IR35: The Meltdown

Bradley Post, Managing Director at Rift Tax Refunds.

The Problem

In simple terms IR35 is a test to determine whether individuals should be treated as employees or self-employed. Its full name is The Intermediaries Legislation and it came into force in April 2000 as part of the Finance Act but its recent application in the public sector is proving increasingly contentious.

Even before the latest round of changes in how the law operates, it was an uncomfortably large and bitter pill for many to swallow. The new rules around IR35 and public bodies were controversial at best when they were first announced. Now that their full effects are being felt throughout the sector, the nightmare scenarios that some were warning about seemed to have been, if anything, slightly optimistic. Here’s what’s happening, and why it matters.

On the 6th of April 2017, a new set of rules came into force that affect public bodies making “off-payroll” payments to contractors, whether directly or through agencies. Essentially, HMRC was no longer going to allow the public sector to take contractors operating through Limited Companies at their word that they were playing fair with employment status law.

From the outset, there were issues with the way the new system was playing out. Fast-forward a year, and we’re now seeing reports of literally thousands of contractors being wrongly classified and over-taxed. In some cases, it’s led to people swearing off public sector work, in others to deliberate non-compliance and the risk of legal challenges. At the heart of it all sits HMRC’s Check Employment Status for Tax (CEST) tool – which, depending on whom you ask, is either God’s gift to tax law or totally unfit for purpose.

Recent figures reluctantly released by HMRC under a Freedom of Information request show 54% of the results coming out of their CEST tool to be “negative”, meaning that that under the terms of the working relationship the contractor should be classified as an employee.

The problem is, that result doesn’t reflect the way people are actually being taxed. With HMRC breathing down their necks, hirers simply aren’t trusting CEST’s judgements. Worse still, a lot of them aren’t even trying to use it, instead making blanket decisions to class everyone as an employee.

What’s the Point of IR35?

IR35 was introduced to combat tax avoidance through ‘disguised employment’. This is where individuals work for organisations on a self-employed basis, often through an intermediary, rather than as employees even though their working conditions are the same as those of a full time employee.

Organisations were happy with this arrangement, benefitting from significant savings due to not having to pay employers’ NICs or offer any employment rights or benefits to the self-employed contractors. Individuals were happy as they could provide their services through their own companies and have more control over their take home pay by distributing profits as dividends for the National Insurance and tax benefits. They could also split ownership of their company with family members to hit lower tax bands.

HMRC, however, was not happy with this cosy arrangement, having calculated that up to £400m a year is slipping through its fingers each year from “bogus self-employment”.

Contractors meanwhile are reporting getting caught up in issues such as paying employer’s National Insurance contributions on top of standard employment taxes or suffering 25% reduction in take home pay as a result of having their employment status reclassified.

Changing the Game

Under the old rules, contractors with their own Limited Companies were responsible for working out if IR35 applied to them. For public sector contracts, that responsibility has now shifted. Under the new rules, it’s either the public body itself that has to make the IR35 decision, or the agency involved if there is one. As it turns out, this was how IR35 was supposed to work in the first place, back when it was first talked about in 1999. In fact, it was a backlash against that rule that saw the burden moved onto the contractor’s company instead.

 If a public body decides that IR35 applies, then the individual will be taken onto payroll as an employee and the body itself starts taking tax and National Insurance payments out of the contractor’s pay at source. The CEST tool is supposed to make these judgements simple and accurate. Of course, even if CEST performs infallibly, it can only ever be as reliable as the information it’s been given to work with. HMRC say they’re happy to stand by CEST’s results, although they’ve stopped short of making that compulsory for the public bodies using it – and left a little wiggle room for themselves as well.

Theory vs. Practice: What Went Wrong?

The term “fiasco” seems to be flying about a bit at the moment, whenever IR35 rears up its head. Basically, a lot of public bodies felt they hadn’t had enough preparation time or support to take on their new legal responsibilities. Honestly, IR35 was never a well understood or consistently applied piece of legislation in the first place, and the new rules have done nothing to fix that.

Public bodies now finding themselves between IR35 and a hard place have been making difficult decisions under pressure, which is leading to problems beyond just simple assessment mistakes. TfL, for instance, reacted with a knee-jerk safety play by banning off-payroll payments to Personal Service Companies altogether. Other bodies have either asked contractors to operate as if they were within IR35 or via an umbrella company. Worse still, there’s plenty of evidence of blanket judgements being made, Essentially, public bodies are simply assuming IR35 applies in all cases, hence the thousands of contractors being overtaxed.

So the next question is, what happened to CEST? Well, it turns out that in some cases it’s simply being ignored. Faced with the legal ramifications of getting the decision wrong, some public bodies are overruling CEST and declaring that IR35 applies. The NHS and MOD have both already been caught making these blanket assessments and now face considerable litigation risk because many contractors have been wrongly classified.

People just don’t trust the CEST tool enough to risk relying on it – and it turns out they might be right not to. For one thing, it appears to ignore the important concept of Mutuality of Obligation altogether. That means it’s going to wrestle uncomfortably with edge-cases – for instance, contractors who could theoretically have someone else do the work, even though there are practical reasons why they wouldn’t. More to the point, it seems like HMRC simply assumes that MOO always exists in contractor agreements, which simply isn’t true.

The Fallout

The IR35 meltdown has had a number of direct and knock-on effects. Many contractors are raising their rates to cover the extra tax they’re paying. Others have simply refused to take on public sector work, leading to project delays or outright cancellations.

Getting caught up in IR35 does carry with it some expectation of accompanying employee rights. Contractors who aren’t getting those could well be in a position to launch legal challenges. There’s no specific HMRC appeals process covering this at the moment, but the situation is continuing to develop and various options might start to bear fruit. Employment tribunals might be used to claim that wage deductions have been made unlawfully, for instance.

Keep in mind that IR35 assessments are supposed to be conducted on an individual basis through CEST. As things stand, only about half of assessments have gone through any compliance tests at all. In fact, CEST was a factor in just 24% of assessments made – partly because of blanket decisions and partly because the tool wasn’t ready when the assessments took place. In an environment that relies on voluntary compliance – and where HMRC simply doesn’t have the firepower to police the whole system effectively – what’s developing is a shocking lack of trust. That’s a backdrop against which a torrent of legal challenges could take place.

HMRC’s Reaction: What Do they Say?

CEST, according to HMRC, is “as good as the data fed into it”. They say they believe that it gives a reliable outcome 85% of the time, and is “a perfectly good tool and supports IR35 compliance.”

 Honestly, from HMRC’s point of view, the CEST roll-out has been pretty much a success. Of course, the only way they seem to measure that is in how much additional revenue it pulls in. The thing is, the raw numbers don’t tell the full story here. Since wrongly overtaxing contractors has the same effect, it’s thin evidence at best that actual compliance is being boosted.

In reaction to this a number of contractor websites are now sharing information on “how to pass the IR35 check” using the CEST tool, although surrounded with many warnings about the dangers of “contriving” a pass and that HMRC will issue status challenges if it believes an individual deliberately answered questions incorrectly.

 On top of that, there’s also the question of how far CEST is trusted by HMRC itself. Although they publicly stand by the tool, they’ve quietly outlined a couple of situations where they can challenge its results. Obviously, if they think the information put into it was inaccurate, they reserve the right not to be bound by the assessment it came out with. There’s been quite a lot of discussion over what that would look like in practice, but the bottom line is that it’s being widely seen as a less-than-ringing endorsement of CEST. That shaky faith only underlines the general concern around the tool, considering the significant gap between the number of “does not apply” results it’s been churning out and the number of people being filed under IR35 anyway.

Looking Ahead…

If the new IR35 system’s goal was to clamp down on non-compliance, it’s hard to call it an unqualified success. If anything, while tax revenue has risen, the door’s been opened on a whole new kind of non-compliance – this time on the part of hirers. Meanwhile, HMRC’s upbeat outlook has a lot of people more worried than ever about a private sector roll-out – perhaps as soon as 2019. If that did happen, it could mean some upheaval for contracts and projects already in progress. Judging from the continuing turmoil in the public sector, it’s going to take careful consideration and planning to avoid falling down the same rabbit-hole. Private sector hirers will need to understand what it would do to their costs if contractors started raising their rates, or what it would mean for their projects if contractors simply refused to accept an IR35 judgement.

At the same time, private organisations will face the same legal threats and consequences as public bodies. They’ll find themselves under the same temptation to deliver blanket assessments, and open to the exact same challenges and push-back from contractors affected. We’ve seen, and continue to see, all this happen in the public sector, with hirers, contractors and HMRC all having points to make and corners to fight. What we haven’t seen yet is a real solution to all three sides of that equation.

Rule one of this new game, naturally, is reaching legal compliance. Companies need to understand that short-cutting individual assessments isn’t the safe option it appears to be, and contractors have to accept that cheating the taxman is the bad idea it always was. If the new system hits the private sector as many expect, it’ll take effective guidance and comprehensive support from advisers to defuse the ticking IR35 timebomb – or at least achieve a more controlled detonation than the public sector did.