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How to test IR35 status and avoid falling foul of HMRC

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Andrew Brookes - Menzies Accountant

Andrew Brookes – Employer Solutions Specialist

With a consultation about how to roll out the changes to the private sector due to end soon, contractors should ensure they have a clear understanding of what the legislation means and how to test IR35 status in order to avoid falling foul of HMRC.

Why was IR35 brought in?

IR35 was originally introduced to address the issue of “false self-employment” – attacking the ability to structure engagements to avoid the payment of PAYE. In the 2016 Autumn Statement, it was announced that the decision about whether the conditions for IR35 were met would move from the contractor and their personal service company (PSC) to the public authority engager.

Consequences of not applying the rules

With HMRC usually keen to look back to the very start of engagement when calculating back-payments, contractors falling within IR35, but who have failed to apply the rules, could be liable for significant tax and National Insurance Contributions (NIC) liabilities. Additionally, with the regulations likely to be extended to the private sector, possibly from April 2019, it is important that all businesses engaging workers through PSCs are aware of the changes and how to ensure compliance.


How do I know if IR35 status applies to my business?

In recent years, contractors have found it increasingly difficult to determine status because the case law used to interpret whether IR35 applies rarely aligns with the contractor’s actual situations. This is not helped by the fact that there are two contrasting methods of testing IR35 status, which is fundamentally an imprecise process.

On the one hand, court guidance advises contractors to “paint a picture” to illustrate all aspects of their engagement, which will then be interpreted as either employment or self-employment. On the other hand, HMRC has recently attempted to simplify the decision-making process with the introduction of its Check Employment Status for Tax (CEST) tool.

Working on a spreadsheet basis, this aims to provide an objective verdict but often fails to take the full scope of the individual’s situation into account.

While the CEST can provide contractors with a level of comfort if they are found to be outside the scope of IR35, it is important to be aware that HMRC will almost certainly side with its own tool if the rules are found to apply. As such, individuals who disagree with its verdict should be aware that if selected for review, they may have to face the costs involved in attending an employment tribunal and persuading the courts that IR35 does not apply. Moreover, as HMRC has stated that it will stand by the result of the CEST unless a compliance check finds the information used to secure the result is inaccurate, it is vital that contractors choose their answers carefully.


CEST- Steps to ensure a favourable verdict

Although it is expected to be the end engager who decides whether IR35 is applied, there are a number of steps contractors can take to help secure a favourable verdict.

  1. Ensure the contract is indicative of a business-to-business arrangement and not fully dependent on a single organisation.
  2. The nature of the way they work continues to reflect what is stated in their contract. For example, while their contract may clearly indicate self-employment, it is not uncommon for the arrangement to change over time to include more indicators of employment through laziness or familiarity.
  3. Use CEST to provide veritable evidence of their status to help to secure an agreement with the engager that the arrangement falls outside of IR35.

Financial implications – Case Study

If IR35 is found to apply, Income Tax and National Insurance will be deducted before payment to the contractor as if they were a PAYE employee. For example, the net take home pay for a private sector contract (currently outside of IR35) and identical payment circumstances for a public sector contract subject to PAYE differ significantly, as indicated in the table below:

 PSC not IR35 (£)PAYE (£)
Gross contract value cost to client100000100000
Corporation Tax Payable155000
Income Tax Payable1160024000
National Insurance Payable016500
Non-deductible Expenses010000
   
Net retained by individual7290049500

For a typical contract of £100,000 cost to the end client, with annual travel and accommodation costs of £10,000, there is a difference in taxes and NIC of £13,400 between the contract outside of IR35 and the one subject to PAYE. This problem is compounded by the fact that for the PAYE contract, the expenses are not deductible, and therefore come out of the employee’s net income. For the purposes of comparison, it has been assumed that the client has passed on the costs of the employer’s NIC by reducing the value of the contract.


The future of contracting

With last year’s changes sending shockwaves through the UK business landscape, numerous contractors moved into the private sector to take advantage of perceived favourable tax conditions. With HMRC’s announcement of similar measures in the private sector looming on the horizon, we may see some contractors venturing overseas instead.

Alternatively, it could be in the interests of both parties to attempt to renegotiate new contracts, perhaps making them direct employees. However, in order to best avoid risks for their historic position, it is vital to incorporate a strong differentiating factor rather than simply seeking employment under the same terms.


This is a constantly changing landscape

When implementing changes to how engagement contracts are structured, it is worth bearing in mind the Government’s other consultation into the gig economy. Given the current fluid landscape, rather than simply making changes and forgetting about them, it is important to remember that the rules around self-employed workers may change yet again, so arrangements should be kept under constant review.

With contractors often enjoying greater levels of flexibility and remuneration than other types of employees, it is unlikely that HMRC’s reforms to IR35 will trigger the death of the contractor. Instead, as intended, the rules should simply catch out false contractors, for example, those where there really is no flexible element to their engagement at all.

By getting up to speed with the changes and negotiating effective contracts with engagers, contractors in both the public and private sectors can avoid costly HMRC investigation settlements while continuing to take advantage of the many benefits of contracting for the years to come.

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Andrew Brookes - CTA

Senior Manager

For more information of the above or discuss the implications of IR35 on your business and employees, contact Andrew Brookes.