Who Determines IR35 Status?

 In Contractors

The way in which IR35 status is determined is about to change for private sector companies and it could have considerable implications for contractors and their clients.

As expected, October’s budget contained a major change to the way private sector companies engage with their contractors. New rules about how IR35 status is determined could see thousands of contractors paying more in tax and could leave businesses facing greater scrutiny from HMRC.

Closing loopholes

IR35 is nothing new and has been with us since 2000 when the Labour Government introduced it in an attempt to combat the practice of disguised employees. This sees people working with clients through their own limited companies, but fulfilling roles for which they would normally be considered employees. However, instead of receiving a regular salary, they invoice the “client”. For tax purposes they are classed as contractors rather than employees.  

This arrangement has benefits for both sides. The contractor can use a more tax efficient structure, while the company has fewer obligations and can dispense with the contractor’s services as and when they like. From HMRC’s perspective, though, this represented lost tax revenue. The introduction of IR35 was their attempt to close this loophole, but it hasn’t been entirely successful.

The rules have been criticised as being too complex and open to misunderstanding and HMRC believes non-compliance is common. The problem, according to HMRC, is the fact that individual contractors had responsibility for determining their own status meant it was open to abuse.

Workers are targeted by numerous tax avoidance scheme promising to help them reduce their tax liability by working within IR35. Some umbrella companies have also falsely marketed themselves as enabling workers to operate outside of IR35 even though those contractors are employed by the umbrella company and should be treated as such for tax purposes.

HMRC aims to address this issue by placing the responsibility for determining IR35 status with the business hiring the contractor (or engager). In its consultation document, HMRC stated that it believed IR35 rules were being applied incorrectly in 90% of cases in the public sector. By changing the rules, it believed it could recoup £1.3bn in revenue up to 2023.

They are encouraged by what they see as a successful role out of new rules in the public sector. In its first year alone, HMRC estimates it has raised £550million in income tax and NIC revenue. For public sector organisations, however, its arrival has been less welcome.

Contractors feel they are being treated unfairly. At a stroke they’ve lost the ability to determine their own employment status and seen their tax burden rise while many have also not been given additional employment benefits.

Teething troubles

The approach of public sector organisations has also come into criticism. The fact that they will be held responsible for any mistakes persuades many of them to take a risk adverse approach to the problem. When in doubt, contractors have been grouped inside IR35, which could lead to many people wrongly being classed as employed.

HMRC’s IR35 tool was criticised for failing to take into account the specific working arrangements of contractors on which IR35 status often hinges. Understandably, a tool developed by HMRC and launched only shortly before the new rules came into force is not trusted by many contractors.

The rules also prompted contractors to move away from the public sector and helped worsen skills gaps which have already been causing a problem. Many contractors say they would leave the public sector if they were classed within IR35.

The Association of Independent Professionals and the Self Employed argued that the changes had seriously damaged the NHS. Their research found that 51% of public sector hiring managers had lost skilled contractors as a result of the changes. Four out of ten independent contractors said they had witnessed project delays and an increased cost as a result of the changes.

Lessons learned

From HMRC’s perspective, therefore, the changes have been a success because they increased tax revenue, but from everyone else’s they have caused complications, created delays and led to a shortage of skilled personnel.

Now, as the private sector gears up the question is: can it learn from the mistakes of the public sector? The good news is that it can. Firstly, it has to prepare well and avoid rushing into decisions. It should avoid collectively moving entire contractor groups into IR35 may seem the safest option, but this in itself will be IR35 non-compliant as it will see contractors wrongly classified as being employed for tax purposes.

It will also have to look at how it assesses these changes. HMRC’s tool struggled to convince its doubters, so organisations will have to take greater control. In many cases employment agencies providing these contractors will manage the assessment, even though responsibility will lie with the end engager. This will alleviate some of the burden but will require a high degree of trust in the agencies own systems.

In many cases, businesses may lack the in-house expertise to make reliable decisions. By turning to outside experts and consultants, they will be able to develop robust processes to ensure the best decisions are made. These will protect the business itself while also being fair to the contractor.

If the experience of the public sector is anything to go by these new regulations will be contentious and contractors will not be happy. It’s hard to blame them. From their perspective this is a lose/lose situation and it is possible that some companies may find it harder to attract good contractors.

They can take steps to remedy the situation. Firstly, they can avoid making rushed decisions or placing contractors within IR35 by default. Secondly, they turn to experts to ensure all their contractors have been correctly classified and thirdly, they can keep contractors happy by ensuring that they do have additional benefits as they become employed. While the rule changes will create challenges, it is possible for everyone to work within this new system as long as it is approached in the right way.

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