IR35 reforms: PAC report blames HMRC for ‘widespread non-compliance’ in public sector

Reasons for reform

The IR35 reforms were introduced as part of a clampdown by HMRC on disguised employment in the public sector, following claims that the way the IR35 rules worked prior to 2017 was open to abuse by contractors, who could game the system to artificially minimise their employment tax liabilities.

The reason for this is that before the reforms kicked in, contractors were 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).

An inside IR35 determination means the contractor is considered an employee for tax purposes, and is therefore liable to make Pay As You Earn (PAYE) and National Insurance Contributions (NICs) as a permanent employee would, but is not entitled to receive paid sick leave or holiday pay, for example.

Once the reforms came into effect in April 2017, responsibility for determining how contractors should be taxed shifted away from the individuals and onto the public sector bodies that engaged them.

Ahead of the reforms coming into force, there were widespread reports of public sector bodies and central government departments issuing blanket determinations, which meant all of their contractors would be classified as working inside IR35, prompting reports of mass walkouts by contractors.

At the same time, some organisations also introduced hiring bans that prohibited the use of limited company contractors, and told these individuals they could only remain working for their public sector hiring body if they were willing to work via an umbrella company setup instead.

Tax status tools need improvement

HMRC provided an online tool to assist public sector organisations with assessing the IR35 status of the contractors they engaged, known as the Check Employment Status for Tax (CEST) tool, a month before the reforms came into force.

The timing of its release has previously seen HMRC come in for criticism by the National Audit Office (NAO), which – in February 2022 – released its own report into how the roll-out of the reforms into the public sector went.

“Public bodies had little time to prepare [for the reforms], some found it difficult to use the original guidance and tool that HMRC provided, and there was limited understanding on all sides of how much time and resource were needed to get it right”

That report said: “Public bodies had little time to prepare, some found it difficult to use the original guidance and tool that HMRC provided, and there was limited understanding on all sides of how much time and resource were needed to get it right.”

The tool has been repeatedly slammed since its launch, with critics claiming its results are error-prone, unreliable and inconsistent with employment case law, while figures released by HMRC in June 2021 revealed that in 210,000 cases it failed to determine how contractors should be taxed.

The PAC report echoed some of these past criticisms, while also pointing to other issues that public sector organisations encountered when using CEST. “Some questions within CEST were difficult to interpret correctly, and the guidance was long, too general in scope and not integrated into CEST itself,” the report stated.

“Employment status is a challenging area to get right, and we are concerned that non-compliance in the public sector may be much more widespread than the instances HMRC has identified so far.”

The report went on to state that improving the guidance and tools HMRC offers would help “reduce the inherent challenge” public sector organisations face when trying to comply with the reforms, and the tax collection agency must do more to work out how widespread non-compliance is.

Elsewhere, the report raised concerns about the difficulties contractors face when trying to challenge the IR35 status issued to them by their hirer, which is something that needs to be addressed.

“Workers can challenge decisions with the hiring organisation, but they have no independent route to appeal. The hirer must respond formally to an appeal from a contractor within 45 days. However, if they do not change the status, the worker has no further recourse other than to seek a refund from HMRC by completing their self-assessment return on a self-employed basis,” the report said.

“It is unclear how effectively these routes operate in practice and the extent to which they are used, because HMRC does not monitor this.”

HMRC ‘underestimated’ compliance costs and challenges

The report also criticised HMRC for the “worrying” lack of work the department has done so far to understand the impact the reforms are having on the contractor community, the wider labour market and whether some sectors are being worse hit by its after-effects than others.

“It is now up to HMRC to prove that it is correctly claiming revenues under the system and that the additional revenues raised are worth the cost and unintended consequences in the labour market”

This, in turn, means HMRC has “underestimated the additional costs of implementing the reforms to hiring organisations” and is unable to “disaggregate the direct impact of the reforms from other labour market trends such as the effects of the EU Exit and the Covid-19 pandemic”, it stated.

The negative impact the reforms have had on the ability of public sector organisations to hire freelance labour is also talked about in the report, which is understood to be a by-product of inside-IR35 contractors demanding higher pay rates to cover the cost of the extra tax they are paying.

In a statement, PAC chair Meg Hillier said despite years of tinkering with IR35 rules to ensure compliance, the “fundamental problems underlying the UK taxation of work remain”.

She added: “It is now up to HMRC to demonstrate that the system can work fairly in the real world, to prove that it is correctly claiming revenues under the system and that the additional revenues raised are worth the cost and unintended consequences in the labour market.”

HMRC welcomes extra tax revenue

Computer Weekly contacted HMRC for a response to the PAC’s findings and was told the department welcomed the report’s acknowledgement that the reforms appear to be bringing in more tax revenue.

“These reforms have succeeded in making the tax system fairer, with more people who work like employees paying tax like employees, levelling the playing field for everybody else and bringing in the tax that is due under law,” a spokesperson for HMRC said in a statement.

“We delivered an extensive programme of education and support before the reforms took effect and we have continued to adapt our approach to improve compliance with the rules and support organisations to get things right.”

IR35 reforms have been a ‘car crash’

Dave Chaplin, CEO of compliance consultancy IR35 Shield, participated in the evidence-gathering stage of the PAC inquiry, and said he considered the contents of its resulting report to be “spot-on”.

“Neither the government nor HMRC are in the habit of admitting when they have made a mistake, but this damning report by the Public Accounts Committee should make them all sit up and listen,” he said.

“HMRC and the policymakers ploughed full steam ahead into rolling out the off-payroll reforms to the public sector in 2017 and over the last year or so we have seen a car crash, a massive pile-up some might say, as even government departments have got it wrong.”

In reference to the fact the government followed up the public sector roll-out of the reforms by extending the changes to the private sector in April 2021, Chaplin said the challenges government departments faced with IR35 were being keenly felt by private firms now.

“HMRC and the policymakers ploughed full steam ahead into rolling out the off-payroll reforms to the public sector in 2017, and over the last year or so we have seen a car crash, a massive pile-up some might say, as even government departments have got it wrong”

“Firms are struggling to get status determinations right, and CEST is proving to be dangerous for firms – a hindrance, not a help. The disproportionate tax risk and double taxation issue has still not been resolved, and neither is there any independent appeals process for contractors who are not being treated fairly,” he said.

“Over the last 20-plus years [since IR35 was introduced], there has been considerably misjudged and damaging legislation heaped on the contracting sector and the sensible option would be to go back to the drawing board and design a fair tax system that works fairly for everybody.”

Seb Maley, CEO of contracting authority Qdos, described the committee’s findings as “damning” and said just because the reforms were credited with generating more tax revenue did not mean they were working properly.

“This IR35 review is damning and highlights many of the government’s failures. Along with evidencing the staggering levels of non-compliance in the public sector following reform, it exposes the flaws of CEST, which frankly still isn’t fit for purpose despite being launched five years ago,” he said.

“It also calls on the government to do more when it comes to assessing the true impact of IR35 reform on the labour market. HMRC has said the changes are generating more tax revenue, but this isn’t necessarily a sign of improved compliance. In our experience, it’s a direct result of genuine contractors being forced to operate on the payroll.”

He added: “The risk-averse approach taken by some businesses is also flagged. What the government refuses to acknowledge is that many organisations have stopped engaging contractors altogether due to IR35 reform. Given IR35 reform can be managed, this is a needless approach and one that sees businesses struggle to attract contractors, exacerbating the UK’s staff shortages.”