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

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.”