In a previous role, I used to advise contractors working in the public sector on how to operate in a more tax-efficient way. As an internal auditor, I now find myself considering how clients in the public sector manage the emerging risks of engaging contractors – especially those who practise tax avoidance. I like to think of it as poaching-turned-gamekeeping.
For many contractors, the viability of operating through their limited company (rather than, for example, through an umbrella provider) rests heavily on a complex, poorly understood and divisive piece of tax legislation called IR35. IR35 is the government’s answer to a growing concern: how do you ensure that those claiming the tax benefits of operating via a limited company are genuinely in business? The legislation aims to tackle those who use their limited company as a vehicle for tax avoidance. How big an issue is this? According to recent HMRC estimates, tax avoidance of this kind will amount to more than £400m in 2016-17 alone.
Seventeen years after it was introduced, IR35 (also known as intermediaries legislation or the off-payroll rules) is now undergoing a significant change. From 6 April this year the onus for complying with IR35 will be passed from the contractor to the public sector client, agency or third party (the “engager” providing payment). For now, private sector organisations are unaffected.
The risks of noncompliance are not insignificant. In 2007, an IT contractor deemed to fall inside IR35 was fined £99,000 in unpaid tax and national insurance (NI). Where non-compliance is found, it is likely that HMRC will also investigate other contractors engaged by the organisation, compounding fines. For public sector bodies who engage a large number of contractors, the results could be catastrophic.
Both public sector organisations and assurance providers will undoubtedly welcome further guidance from HMRC, especially if it outlines acceptable monitoring levels to determine whether contractors fall within the scope of IR35. So far, HMRC guidance focuses predominantly on the recently implemented Employment Status Service (ESS). The ESS is an online questionnaire designed to provide contractors and end clients with some degree of certainty over the IR35 status of a contract. However, the practicality of undertaking the questionnaire for hundreds, if not thousands, of limited company contractors is still in question.
This has caused further concern in the contracting community that public sector organisations will simply deduct tax and NI at source to save administration costs and enforce compliance. Some public sector clients may even disallow contracts with personal service companies (limited companies) altogether. Both responses will leave contractors who operate outside of IR35’s scope unfairly out of pocket. Amid these concerns, there is an open petition to repeal the proposed reform. This has so far gained 20,000 signatures, including Labour and Tory MPs and the speaker of the House John Bercow MP.
Criticism is not just external. The Office of Tax Simplification (OTS) criticised changes to current legislation on the grounds that it will increase administration and the Employment Status Service did not add any certainty to the outcome of an IR35 investigation. We have seen this before; HMRC’s (now withdrawn) Business Entity Tests also tried to apply broad questions to determine IR35 risk. If we learn anything from previous failures, it is that a generic tool such as the ESS does not belong in such a subjective arena.
The changes have also reignited concerns that first appeared when IR35 was introduced in 2000. These focus on the unnecessary complexity of IR35 legislation, as well as the insufficient level of guidance to help distinguish between a genuine business and one set up purely for tax purposes. After all, how can public sector organisations (and internal audit) evaluate compliance with legislation, when guidance has so far struggled to define exactly what compliance looks like?
It is not just contractors and clients who find IR35 compliance perplexing. In 2011 HMRC appeared to stop taking IR35 cases to tribunal after it lost two cases in as many months. In both instances, HMRC had incorrectly deemed a contractor to have been caught by the legislation. Contractors may seldom escape HMRC’s grasp, however an understanding of IR35 seemingly can.
Internal audit can help to provide assurance on whether public sector clients have an appropriate plan continually to monitor their compliance with, and exposure to, IR35. Additionally, internal audit can review whether there has been appropriate consideration into how best to respond to the changes. Many fear that public sector organisations may simply choose to make deductions at source and pay contractors an inflated rate to remain competitive (so increasing the cost of public sector services). Although this may be the easiest option, it is arguably the most unethical.
Regardless of individual solutions, it is clear that public sector organisations need to work together to share best practice. For the public sector, we can only hope that the changes do not push contractors away from organisations that already face an uncertain future.
Daniel Severn has worked in compliance and internal audit for both public sector and private sector clients. He now provides internal audit services to clients across Yorkshire. He hopes this article will encourage newer members of internal audit to contribute to the Chartered IIA network and the wider profession.