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IR35: NAO slams HMRC’s ‘haphazard’ roll-out of off-payroll reforms to public sector

National Audit Office’s 60-page report on the 2017 roll-out of the IR35 reforms claims HMRC’s actions made non-compliance a ‘highly likely’ outcome for public sector bodies

HM Revenue & Customs’ (HMRC) “haphazard” handling of the initial roll-out of the IR35 reforms to the public sector contributed to high levels of non-compliance by government departments, resulting in some being hit with multimillion-pound tax bills.

That is according to Public Accounts Committee (PAC) chair Meg Hillier in response to the findings of a 60-page report by the National Audit Office (NAO) into how HMRC handled the introduction of the reforms to the public sector in April 2017.

“HMRC’s haphazard roll-out of stage one of the new IR35 guidance meant public bodies were confused by the changes and had no time to prepare,” said Hillier.

The IR35 reforms were rolled out to the public sector in April 2017 as part of a push by HMRC to clamp down on disguised employment among personal service company (PSC) contractors.

The changes saw public sector contractors cede responsibility for determining how they should be taxed to the organisations that hired them.

Previously, it was down to contractors to decide whether the work they did and how it was performed meant they should be taxed in the same way as salaried employees (inside IR35) or as off-payroll workers (outside IR35).

According to HMRC, letting contractors decide for themselves how they should be taxed resulted in thousands of individuals deliberately misclassifying themselves as working outside IR35 to minimise their employment tax liabilities. This practice had, it is claimed, cost the Treasury £440m in unpaid tax during the 2016-17 financial year.

However, the shift in responsibility would place a sizeable, additional administrative burden on public sector bodies, as well as extra compliance costs, and, in the NAO’s view, HMRC did not give these organisations enough time to prepare for the changes. As a result, many central government departments have since faced enforcement action.

“This [lack of preparation time] contributed to high levels of non-compliance by government departments and it’s a potentially rocky road ahead as HMRC wheels out the changes for the private sector, which is far larger and more complex,” said Hillier.

In the face of strong opposition, the government extended the IR35 reforms to the private sector in April 2021, with HMRC moving to assure the medium-to-large firms in scope of the rules that it would not take a “heavy-handed” approach to enforcing the rules during the first year.

That 12 months grace period is nearing an end, and the NAO report gives an insight into the complexities that await HMRC when it comes to tackling non-compliance in the private sector.

A major factor in this is that there are about 180,000 PSCs working in the private sector, which is around four times the number that were affected by the 2017 reforms, according to HMRC’s own figures.

At the same time, there is also uncertainty about what shape compliance will take in the private sector, said the report. “HMRC has published its compliance approach for the 2021 reforms and established a framework for penalties,” it said. “However, its assessments and penalties have not yet been tested because it has so far only found central government bodies to be non-compliant, none of which have challenged it in court.”

For this reason, Dave Chaplin, CEO of contractor compliance consultancy IR35 Shield, said the private sector could be in for a rude awakening once HMRC ramps up its enforcement activities.

“The private sector is four times bigger [than the public sector], according to the NAO,” he said. “Does this mean there is a £1bn tax bomb ticking away that could end up sending businesses to the wall, despite them all trying to act in good faith and follow HMRC guidance?”

Public sector clampdown

According to the 2020-2021 financial statements of government departments and agencies published to date, a total of £263m has been paid or is owed to HMRC by public sector organisations that failed to implement the IR35 reforms correctly.

The Department for Work and Pensions (DWP) has incurred the biggest bill so far, after it came to light in July 2021 that it was hit with a £87.9m tax bill by HMRC for “historic” errors in how it assessed the IR35 status of its contractors.

Later that month, it also came to light that the Home Office had been landed with a £33.5m bill over its “careless” application of the IR35 rules.

Since then, several other departments have been hit with similar multimillion-pound tax bills, with the NAO report confirming that HMRC’s IR35 compliance and enforcement checks have predominantly targeted central government departments.

However, from 2021 onwards, HMRC has increasingly been turning its attention towards monitoring how local public sector bodies have implemented the IR35 changes, said the NAO report .

It pointed out that mistakes – like the ones that saddled government departments with such large bills and penalties – were “highly likely” to happen because public sector bodies had little time to make sense of the changes and achieve compliance.

“The public sector faced challenges with the initial roll-out: 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,” said the report. “As a result, it was highly likely that some public bodies would make mistakes.”

As detailed in the report, the government confirmed in November 2017 that the public sector IR35 reforms would be introduced in April 2017, and published guidance in February 2017 to help public sector organisations prepare for the changes.

HMRC also rolled out its much-maligned Check Employment Status for Tax (CEST) online tool a month before the changes were due to take effect, for which it was criticised at the time.

“Public bodies had little time with the new guidance and tools before the rules came into effect,” said the report, adding that while “most public bodies found HMRC’s guidance and online helpful, some experienced problems using them”.

One particular problem with the guidance issued by HMRC was that it was too general in scope, and included guidance on roles that were “not relevant to most public bodies (such as pilots) rather than those widely used in the public sector (such as IT specialists)”, the report said.

Difficulties with CEST

Public sector bodies also ran into difficulties when trying to correctly interpret the questions asked by CEST during employment status determinations, said the report, before detailing the work HMRC did in 2019 to improve both CEST and the guidance it offered public sector bodies.

Even so, one of the recommendations in the report is that HMRC should continue to develop CEST further and its accompanying guidance, particularly because complying with the reform will require ongoing work for private and public sector organisations into the future.

On this point, the NAO report suggested that the cost and effort involved in complying with the reforms is likely to have taken some public sector organisations by surprise, with some also reporting longer-term challenges when trying to recruit and retain contractors.

“Public bodies we interviewed explained that they had dedicated a lot of ongoing resource to employment status determinations, such as full-time staff, supporting teams and review panels,” said the report.

“They also indicated that managing disputes with contractors, and more generally engaging with them to answer queries about the reforms and changes in employment status, has taken additional time and resource.”

The report added: “Some public bodies have also reported difficulties in finding contractors and that fee rates have risen.” However, it also acknowledged that this trend may have eased since the onset of the private sector IR35 reforms in April 2021.

“Public sector bodies were also competing with the private sector where, until 2021, contractors continued to work under the previous rules,” it said. “Following the private sector roll-out of the reform, this incentive is likely to have reduced.”  

The report said HMRC has learned lessons from its handling of the public sector roll-out of the IR35 reforms, which have gone on to inform its approach to introducing the same changes to the private sector.

Even so, the NAO concluded that HMRC faces ongoing challenges when it comes to implementing the reforms in the private sector, because it is a much bigger entity, which will make monitoring non-compliance a bigger challenge.

“Complex supply chains are more common in the private and third sectors,” said the NAO. “This creates a greater risk of companies making errors when determining tax status, and of the reforms resulting in workers changing careers, or businesses moving overseas.”

Read more about IR35

Gareth Davies, head of the NAO, added: “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.”

The report also stated that the reforms have “broadly had the intended effect” of increasing tax revenue while ensuring that a higher proportion of contractors are now classified as deemed employees.

“HMRC initially assessed that an additional £550m of income tax and national insurance contributions were collected in the first year,” said the report. “Offset against taxes that would otherwise have been paid by workers and their PSCs, this meant a net increase in tax revenue of £250m, more than the £150m that HMRC had expected. HMRC’s latest estimate of the net increase in revenue was £275m in 2018-19.”

Seb Maley, CEO of IR35 compliance consultancy Qdos, said the fact that the reforms generated more tax revenue than HMRC anticipated could be interpreted as another sign of how poorly managed the roll-out has been.

“The fact that the 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 [by public sector bodies], where they are taxed as employees,” said Maley.

“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 owned by public sector bodies.”

Computer Weekly contacted HMRC for a response to the findings of the NAO report, and a spokesperson said the organisation welcomed its findings.

“We welcome the report’s recognition that the reforms succeeded in making things fairer, with increased compliance with the off-payroll rules,” the spokesperson said. “More people working like employees have paid tax like employees, levelling the playing field.

“We have continued to adapt our approach to improve compliance with the rules in the public sector, support organisations to get things right, and enable a successful extension of the rules to the private and voluntary sectors.”

Incidentally, HMRC published the findings of its own report into the impact the IR35 reforms had on the public sector earlier this week, which paints a slightly different picture of how the changes were received.

In that report, it claimed its research showed that the “majority” of the public sector organisations that participated in its research felt the reforms were “easy to comply with” and that CEST had played an “important role in compliance generally”.

The report said: “Among those that said it was easy to comply, the most common reason was that the CEST tool made assessments quick and easy. There was overall less negative feedback related to CEST in 2021 compared with the research in 2017, suggesting improvements to the tool had been well received.”

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