What is IR35 and why does it matter?

Essentially, IR35 is an anti-avoidance tax rule which targets the use of so-called ‘Personal Service Companies’ (PSCs) to avoid paying employment taxes. A PSC is generally a limited company, the sole shareholder of which is its director, who instead of being directly employed by other businesses, operates exclusively through their own company. Practically, this meant that before IR35, where an individual contractor is engaged by a company ‘off-payroll’ through their PSC, the PSC contractor could technically facilitate employment tax savings, whilst the engaging business was not required to pay employer national insurance contributions IR35 changed this and aimed to ensure that when a business engages an individual through an intermediary such as a PSC they pay the appropriate tax (when the individual would have been considered an employee for tax purposes, if the PSC did not exist and they had been employed directly, then they should be taxed as an employee).

There have been some recent changes to the IR35 regime which will affect a large number of businesses. Under the previous regime, the PSC was responsible for assessing their tax status and accordingly paying any employment taxes if they were deemed to be captured by the arrangement.

However, this changed in April 2021, primarily to respond to reports of widespread non-compliance. The government decided to shift responsibility for assessing the PSC individual to the business that engaged them, rather than letting them do it themselves. The engaging businesses, therefore, are responsible for determining the PSCs’ employment status and paying Income Tax and NICs for those who are deemed to be employees or workers. This rule came into effect last April, but there is a period of grace for implementation which is set to end in April 2022, during which time HMRC have said they will not impose penalties on businesses who made genuine mistakes. Importantly IR35 has – and still does – exclude small companies who are exempt from assessing PSCs.

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Why compliance is crucial

Some recent examples of HMRC – responsible for IR35 – enforcing the rules to public sector organisations should provide a stark warning to businesses and organisations captured by the new rules.

HMRC’s enforcement so far

‍HMRC have found that both the Home Office and the Department for Work and Pensions breached the rules, and they have been awarded subsequent tax bills with interest charges respectively.

These instances of Government departments being caught unawareness demonstrates the relative complexity of these rules.

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Why is it so difficult to understand and get right?  

The 2021 rules made no material changes to the test it uses to determine employment tax status, which show whether or not a PSC contractor falls inside IR35. The test, however, is complicated and can often lead to uncertainties regarding the tax status of contractors.

The issue with the test is that it is not really a test as such, but a combination of methods. Businesses must determine employment tax status through how it has developed in caselaw, meaning they need to consider a host of issues that include: whether the PSC contractor can provide a substitute to work on their behalf; the level of control that the client (i.e. the engaging business) exerts over the individual; and whether mutuality of obligation exists between the parties. The ‘practical reality’ of any arrangement will be looked at rather than whatever written contract exists.

Recent cases concerning employment tax status demonstrate that even tribunals can mis-categorise workers’ status as they pertain to the IR35 rules. For example, in a recent case HMRC v Professional Game Match Officials Ltd [2021] the Court of Appeal in its judgement concluded that both the Upper Tribunal and First Tier Tribunal had erred in law with regards to the mutuality of obligation point.

What can you do about it?

‍If your business engages with contractors that you hire directly, i.e. you have ‘off-the-payroll’ staff, you are likely to already be captured by the IR35 rules and be responsible for ascertaining their employment tax status.

Despite the above, there are steps you can take. Fortunately, in response to complaints about the uncertainty of the rules, HMRC has developed the 'Check Employment Status for Tax (CEST)' online tool which aims to consolidate all of the relevant considerations and give a definitive answer. The tool, however, has been criticised as it can only produce a result in approximately 85% of the circumstances.

The good news is that if you are given a CEST result, HMRC has confirmed this is definitive and will hold up as evidence. Using the tool, therefore, should in general reduce the risk of being subject to a potentially damaging HMRC enquiry and furthermore satisfy the requirement to take reasonable care when making status determinations if such an enquiry takes place.

To conclude, the best step your business can take is to use the CEST online tool. The tool should be used in conjunction with exercising careful judgement, seeking legal advice and recording any decision-making processes – particularly in complex cases – to reduce risks.