No help for IT contractors on IR35 tax errors

NAO says £263m in IR35 tax mistakes is just the start...

UK IT contractors have been given no guidance on how to claw back tax erroneously taken by employers under IR35 rules, which already cost central government bodies £263m when they failed to correctly adhere to the guidelines.

According to a report from public spending watchdog the National Audit Office (NAO), the UK's tax collector has failed to clarify the controversial new rules which govern contractor's tax status, while there is no new legal framework to interpret the rules.

The IR35 reforms, which put the onus on the employer, rather than the contractor, for determining their employment status, were introduced in the public sector in 2017. Following a year's delay, they were introduced to large and medium-sized private sector businesses in April 2021.

The NAO has found that 2020-21 financial statements of government departments and agencies include a total of £263m paid, owed or expected to be owed in additional tax for failing to administer the reforms correctly. The Department for Work & Pensions (£87.9m), Ministry of Justice (£72.0m), Home Office (£29.5m), Department of Environment, Food & Rural Affairs (£19m) and NHS England (£4.2m) all made errors. There are liabilities not yet confirmed (totalling £50m) at three more central government bodies.

Meanwhile, NHS Digital, the now-defunct non-departmental public body under the umbrella of the Department for Health failed to implement the reforms and got a £4.3m. A right-minded individual might think that the private sector now applying IR35 for the first time could learn from the mistake of public sector trailblazers. But not so, according to the NAO.

In its report published on 10 February, it said where departments and agencies had got the status determinations wrong, Her Majesty's Customs & Revenue found that the public body had "not taken reasonable care to prevent errors, including when answering questions in CEST," HMRC's online IR35 assessment tool.

"However, [HMRC] had not set out how it would interpret reasonable care for the new requirements when they first took effect, and no public bodies have challenged the decisions in court so there is no case law to guide the definition,” the NAO said. When employers get IR35 status wrong, the process by which contractors can claim back tax they've already paid under the erroneous judgement are obscure.

"HMRC collects the amount due in accordance with the law at that time. It does not offset the total amount against any tax the worker or their PSC [professional services company] already paid and told us this was not allowed within the current legislation. This means that HMRC collects more tax in total than is due.

"Once the non-compliant client organisation accepts that its determinations were incorrect, the workers become entitled to claim back the tax that they and their PSCs have already paid. If they do, they in effect pay no taxes on that income because these are borne in full by the non-compliant public body. However, HMRC does not actively promote this and it is unclear how many workers reclaim their taxes in practice," the report said.

What is IR35?

IR35 is a reform unveiled in 1999 by the UK tax authorities. The latest regulation change – which came into force in April 2021 – forces medium and large businesses in the UK to set the tax status of their contractors and freelancers. Previously this was set by the contractors themselves.

Contractors found to be within the scope of the legislation – ie, inside IR35 – will have to pay more tax than they might expect.

The reforms are part of the government's crackdown on so-called disguised employment, where workers behave as employees but avoid paying regular income tax and national income contributions by billing for their services through personal service companies (PSCs), which are taxed at lower corporate rates.

The measures first came into effect in the UK public sector in 2017. The British government hoped the reforms would recoup £440m by bringing 20,000 contractors in line.

HMRC reckons that only one in 10 contractors in the private sector who should be paying tax under the current rules are doing so correctly. It estimates the reforms will recoup £1.2bn a year by 2023.

HMRC compliance checks have so far focused mainly on central government up to 2021 and it is set to examine more local public sector bodies in more detail this year. It is set to take a similar "risk-based" approach to private sector organisations.

Dave Chaplin, CEO of tax compliance firm IR35 Shield, said the NAO report revealed the weaknesses of the CEST, which had "played a key role in the off-payroll debacle."

He added: "The whole tax offsets issue that the NAO has flagged up is appalling and fails to align with the principles of equitability in the tax system. HMRC is taxing the same money twice.

"In essence, £263m was paid by a government body to another government body, and now all those contractors can reclaim their tax back, and pay no tax on their earnings – that would result in a loss of revenue as a result of their investigations.

Chaplin pointed out that if the private sector makes the same kind of errors in interpreting IR35 seen in the public sector, it could result in a huge, unexpected tax bill. "With the NAO stating that the private sector is four times bigger, does this mean there is a £1bn tax bomb ticking away that when detonated will send businesses to the wall, despite them all acting in good faith and trying to adhere to the new rules?"

Gareth Davies, head of the NAO, said: "The 2017 reforms to IR35 tax rules have achieved their primary purpose of reducing non-compliance. However, HMRC did not give public bodies sufficient time to prepare for the roll-out, and it was highly likely that mistakes would be made.

"While key lessons were applied during the wider rollout in 2021, inherent differences in labour markets create new challenges that HMRC will need to manage for the reforms to be a success," he said.

Andy Chamberlain, director of policy at IPSE, told The Reg: "We welcome NAO's findings into IR35. We have long argued the reform to the off-payroll working rules in the public sector in 2017 was rushed, and it is encouraging to see that our concerns have been supported by this report.

"We were struck by the fact that the NAO found HMRC received significantly more revenue from the reform than they initially thought it would raise. We believe this must in a large part be due to what we have always suspected and feared - that public sector bodies made incorrect determinations resulting in thousands of contractors paying more tax than owed and HMRC receiving revenue it was not entitled to.

"It is deeply concerning, yet highly likely, that the same injustice is happening today but on a much larger scale as the rules now apply in the private sector too."

Also yesterday, the Economic Affairs' Finance Bill Sub-Committee wrote to the government about the extension of the off-payroll working rules to the private sector. The Lords said the rules, brought in during April 2021, appeared to "have resulted in an increased use of umbrella companies."

The group also recommended that HMRC take "a more coherent approach to the issue of employment status, which considers both tax and employment rights. It is unfair that individuals are treated as employees for tax purposes but without the rights which are normally associated with employment."

Sub-committee chair, Lord Bridges of Headley, said: "The whole point of the off-payroll reforms was to crack down on tax avoidance. Yet... it risks giving rise to a new wave of tax avoidance, as people — many of them on low incomes — end up in rogue umbrella companies. The Government must take action to protect workers from 'rogue' operators as a matter of urgency." He added: "It is right that HMRC commissions external research into the impact of these off-payroll rules. But by only focusing on engagers, it will only get half the story. Its scope needs to be widened to include contractors — and needs to be carried out more quickly." ®

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