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Public sector bodies accused of freezing out SME IT consultancies over IR35 compliance fears

After details emerged about the multimillion-pound tax bills and penalties some public sector organisations have incurred due to IR35 compliance failings, it is claimed some government departments are cutting their SME consultancy partners loose

Tech-focused small and medium-sized enterprises (SMEs) are being shut out of public sector contracts as risk-averse government departments fear finding themselves on the receiving end of multimillion tax bills for IR35 compliance errors, it is claimed.

A Public Accounts Committee (PAC) report in May 2022 confirmed that mistakes made during the implementation of the IR35 reforms in the public sector, which came into force in April 2017, had so far left government departments owing £263m in unpaid tax to HM Revenue & Customs (HMRC).

As revealed by Computer Weekly in July 2021, the Department for Work and Pensions (DWP) was among the first to declare, in its accounts for the 2020-2021 financial year, that a review of its IR35 compliance procedures had left it owing HMRC £87.9m in back taxes.

Since then, details of the IR35-related tax bills incurred by other departments – including the Home Office, the Ministry of Justice (MoJ), and the Department for Environment, Food and Rural Affairs (Defra) – have emerged.

Fearful of befalling a similar fate, it is claimed that some government departments have tweaked their hiring policies and are enforcing bans on the use of consultancies whose directors are actively involved in the delivery of the service their companies provide so they do not have to carry out IR35 status determinations for these engagements.

As a result, it is being claimed some departments have opted to avoid carrying out a status determination by simply cutting their SME suppliers loose.

That’s according to Romy Hughes, director of private and public sector digital transformation consultancy Brightman, who told Computer Weekly that she has witnessed this first-hand, and claims HMRC’s enforcement action against government departments is to blame.

According to the government’s own Digital Marketplace sales dashboard, Brightman has previously secured contracts with the likes of the National Crime Agency and HM Land Registry. 

“It is because HMRC actively went after bits of the public sector and levied fines against them [for IR35 errors] that the fear across the public sector of getting things wrong is huge. It’s the fear of an unexpected fine or tax bill that has really driven this behaviour more than anything,” she said.

“Any SMEs like ours, where my business partner and I work in the delivery of the service, are being deemed too risky to use by some of our [public sector] customers, and therefore they do not want to include us in their procurement pipelines,” she said.

“What we’ve got is a situation where public sector is cutting out huge amounts of SME expertise, and they’re not even getting as far as doing an assessment to say that you’re inside or outside IR35. They’re simply saying, ‘If you work as a director of an SME on delivery, we simply won’t have you in our supply chain’.”

Speaking to Computer Weekly, Dave Chaplin, CEO of compliance firm IR35 Shield, said – from a legislative perspective – he can see why public sector organisations may be responding in this way.

“The public sector appears to be trying to make sure they are not the ‘client’ from an off-payroll working point of view so that all services are delivered on a ‘fully contracted out’ basis. That means service delivery by the provider, without having to do any IR35 determinations at all,” he said. 

“If the director of the provider is also a shareholder of the service provider, then the off-payroll working [rules] comes into play for that person, because they have a material interest in service provider, and a determination needs to be made. This is just one of many damaging consequences of the ill-thought through legislation.”

This “consequence” also flies in the face of the UK government’s overall commitment to ensure more procurement spend is awarded to small businesses, continued Hughes, and could set back the pace of digital transformation within the public sector considerably as time goes on.

“These public sector organisations are beginning to curtail their ability to digitally transform their organisations by acting this way, and they’re removing all of the expertise and intellectual influence from that and pushing themselves into a corner where they can only rely on the big consultancies to deliver change,” continued Hughes.

“It’s an unintended consequence of IR35, because what’s really happening is the administrative overhead of [doing determinations] puts the public sector off, and that problem is only going to get worse with the [proposed] civil service headcount cuts. So, we’re in a position now where it is increasingly difficult to do business as an SME with the public sector.”

Changing attitudes

Hughes said she first picked up on this change in attitude towards the use of SME suppliers in March 2022, citing a marked rise around this time in the number of inside IR35 contracts appearing on the government’s Digital Marketplace procurement hub.

“We have seen a significant policy change across the public sector since March where even contracts that were clearly outside IR35 are being listed as inside IR35, which is quite surprising,” she said.

“The customers will see an increase in price if they put those contracts inside IR35, which means the public sector is willing to take a hit on the public purse – and not an insignificant hit either. You’re talking in the region of 20%.

“If you did a financial assessment of the risks of the fine compared to walking into a significant price increase then that seems to be a crazy assessment that’s happening there.”

Hughes’ observation of an uptick in inside IR35 roles within the public sector is supported by data accrued by Ricky Whitfield, founder of the Outside IR35 Roles website, which advertises currently available outside-IR35 roles on behalf of recruiters and end-hirers.

“In March 2022 we saw a drop off in public sector outside IR35 contracts advertised on the website of around 39% compared to the start of the calendar year. This then dropped further in April to 66% compared to the start of 2022,” he told Computer Weekly.

That said, he has noted a “bit of a spike” in outside IR35 roles being advertised within the past few weeks, which could hint at a sign the tide is turning.

Inside IR35 vs Outside IR35

The IR35 reforms came into force in the public sector five years ago, as means of enabling HMRC to clamp-down on disguised employment and tax avoidance within the limited company contractor community.

The changes saw contractors cede control for determining how they should be taxed, based on the work they do and how it is carried out, to the public sector organisations who hired them.

This is because – in the view of HMRC – some contractors have sought to misclassify their working arrangements to minimise their employment tax liabilities, and artificially bolster their take-home pay.

This is because a contractor whose engagement is classified as being in-scope of the IR35 rules (inside IR35) are liable for Pay-As-You-Earn (PAYE) and National Insurance Contributions (NICs), and are – essentially – treated as an employee for tax purposes.

However, when a limited company contractor is working outside IR35, they have the option to draw a relatively small salary from the business and make up the rest of their income in dividends. Employer’s NI is not payable on company dividends, but it is on salaried income.

Therefore, drawing a lower salary from their business gives contractors a way to minimise the amount of employer’s NI they have to pay.

This is a view shared by Seb Maley, CEO of IR35 compliance consultancy Qdos, who told Computer Weekly that – on the whole – public and private sector organisations are taking a more measured and pragmatic approach to complying with reforms now they have had some time to bed in.

“I don’t expect things to get worse, though, for contractors, regardless of the staggering bills issued in the public sector. In recent months – and based on our experience – the number of businesses taking a measured, fair and pragmatic approach to IR35 reform seems to be on the rise. 

“It’s vital that businesses see non-compliance in government departments as a reminder to prioritise their own IR35 compliance, rather than make needless knee-jerk reactions, like forcing all contractors to work [on a] Pay-As-You-Earn [basis].”

For Hughes, though, there is a genuine concern that medium-to-large private sector organisations – which were brought into scope of the IR35 reforms in April 2021 – will follow the lead of the public sector and also start dropping SME consultancies from their supply chains too.

“Over the next couple of decades and beyond we will see continued digital transformation, but this will hit the private sector now as well because of the change in rules taking effect there [in 2021] and what we will see is a real inhibition of the UK’s [potential] to be at the forefront of digital transformation, even though this is key to the UK maintaining its position in a lot of markets.”

Computer Weekly contacted HMRC for a comment on this story and to get its response to the claims that IR35 is having an unintended and detrimental impact on the UK government’s SME agenda, and received the following statement in response:

“The off-payroll reforms introduced in 2017 ensure that individuals who work like employees, but through their own limited company, are taxed like employees. HMRC consulted extensively on the reforms and delivered comprehensive education and support programme to help public sector bodies get things right,” the spokesperson said.

“The reforms raised an additional £525m in the first two years, levelling the playing field for workers and providing money that would not otherwise have been available for vital public services.

“The government spent a record £19bn with SMEs last year, the fourth consecutive annual increase. The new Procurement Bill will make it easier for SMEs bidding for government contracts, including those for digital services.”

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