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IT contractors warned as HMRC draws on ‘IR35-adjacent’ legislation in tax avoidance clampdown

IT contractors are being urged to take action now, as details emerge about how HM Revenue & Customs is drawing on some IR35-adjacent legislation to send out five-figure tax bills to individuals who engage with contractor-focused accountants

HM Revenue & Customs (HMRC) stands accused of using some IR35-adjacent legislation to mount a large-scale tax grab on IT contractors, which could have concerning implications for the accountancy firms that represent them.

The government tax collection agency’s latest round of enforcement action has seen the clients of at least two accountancy firms that specialise in the provision of services to limited company contractors hit with five-figure tax bills by HMRC. One of the accountancy firms HMRC is known to have in its crosshairs is Potters Bar-based Churchill Knight & Associates. 

The company confirmed to Computer Weekly that it is challenging HMRC’s actions against the firm and its clients, which stem from the claim that Churchill Knight’s business operations fall foul of anti-tax avoidance managed service company (MSC) legislation.

The MSC rules shares some similarities with HMRC’s IR35 regulations, in that they are both geared towards clamping down on tax avoidance within the limited company contractor community by targeting individuals who HMRC claims should be treated as employees for tax purposes. 

The MSC legislation was introduced in April 2007 to ensure limited company contractors are in business on their own account, as Chris Maslin, founder of Kent-based chartered tax advisory firm Maslins, set out in a recent LinkedIn post about HMRC’s enforcement action.

“There have always been lots of little, one-person limited companies. [Around] 20 years ago, accountancy firms started going above and beyond what an accountant would historically do to make their clients’ lives easier,” said Maslin.

“They would issue invoices to clients on the contractor’s behalf, have write access to the contractor’s company bank account, chase up payments from clients, pay suppliers and – indeed – the contractor personally.

“The contractor was legally the business owner, but all the contractor had to do was the chargeable work. The accountant did everything else. They effectively ran the company, with the contractor being the worker.”

According to HMRC, accountancy firms that behave in this way should be classified as managed service company providers (MSCPs), while the contractor companies they work with are described as being managed service companies (MSCs).

Because the MSCP is effectively running the contractor’s business for them, the contractor should be considered an employee of the accountant’s business and taxed as such, according to HMRC.

This means the contractor should be liable for Pay As You Earn (PAYE) and National Insurance Contributions, but by participating in an MSCP setup, the contractors avoid this.

Typically, though, limited company contractors pay themselves by drawing a relatively small taxable salary and make up the rest of their income in lower-taxed dividends. They are also liable to pay corporation tax.    

In the wake of the MSC legislation coming into force, many accountants “backed off” from working in this way, continued Maslin, and limited company contractors received more “arm’s-length assistance from their accountants” instead.

The number of accountants – and their clients – that could be caught in scope of the legislation fell because of the change in behaviour it bought about.

However, it was not until 2019 that HMRC won its first case at the court of appeal pertaining to the MSC legislation, netting it tens of thousands of pounds in unpaid tax as a result.

“HMRC will see the legislation as a huge opportunity – and if the tax office wins one major case, it could set a precedent&Rdquo;
Seb Maley, Ados

It is this success that many contractors and other industry stakeholders cite as the reason why HMRC is taking a closer look at the working relationships between contractors and their accountants now.

Speaking to Computer Weekly, Seb Maley, CEO of IR35 compliance consultancy Qdos, said: “HMRC believes it can find hundreds – even thousands – of contractors in breach of the MSC legislation by launching just one probe into a contractor accountant. HMRC will see the legislation as a huge opportunity – and if the tax office wins one major case, it could set a precedent.

“Contractors are liable initially, irrespective of whether they were advised to work in this manner by their accountant or not. In theory, any contractor who has engaged a specialist contractor accountant is at risk of being investigated under the MSC rules. This figure could easily run into hundreds of thousands.”

Computer Weekly has spoken to a handful of contractors who have received letters from HMRC telling them they owe tens of thousands of pounds in unpaid tax because their working relationship with Churchill Knight marks them out as an MSC.

The MSC legislation means HMRC can target large groups of contractors in one fell swoop, which is less labour-intensive than pursuing them individually via the IR35 rules, said one contractor, who spoke to Computer Weekly on condition of anonymity.

“The approach that HMRC is taking now is its way of trying to catch those of us who are operating so far outside of IR35, and compliantly, that we are virtually untouchable,” said a contractor, who has received a tax bill just shy of £20,000 for the 2017/18 financial year.

Computer Weekly put the claim to HMRC that it is leaning on the MSC legislation to target large numbers of contractors who it cannot reach through the IR35 rules, and received the following statement in response.

“People who work like employees must pay tax like employees. The MSC rules prevent an intermediary company setting up a structure that facilitates tax avoidance. We will take action where we find such a structure is being used, to ensure the right tax is paid,” a spokesperson for HMRC said. “If anyone has a query about any letter they have been sent by us, we encourage them to get in contact with us so we can help.”

Digging into the details of the MSC legislation

HMRC’s definition of an MSCP is featured in Section 61B (1) Chapter 9, Part 2 of the Income Tax Earnings and Pension Act (ITEPA).

It defines an MSCP as being an organisation that benefits financially on an ongoing basis from services the contractor provides. These providers also have the power to control and influence how those services are delivered, as well as how the contractor is paid for them.  

An MSCP also has influence and control over the limited company contractor’s finances and promotes undertakings to make good any tax loss.

An accountancy firm only needs to satisfy one part of the above definition to be considered in breach of the MSC legislation, and – in turn – trigger HMRC to send out letters to contractors demanding they repay the tax it claims they avoided while operating as an MSC.

HMRC is time-barred from taking enforcement action against contractors after four years, which appears to be why its action so far has focused on chasing unpaid tax from contractors for the 2017/18 financial year.

However, the contractors Computer Weekly has spoken to are fearful that this first round of letters will be followed up in due course with similar payment demands covering more recent financial years.

This could result in some contractors being saddled with life-changing tax bills that they will find impossible to pay, which could have big financial implications for the agencies and the clients that engage them.

“The MSC legislation poses a big threat not just to contractors, but also their accountants, agencies and even end clients,” said Maley. “If the contractor can’t pay – what in some cases is up to £50,000 for a single year – the liability can transfer up the supply chain.”

Computer Weekly has been supplied with a copy of the letter HMRC sent to Churchill Knight’s contractor clients in early March 2022, telling them the amount they allegedly owe in unpaid tax.

The letter confirms contractors have the right to appeal the contents of the letter within 30 days of it being despatched by HMRC, and they will not have to pay the amount HMRC claims they owe while the appeal process is underway.  

Tom Edwards, operations director at Churchill Knight, told Computer Weekly that all of its clients are being advised to appeal against the letters, not least because the amounts HMRC claims they owe are inaccurate.

“The liability [figure] is too large. Straight away, I can tell you that without even looking at the letter. The reason it’s too large is because HMRC hasn’t offset the tax people have already paid in terms of corporation tax and dividends tax,” he said.

“HMRC might send out a bill for say £20,000, but [the contractor has] already paid £13,000 to other tax offices, and that headline figure will look quite shocking. But when the appeal is put in place, the liability is put on hold and there will be time to have that revised and other taxes reclaimed in the event of HMRC winning the case.”

Computer Weekly understands HMRC’s investigation into Churchill Knight’s affairs began at the end of 2018, with an “information-gathering” exercise that the accountancy firm duly cooperated with.

However, it was not until December 2021 that HMRC got back in touch with the company to say its investigation found its operations to be in-scope of the MSC legislation. This conclusion is one Churchill Knight is fiercely challenging.

“We know we’ve done nothing wrong, so we definitely know [our clients] haven’t done anything wrong,” added Edwards.  

Queries and support

In its March 2022 letter to contractors, HMRC claimed its review of Churchill Knight’s business revealed that the firm meets three of the five qualifying criteria needed for it to be classified as an MSCP.

In a copy of the letter, seen by Computer Weekly, HMRC said the fact Churchill Knight charges contractors an annual fee that is broken down and collected over 12 months marks it out as an MSCP.

It also claimed Churchill Knight controls the way payments are made to contractors because it provides each of its clients with a yearly statement showing how much they will be paid, which is then divided by 12 and spread across the year.

“If the client company would like to change this, then they would have to contact Churchill Knight,” said HMRC, in the letter.

The letter went on to state that because Churchill Knight provides clients with an online portal, this also puts it in breach of the MSC legislation.

“It is apparent that [clients] cannot operate without the portal as they do not pay themselves without checking/using the portal first,” stated the letter. “HMRC contends that there is no independence from the portal and, by extension, Churchill Knight.”  

In anticipation of these letters going out, Churchill Knight created a support platform for its contractors to give them an insight into how the company is responding to the investigation.

“Transparency is key so clients can see where we are coming from and why we’re saying there has been an incorrect application of the legislation from HMRC&Rdquo;
Tom Edwards, Churchill Knight

“That platform has a variety of important information available to individuals, including information on the legislation, the areas of concern from HMRC and our technical response to those areas. Transparency is key so clients can see where we are coming from and why we’re saying there has been an incorrect application of the legislation from HMRC,” said Edwards.

“We’re trying to support individuals as much as we can and, in the meantime, we are discussing a lot with our lawyers and HMRC behind the scenes, including the interpretation of the legislation and how it is being applied, for example.”

The firm is also compiling evidence of its own to support its rejection of HMRC’s claims against it, continued Edwards.

“There are some things in Section 61B(1) that are factually incorrect. So, again, we’ll be presenting that to HMRC and providing evidence as to why these particular cases shouldn’t go as far as going for appeal or tribunal because they are factually incorrect, even by HMRC’s own application of the legislation,” he said.

“As you can imagine, there are a lot of appeals to be done and we don’t want to move focus away from the fact that clients need support during this process.”

Speaking to Computer Weekly, Rebecca Seeley Harris, a former senior policy advisor to the Office of Tax Simplification, said – as the Churchill Knight case indicates – the legislation is so widely drafted and broad that it could be a catch-all for a lot of accountancy firms.

“As an example, it is claimed [Churchill Knight] has ‘influence and control’ because it has its own portal that the firm developed and there is no independence from that,” she said. “That is very close to how pretty much every other contractor accountant works as well, although most others will use a third-party portal like FreeAgent.

“I think or hope [this action] is a fishing expedition. There will be those who pay up [without appealing] and HMRC gets a quick win,” she added.

Contractors urged to act fast

Dave Chaplin, CEO and founder of contractor compliance consultancy ContractorCalculator, also pointed out that HMRC’s take on the MSC legislation meant it could accuse any accounting firm that charges a fixed fee of being an MSCP, which is “clearly nonsense”.

He added: “What’s even sillier is that since the MSC legislation came into effect in 2007, we have seen the rise of online bookkeeping and accounting services, the rise of the software-as-a-service subscription revolution [for accountancy software]. The MSC legislation and how the common law emerged runs counter to that. A mess will ensue.”

Computer Weekly understands the contractors caught up in the Churchill Knight investigation have until mid- to late April to lodge an appeal with HMRC. If HMRC rejects their request, they can ask for an internal review or request to have their case escalated to a tribunal.

Chaplin said anyone in receipt of one of these letters needs to act on its contents quickly, and can ill-afford to bury their heads in the sand.

“If they have received a letter from HMRC, then it must be dealt with,” he said. “Contractors who have tax investigation insurance must speak to their insurer immediately, as failing to inform them early may invalidate a claim. Any contractor who isn’t insured should seek advice from a tax defence specialist.”

In the wake of the news about the Churchill Knight investigation, Chaplin, in collaboration with tax specialist David Kirk & Co, has launched the MSC Survivors Group for contractors affected by HMRC investigations of this nature.

Any contractors with concerns about whether the accountancy firm they use might end up subject to a similar investigation by HMRC in future should consider acting now too, he said. 

“For those contractors who haven’t received a letter, I would urge them to contact their accountant to establish if HMRC has opened an enquiry with them,” he said, as it can take some time for that news to translate into a letter sent direct to the contractor.   

In the meantime, contractors are advised to ensure there is nothing in how they interact with their accountancy firms that is likely to raise red flags.

“My advice [to contractors] would be to make sure you are setting up your own company and paying your own levels of salary and dividends, even if the accountant is advising you what the tax rates are,” said Seeley Harris.

“You have to break the chain of control and decision-making so that it is your decision and you are not a managed personal service company.”

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