Analysis: The repeal of the off-payroll working (IR35) legislation

Analysis: The repeal of the off-payroll working (IR35) legislation

It was certainly an unexpected U-turn to repeal the off-payroll working (IR35) legislation in April 2023, after only six years in operation in the public sector and a mere two years in the private sector! What do the changes mean? 

Nobody saw this coming, and so the question on everyone’s lips is ‘why?’

Cards on the table

In order to understand why many are so surprised, let us wind the clock back to the introduction of the Intermediaries Legislation (IR35) in April 2000. This put the burden upon contractors engaged through their own limited or personal service companies (PSCs) to determine their employment status on each and every engagement.

In the early years, there seemed to be sufficient IR35 enquiries when compared to the PSC demographic for contractors to be genuinely concerned about the risks of getting it wrong. HMRC also had some notable successes, such as the Dragonfly case (Dragonfly Consultancy Ltd v HMRC Commissioners [2008] EWHC 2113) with its newsworthy £99K assessment, but two things went against HMRC: firstly, the contractor population grew, but the number of enquiries went in the opposite direction falling from over 1,000 per year in the earliest years to an average of around 250 10 years later - even reaching a low of only 12 in 2010/11!

Secondly, HMRC was losing too many enquiries, until recent years, when it has achieved some success prosecuting cases in the media, in particular contractors working through their limited companies at the BBC. The complacency that existed in the contractor market about IR35 was recognised by a Government discussion document in 2015, which was noted in March 2021, by a House of Commons Research briefing that stated: “in 2011/12 around 10,000 people paid tax under IR35, an estimated 10% of those who should have paid tax on at least part of the income their PSC receives under the legislation.”

From HMRC’s perspective, introducing a system whereby initially public sector bodies (from April 2017) and private sector end clients (after three years of delay from April 2021) determined the status of each engagement made sense. After all, it is the engager/hirer rather than the contractor who genuinely knows whether the engagement is for a project rather than to cover for a vacancy which cannot be filled, or is really no different from the work being undertaken by employees.

It also narrowed HMRC’s target pool from an estimated 500,000+ contractors to about 60,000 end clients (because small companies as defined by the Companies Act were exempted) and 20,000 recruitment agencies.

In HMRC’s consultations leading up to the planned introduction of the private sector off-payroll working changes, HMRC indicated an expectation that a third of all contractors would be deemed to be ‘inside IR35’ once the legislation came into effect. As Markel Tax’s own experience of contract reviews suggested that the ratio of inside to outside engagements was probably closer to 50%, the ‘one third’ target didn’t necessarily seem to be that ambitious.

In the end, a mixture of the reaction of many end clients who effectively banned the engagement of limited company contractors, and the effects of Covid, probably caused not only the number of engagements to become PAYE, but also had a dramatic effect of contractor numbers generally – seemingly, a win for HMRC.

Reshuffling the pack

So, why change it?

If we look at the document released immediately after the Budget by the Treasury, The Growth Plan 2022, there are two references to IR35. The first of which under the “Growth” section at 3.44 is where we can find some clues.

“The Growth Plan sets out first steps in taking complexity out of the tax system. The 2017 and 2021 reforms to the off-payroll working rules (also known as IR35) will be repealed from 6 April 2023. From this date, workers providing their services via an intermediary will once again be responsible for determining their employment status and paying the appropriate amount of The Growth Plan 2022/23 tax and National Insurance contributions. This will free up time and money for businesses that engage contractors, that could be put towards other priorities. The reform also minimises the risk that genuinely self-employed workers are impacted by the underlying off-payroll rules.”

It would seem that medium and large-sized businesses have lobbied hard on the grounds that the rules have created unnecessary red tape, and the final sentence suggests that concerns from contractor representatives have also been noted. Blanket bans in terms of PSC engagement and over-cautious assessments of the IR35 status of assignments did surely contribute to genuinely self-employed workers being taxed incorrectly.

Nevertheless, as we predicted and based on the market’s reaction to the false self-employment legislation in 2013, engagers were always going to retreat into their risk-averse shells before recognising that if you wanted the best contractor talent, you would have to engage with the legislation. A number of sources had reported that this was starting to happen. It seemed that, albeit reluctantly in some quarters, the argument had been won by HMRC.

It’s possible that there was also pressure from the public sector. It is well documented that the collective tax bill for various government departments has exceeded a quarter of a billion pounds. Money paid out to HMRC is therefore unavailable to provide front line services and action government policy, so you can see why ministers might have lobbied the chancellor to put an end to the time, effort and cost, effectively reallocating government funds to the Treasury.

Yet, in the private sector, HMRC compliance visits would have resulted in ‘real’ money coming into the Treasury, and one assumes that the government would rather see those potential tax bills being used to fund growth in the economy.

On the face of it, all this time and effort expended by both the public and private sectors appears to have been in vain. We are returning to what everyone is describing as the ‘old’ Chapter 8 (Part 2 ITEPA 2003) position of the contractor being responsible for IR35. Contractors will be pleased, as they are no longer at the mercy of end clients unwilling or unable to properly engage with the (Chapter 10) legislation, and can determine their own destiny.

End clients and public sector bodies no longer have to determine the IR35 status of each and every engagement. Recruitment agencies who found themselves as the fee payer (the entity responsible for paying the PSC) no longer have the liability for end clients who could demonstrate that they had taken reasonable care in their decision-making process, but had nevertheless made an incorrect decision – a classic example of tax logic trumping common sense.

It’s easy to see why HMRC is likely very frustrated. Before the private sector reforms last year, finding contractors who were inside IR35 resembled looking for the proverbial needle in a haystack. There may not be half a million contractors now, but already contractors are re-forming companies ,and you can expect that to increase rapidly. We'll wait to see if HMRC recruits to beef up its small team of IR35-specialist officers, because if it doesn’t, there is every chance we will return to the old landscape.

Unless, of course, HMRC have some aces up its sleeve.

How will HMRC respond?

Firstly, we need to consider the MSC legislation. It is no secret that HMRC has been looking into the affairs of two accountancy service providers, arguing that the services they provide to PSCs go beyond that of an accountant and are influencing, if not controlling, the way the contractor is running their business.

If HMRC is successful in its quest, more than 1,000 contractors who received assessments for 2017/18 could find that these will be due. For them and many other clients of those firms, there could be further assessments arising for 2018/19 onwards.

But HMRC may not stop there. There's a number of contractor accounting specialists active in the market, as well as general practitioners with significant contractor portfolios, and this pool runs to hundreds of firms, not the 60,000 end clients which HMRC estimated were responsible for IR35 from April 2021 onwards.

Secondly, HMRC could be intending to make better use of the Intermediaries Reporting by recruitment agencies, which have to advise the PSCs they are paying gross (because the engagement falls outside IR35). This seems to be an untapped opportunity, even if it still means targeting a greater number of taxpayers.

Even if HMRC doesn't start enquiries, you could see it making use of ‘nudge letters’ to provoke a response. If a contractor decides to reclassify an engagement on the basis that they have received a communication from HMRC asking them if they are sure that they have complied with their responsibilities under IR35, it is not a bad return for the cost of a letter posted second class.

Thirdly, there is the targeted anti-avoidance rule (TAAR), which is more targeted to deal with ‘phoenixing’ (i.e., closing down one PSC, extracting the profits in the most efficient manner and then starting a new PSC), which has been used by contractors as a ‘defence’ against IR35.

The relevant legislation is ITTOIA 2005, s.396B, which establishes four conditions that must all be satisfied. The first three, around liquidating the company in which the contractor had at least a 5% share, that the PSC was a close company, and the contractor sets up a new company in the same trade or activity, are likely to be satisfied.

However, it is the fourth, Condition D, which HMRC will be keen to prove: that it is reasonable to assume that one of the main purposes of the liquidation was to avoid or reduce the payment of income tax.

Again, can we expect a nudge letter campaign? HMRC has its Connect system, which has access to billions of lines of data, so the exercise shouldn’t be beyond the taxman.

Finally, could some form of IR35 certification be on the cards? A Status Determination Statement which the contractor has to create? The requirement to provide evidence that the contractor has taken reasonable care to review the contractual terms and working practices of all engagements?

Are these reasons why HMRC has agreed to this change?

Contractors: don’t play your cards to your chest

From April 2023, the responsibility and liability for IR35 will rest with the contractor. For some contractors – those engaged by small companies or businesses based wholly overseas with no UK presence – nothing changes. But for many, the return to Chapter 8 offers genuine independence in terms of their tax affairs.

But with independence comes responsibility. Under the private sector off-payroll working legislation, the onus was on the end client to demonstrate reasonable care in their IR35 decision-making. Now this focus returns to the contractor, and there is only one way to demonstrate reasonable care: consider the contractual and the actual working arrangements. These two elements must be aligned.

If you are an experienced contractor with an in-depth knowledge of IR35, then you will know the key factors that determine IR35 status and what to look for in a contract. However, most contractors are going to want to undertake an independent and unbiased assessment: if you can demonstrate reasonable care, then the cost of a contract review will be far offset by the fact that even if HMRC is successful in arguing IR35 applies, you won’t have a 15%-30% penalty added to the tax and interest.

For those whose engagements are deemed to be outside IR35, there is also the opportunity to insure against the tax loss.

It doesn’t have to be HMRC holding all the cards. Click here to learn more about IR35.