Public bodies not given enough time for IR35 reforms

HMRC had key lessons to learn from the initial roll-out of IR35 tax reforms in the public sector, but faces new and challenging risks in implementing the regime more widely, according to the National Audit Office (NAO).

The report also finds that the public bodies were not given sufficient time to prepare and adapt, which led to mistakes.

It also shows that the measures brought in £100m more tax than was anticipated, although one industry expert attributed this to the large number of contractors whose status was incorrectly determined, and described the report as 'damning'.

In April 2017, the Government introduced IR35 reforms which made public bodies responsible for determining the employment tax status of all those it hired through intermediaries. It did this to tackle high levels of non-compliance which HMRC estimated cost the Exchequer £440 million in 2016-17. The reforms were initially introduced in the public sector, and later extended to the private and third sectors in April 2021.

Since their introduction they have been subjected to much criticism from professionals, contractors, freelancers and clients in the sector who have tried to implement them against a backdrop of errors and misleading information.

Public bodies had little time to consider HMRC's guidance and tools before IR35 reforms were rolled-out. HMRC published guidance in February 2017, just two months before the new rules came into effect. HMRC's key tool to help public bodies comply with the reforms, Check Employment Status for Tax (CEST), was launched in March 2017 with only one month to go. HMRC's 2018 research found that nearly half of all surveyed bodies found the reforms difficult to comply with, and one of the most common reasons given was difficulties using CEST.

In 2019, HMRC launched an updated CEST tool which changed some features that users said were causing difficulty. HMRC also made several updates to its technical guidance, and began to work more collaboratively with public bodies and other stakeholders.

Gareth Davies, head of the NAO, said: "The 2017 reforms to IR35 tax rules have achieved their primary purpose of reducing non-compliance. However, HMRC did not give public bodies sufficient time to prepare for the roll-out, and it was highly likely that mistakes would be made.

"While key lessons were applied during the wider roll-out in 2021, inherent differences in labour markets create new challenges that HMRC will need to manage for the reforms to be a success."

Extra tax

HMRC estimates that between 2017 and 2019, at least 50,000 additional workers were on the payroll of public bodies because of IR35 reforms. These people previously provided services through intermediaries. The net increase in tax revenue between 2017 and 2018 was £250 million, more than HMRC previously expected (£150 million).

The report says that it is difficult to know the extent to which this is because of the reforms, or other factors. Public bodies the NAO spoke to said that difficulties finding contractors and rates increasing were partly due to the IR35 reforms, but that it was difficult to disentangle this effect from wider labour market trends affected by COVID-19 and EU Exit.

The 2020-21 financial statements of Government departments and agencies include a total of £263 million paid, owed, or expected to be owed for failing to administer IR35 reforms correctly. In all cases, HMRC found that the public body had not taken reasonable care to prevent errors, including when answering questions in CEST.

Lessons learned from the experience of implementing IR35 reforms in the public sector were applied to the wider roll-out in the private and third sectors in 2021.

According to the NAO, HMRC faces ongoing challenges implementing IR35 reforms:

• Labour markets in the private and third sectors are larger, which makes monitoring non-compliance a bigger challenge.
  
• Complex supply chains are more common in the private and third sectors. This creates a greater risk of companies making errors when determining tax status, and of the reforms resulting in workers changing careers, or business moving overseas.
  
• There is uncertainty over HMRC's approach to non-compliance in the private sector. Its assessments and penalties have so far only been tested on central government bodies, none of which have been challenged in court.

The NAO recommends that HMRC further develops the CEST tool and accompanying guidance to make it as easy as possible to use accurately. HMRC should also build on its improved collaboration with stakeholders to pre-empt further challenges.

Damning

Seb Maley from IR35 tax investigation specialists, Qdos, said: "This investigation is damning and exposes many of the gaping holes in HMRC's plan for IR35 reform. It shows that public sector changes were rushed, the tax office's IR35 tool (CEST) is deeply flawed and that contractors had next to no chance of appealing unfair IR35 status decisions. As far as I'm concerned, it asks all the right questions – a far more accurate reflection of the public sector experience compared to the recently published HMRC-commissioned research.

"The fact that public sector reform brought in £100m more in tax than even HMRC expected is, in my opinion, inextricably linked to the sheer number of contractors wrongly placed inside IR35, where they are taxed as employees.

"Another key point made is how tax is collected in cases of non-compliance, which sees HMRC net more tax overall than is actually due. If HMRC finds a contractor has been wrongly engaged outside IR35, the tax office ignores the fact that the contractor will have already paid Corporation Tax and Income Tax on these earnings. HMRC won't offset the amount and, to make matters worse, there are no plans to address this, which is frankly wrong.

"Private sector businesses can learn a lot from this investigation. It makes clear that CEST should not be relied on to assess IR35 status and that HMRC has no hesitation in issuing staggering tax bills for non-compliance, evidenced by the £263m owed by public sector bodies."

Recently, HMRC commissioned its own report into the roll-out which was considerably less critical.