and taxed accordingly. Second, the primary test is the "results test". A person who earns at least 75 per cent of his or her income as an independent contractor in a year will be treated as a business for tax purposes. If this test is passed, the person need not consider any of the other tests. However, a person who fails this test may still be entitled to business-tax status if he or she does not receive more than 80 per cent of income from one client in a year and has unrelated clients or employs people or has separate business premises. (13)
The clear intent of the legislation is to allow independent contractors to be treated as businesses for tax purposes. For practical purposes, the results test is the common-law test for independent contractors with two minor qualifications. In effect, the common-law test for independent contractor status is the key to accessing business-tax status. This is how the situation should be.
The point of discussing the contractor tax issues, with its sometimes endlessly circular arguments, is that the tax treatment of contractors is one of the strongest examples of how labour regulation is dominated by distorted understandings of labour contracts that have been locked in through historical circumstance, officials' personal experience and views of human relationships, and academically time-warped constructions of labour relations.
This is important to understand because it lays the basis for comprehending how these distorted understandings create problems in other areas of labour regulation -- the subject of the next chapter.
ENDNOTES
1. Milton and Rose D Friedman, Two Lucky People: Memoirs, The University of Chicago Press, Chicago & London, 1998.
2. Australian Bureau of Statistics, Cat. No. 6359.0, August 1998, released February 2000.
3. Mark Wooden and Audrey Vanden Heuvel, The Use of Contractors in the Australian Workplace: Evidence from a survey of Employers, Monograph Series Number 3, National Institute of Labour Studies, Flinders University of South Australia.
4. Queen, IR and PGA High Court Case No CO/2302/00, April 2001. [IR 35]
5. UK 1999 Budget news release numbered IR35. See http://www.inlandrevenue.gov.uk/ir35/index.htm
6. IR 35.
7. See Professional Contractors Association Website: www.pcg.org.uk
8. IR 35
9. IR 35 Case at 44. Note: As of 2005, IR35 remained in place and continued to attract criticism from the independent contractor community. See www.inlandrevenue.gov.uk/ir35/index.htm and www.pcg.org.uk/aboutus/PCGAchievements2004.html
10. That is, the ATO wants to stop a person who earns income artificially splitting income with a spouse, thus lowering the overall tax liability by accessing lower tax rates.
11. Australian Bureau of Statistics, op. cit.
12. "Tax Reform not a new tax, a new taxation system". Circulated by the Treasurer of the Commonwealth of Australia, AGPS, 1998. (ISBN 0642 26153 9)
13. A basic explanation of the relative distinctions and their implications may be found at: http://www.contractworld.com.au/reloaded/ica-taxclarity2.php
No comments:
Post a Comment