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UK government having hard time complying with its own IR35 tax rules

This shouldn't come as much of a surprise if you've been reading the headlines at all

Government departments are guilty of high levels of non-compliance with the UK's off-payroll tax regime, according to a report by MPs.

Difficulties meeting the IR35 rules, which apply to many IT contractors, in central government reflect poor implementation by Her Majesty's Revenue & Customs (HMRC) and other government bodies, the Public Accounts Committee (PAC) said.

"Central government is spending hundreds of millions of pounds to cover tax owed for individuals wrongly assessed as self-employed. Government departments and agencies owed, or expected to owe, HMRC £263 million in 2020–21 due to incorrect administration of the rules," 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 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.

"This is not acceptable considering government departments should be in a good place to understand the rules and communicate with HMRC. However, mistakes were likely as the reforms were rushed in by HMRC and public bodies were given little time to prepare – in particular, they had only two months or less with HMRC's new guidance and tools before the new rules came into effect."

New IR35 rules were introduced for businesses in April 2022 following a year's delay caused by the COVID-19 pandemic. The rules were introduced in the public sector in 2017.

Part of the problem complying was down to HMRC's guidance and the Check Employment Status for Tax (CEST) tool. "Some questions within CEST were difficult to interpret correctly, and the guidance was long, too general in scope and not integrated into CEST itself," the PAC said.

Such difficulties do not bode well for IR35 in the wider business environment.

"Despite years of reforming the IR35 rules, there are still structural problems with how they work in practice. The IR35 rules do not work well with the realities of contracting, both in determining workers' tax status and in resolving issues when mistakes have been made," the report said.

In February, HMRC compliance director Nicole Newbury told a PAC hearing that businesses implementing blanket bans on contracting personal service companies could be found not to have complied with freelancer tax reforms, but challenging decisions could be a lengthy process.

Seb Maley, CEO of tax advisor and insurer Qdos, said the PAC's IR35 review was "damning" and highlighted many of the government's failures.

"Along with evidencing the staggering levels of non-compliance in the public sector following reform, it exposes the flaws of CEST, which frankly still isn't fit for purpose despite being launched five years ago," he said.

"It also calls on the government to do more when it comes to assessing the true impact of IR35 reform on the labor market. HMRC has said the changes are generating more tax revenue, but this isn't necessarily a sign of improved compliance. In our experience, it's a direct result of genuine contractors being forced to operate on the payroll." ®

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