Why IR35 continues to impact businesses | Deloitte UK has been saved
Dan Todd, an Associate Director in Employment Tax at Deloitte, examines the on-going impact of the IR35 rule changes for hiring off-payroll labour that came into effect in April 2021, exploring the importance of compliance and how best to navigate the challenges of effective workforce resourcing.
The rules for IR35 changed in the private sector on 6 April 2021 and, whilst many companies are still getting to grips with the impact of IR35, it should remain a high priority for businesses.
Organisations will probably be aware that HMRC have started enforcement reviews, with initial activity focused on the Financial Services and Oil & Gas sectors. This follows on from the experience of the public sector where the rules changed in April 2017. Since then there have been well publicised cases of HMRC successfully pursuing significant income tax and National Insurance Contributions (NIC) liabilities within the public sector and issuing penalties for non-compliance.
Any HMRC interaction with your business, including as part of Business Risk Reviews or wider employer compliance checks, should therefore be treated carefully, including any early-stage conversations related to your organisation’s approach to IR35.
But what is IR35? Why does it still matter to your business? And what should you be doing about it?
IR35 applies to scenarios involving the procurement of off-payroll labour, those where contractors, consultants or similar individuals not on your payroll are being contracted by your business, and where a personal service company (known as a PSC) or another similar intermediary (e.g. a partnership that falls within the rules) is involved in supplying the services of these workers to your business.
The effect of the rules is to place an obligation on the end-client of the contractor’s services, i.e. your business, to make an assessment as to whether or not the contractor should be treated for tax purposes as a ‘deemed employee’ of your business, which is often referred to as ‘inside IR35’.
If found to be inside IR35 and you continue to contract with the PSC directly, you would need to add the individual to your business’s payroll and account for their income tax, NIC, and Apprenticeship Levy via PAYE.
In some cases, businesses have sought to remove PSCs from the arrangements and have instead used one of a number of PAYE alternatives, for example either directly employed individuals on fixed term contracts, utilising agencies to operate PAYE directly, or engaging via umbrella companies. The latter cases present wider employment legal compliance considerations and I would recommend appropriate diligence is undertaken to ensure your supply chain operates in a compliant manner.
The IR35 rules in the private sector that place obligations on end users of labour currently only apply to medium or large businesses. To help navigate whether your company is impacted, “medium” and “large” businesses have been defined to mean organisations that meet at least two of these three conditions for two consecutive finance years:
• Annual turnover of more than £10.2 million
• Balance sheet total of more than £5.1 million
• More than 50 employees
Looking at these thresholds and businesses based in the South West, IR35 is likely to impact around 2,000 companies across the region. When you consider the Welsh business landscape, IR35 would seem to impact around 900 companies located in Wales.
IR35 is a complex area and my colleagues and I have heard that in some sectors there is some disparity between organisations in how they are each applying the rules. Even though the roles are very similar, some organisations are observing different IR35 tax positions to their competitors. If an organisation has evaluated a role and decided it needs to be subject to payroll taxes, this means there is an additional cost to their business for hiring that labour, and in some cases that may result in them being simply uncompetitive against a competitor reaching a different IR35 tax answer.
As HMRC are still mobilising to properly enforce the rules, there is no easy solution to this challenge, with some organisations paying higher rates, and others seeking to adopt different working models to support a self-employed outcome.
The cost of non-compliance can be very expensive, and the quantum increases the longer such engagements are on-going. The increase in NIC rates from April 2022, and following that, the future introduction of the Health and Social Care Levy, will increase the cost disparity between employed and self-employed models. HMRC have already recovered multi-million-pound tax liabilities and penalties in the public sector, and so businesses that do accept a level of risk with their IR35 status positions should be prepared for scrutiny over time and be aware of the potential consequences.
This risk is compounded by how liabilities are currently recovered by HMRC within settlements and the existing law in this area. As it stands, under the IR35 rules where an end-client of a contractor’s services is found to have not operated PAYE/NIC correctly, the liability for any underpayments to HMRC sits solely with the end-client, without any statutory relief or offset being available for any taxes that the contractor/PSC has paid to HMRC.
In fact, currently the contractor is able to apply for their own refund of the taxes they may have paid through their PSC. Therefore, an end-client could be liable to HMRC for approximately 60% - 70% additional tax cost in such arrangements, over and above the core rate that was paid to the contractor in the first place.
A more immediate impact may be experienced where businesses are seeking to sell or to obtain external investment and are subject to due diligence exercises by potential investors. For organisations with reasonably sized off-payroll workforces, IR35 risks are fast becoming a key tax risk in those pre-transaction reviews and can impact valuation where “risky” positions have been taken.
All of this means that non-compliance with the rules can be very costly and the resolution process with HMRC time consuming and painful, but of course it must be recognised that organisations will be grappling with this in tandem with wider commercial risks.
In advance of April 2021, before the extended IR35 rules came into effect in the private sector, my colleagues and I saw many businesses undertake preparations aimed at complying with the legislation.
The readiness preparations included identifying the use of PSCs within their off-payroll workforce, undertaking assessments regarding the type of service being provided and completing assessments of employment status for tax purposes (as appropriate), and then communicating these outcomes and actioning compliance obligations related to the rules.
Now that private sector businesses are operating within the changed rules, there are three key areas of focus: process gaps, operational change, and business growth.
1. Process gaps – It is important for organisations to test the governance, process and controls they introduced ahead of 6 April 2021. At the very least I would recommend this covers:
Additionally, I recommend great caution when presented with ‘fully compliant IR35 solutions’ which appear too good to be true and also to seek professional advice on evaluating the risks. This could include,for example, traditional labour agencies who now purport to offer consultancy services that are outside of the IR35 rules, rather than a supply of people. In addition, a very low effective rate of tax offered by some labour suppliers operating PAYE should be a sign that further review is needed to test that the arrangements are compliant.
Tax is not the only angle to this either, as the overlap with employment law and the employment rights that workers can obtain, for example under the Agency Worker Regulations), mean that the risks of engaging workers through non-compliant solutions extend further than the underlying tax position.
I’d recommend regularly and thoroughly testing your processes through live cases, and making sure you revisit any IR35 assessment process you put in place before April 2021 to confirm that it is operating as expected, particularly for cases that you assessed as falling outside of the IR35 rules. In addition, be sure to apply both an employment tax and an employment law lens to your arrangements to ensure compliance on both fronts.
2. Operational change – The COVID-19 pandemic has massively changed the way workforces operate, with working from home and hybrid working arrangements now much more common. Consequently, the basis on which many employment status assessments were originally undertaken may no longer be valid due to changed circumstances.
For example, changes in where, how and when work is performed, the types of cost incurred, and increased prevalence of workers on a “gig” basis means that you should revisit these assessments to confirm that they remain valid in these new circumstances and arrangements.
3. Business growth – Where a business previously qualified as “small” but has since outgrown the small company threshold, there will now be an obligation to assess the IR35 rules and the extent to which they apply to your business. This can in turn create a need to set up a new process, review existing contracts, and apply payroll withholding from the start of the new tax year.
Even if not yet falling within the rules, if your business is growing, you should also put in place a regular check to assess how close you are to exceeding the thresholds so that you can plan accordingly.
Although nearly a year on from the extension of IR35 to the private sector, the ever-changing landscape that businesses are reacting to is having a knock-on impact on the way the whole workforce, including contractors, is engaged and utilised.
To assess the tax compliance of your IR35 process you should now consider the following steps:
My colleagues and I were actively involved in supporting many businesses to create effective IR35 processes in advance of the 6 April 2021 changes and, now that the rules are in force, we are increasingly being asked to undertake process reviews to assess continued tax compliance. Additionally, given the increase in HMRC review activity, our focus is also shifting to supporting businesses in their preparation for reviews by HMRC, and the extensive knowledge accrued by our dedicated public sector team on this topic uniquely positions us to provide comprehensive advice on the appropriate approach and response.
To understand more about the IR35 rules, please visit our dedicated pages that inform and support organisations who use off-payroll or contingent workers. It’s where we share our latest insights, key updates and information on our services to support businesses interpret IR35 and meet their tax and legal compliance requirements.
Dan is a director who specialises in employment taxes. He regularly works with a range of clients, from FTSE-100 multi-national companies to local owner-managed businesses, advising them across the breadth of employment tax issues faced by employers, including day-to-day compliance and longer-term consulting or structuring.