IR35 reforms: Private sector warned HMRC's 12-month 'light-touch' enforcement period is ending

Medium-to-large private sector firms could be subject to multimillion-pound penalties for IR35 compliance errors, now the government’s 12-month pledge not to enforce the rules in a heavy-handed manner has ended.

Ahead of the IR35 reforms being extended to the private sector in April 2021, business leaders were assured by the chancellor of the exchequer, Rishi Sunak, that HM Revenue & Customs (HMRC)  would not enforce the rules in a “heavy-handed” manner in the year after they came into force.

In February 2020, HMRC reiterated this point in a statement that confirmed it would take a “light-touch” to issuing penalties to firms that have made mistakes when trying to comply with the reworked tax avoidance legislation. This grace period would last 12 months, the statement added, and would not apply in instances where there was evidence of deliberate non-compliance going on.

The reforms have now had a year to bed in, and contracting experts warn that the medium-to-large private sector organisations within the scope of the reworked rules could now find themselves on the receiving end of multimillion-pound penalties for compliance failures.

The IR35 legislation is one of a number of tools that HMRC has at its disposal to tackle the issue of tax avoidance within the limited company contractor community.

In their original form, the legislation made limited company contractors responsible for determining if the work they did and how it was performed meant they should be taxed in the same way as permanent employees (inside IR35) or as off-payroll workers (outside IR35).

Therefore, an inside IR35 determination means contractors must pay the same employment taxes and National Insurance Contributions (NICs) as permanent employees, but they are not eligible to receive workplace benefits such as paid holiday or sick leave, for example.

Meanwhile, an outside IR35 classification means limited company contractors are able to pay themselves a relatively small taxable salary and make up the rest of their income in non-taxable dividends.

According to HMRC, allowing contractors to decide for themselves how they should be taxed resulted in some individuals opting to deliberately mis-classify themselves as working outside IR35 to artificially minimise the amount of tax and national insurance contributions they had to pay.

This prompted HMRC to rework how the legislation works in recent years, so that the end-user organisations who engage the contractors are now liable for determining if their engagements are inside or outside IR35.

The same changes were first introduced to the public sector, amid much outcry, in April 2017, and since then several high-profile central government departments have been handed multimillion-pound tax bills by HMRC for implementing the changes incorrectly.

As reported by Computer Weekly, it came to light in July 2021 that the Department for Work and Pensions (DWP) received an £87.9m tax bill by HMRC for “historic” errors in how it assessed the IR35 status of its contractors.

Later that same month, it also emerged that the Home Office had been landed with a £33.6m tax bill over its “careless” application of the IR35 rules.

Furthermore, in late 2021, the publication of the Ministry of Justice’s Annual Report and Accounts confirmed it had incurred a liability of £72.1m, plus £4.5m in interest, for similar mistakes.

Scant detail has been made publicly available about just how some of these public sector organisations have fallen foul of the IR35 rules, aside from comments about how some of them had incorrectly assessed the tax status of their contractors. Meanwhile, the legislation states that end-user organisations must take “reasonable care” when deciding how the contractors they engage should be taxed.

With today marking the end of HMRC’s 12-month period of “light-touch” enforcement activities, Seb Maley, CEO of IR35 compliance and insurance consultancy Qdos, said private sector firms are now at risk of receiving similarly sized fines for implementing the reforms wrongly.

“HMRC can now issue businesses staggering financial penalties for carelessly applying IR35. You only need to look at the public sector…for evidence of how seriously HMRC are taking compliance,” he said. “With this in mind, it’s never been more important for businesses to review their existing processes and ensure IR35 compliance.”

This is especially, as he pointed out, that the chancellor’s recent Spring Statement revealed that HMRC is due to receive an additional £161m in funding over the next five years to enforce tax compliance.

“The number of tax investigations already having risen by 9% in the second half of last year, so IR35 is set to be a key area of focus going forward,” he added.

His comments were echoed by Matt Fryer, head of legal services at contractor-focused law firm Brookson Legal, who said some firms have already started preparing for the end of HMRC’s “soft-launch” period by taking steps to ensure their compliance procedures are on point.

“Many businesses have asked us to reassess their solution in recent months. This is especially true for those organisations that have not engaged with IR35 since their initial audit, leading them to seek advice and reassurance around meeting HMRC’s reasonable care threshold,” he said.

“Businesses that have implemented effective IR35 processes and procedures to manage the status of off-payroll workers have been able to use this time to explore how they can continue to demonstrate ‘reasonable care’ beyond initial status determinations.

“As these organisations move onto the next step in their IR35 journey, they’re reviewing contracts and implementing staff training – both of which have been highlighted by HMRC as crucial parts of an ongoing ‘reasonable care’ responsibility.

“This is driving an increase in mock investigations and supply chain audits, as hirers begin to stress test their solutions and ensure that they are confident and compliant in the case of an HMRC investigation,” he added.