The recently published Annual Report and Accounts for High Speed 2 ("HS2"), the Government railway initiative, reveals HS2 is facing a tax bill of £9.5m for errors made when implementing the off-payroll IR35 reforms. The multi-million-pound tax bill comes despite the Report confirming that HS2 used HMRC's Check of Employment Status for Tax (CEST) tool and accompanying guidance to make the assessments.
This new finding follows a Public Accounts Committee report in May 2022, which reported £263m of IR35 errors in the public sector, and observed that it is "clear that structural problems remain with the way IR35 operates" and "Hiring organisations unable to properly assess a worker's status."
But, Dave Chaplin, CEO of IR35 Shield, indicates a more pressing concern: "A gaping hole in the off-payroll legislation remains, whereby whenever HMRC enforce the rules in the public sector, it results in a tax loss for the Treasury, which in this case could be around £8m.
"This hole however, has the opposite effect in the private sector, saddling firms with excessive tax bills, which should be mitigated by paying careful attention to indemnities and warranties in their contracts."
The legislative flaw in the off-payroll legislation
The structural flaw concerns the lack of an offset provision for the tax that the contractor has already paid and was brought to the attention of HMRC around two years ago, but it has still not been resolved. When HMRC steps in and successfully challenges an "outside IR35" status, the hiring firm is charged with the full amount of tax, resulting in the contractor paying zero tax. This tax bills can be crippling for firms.
This anomaly was picked up by the National Audit Office in their Feb 2022 report, which investigated the implementation of the IR35 tax reforms. The NAO reported that "Once the non-compliant client organisation accepts that its determinations were incorrect, the workers become entitled to claim back the tax that they and their PSCs have already paid. If they do, they in effect pay no taxes on that income because these are borne in full by the non-compliant public body."
HMRC admits, "I am afraid that is the case."
The Public Accounts Committee addressed the offsets issue on 21st Feb 2022, where HMRC CEO Jim Harra provided witness evidence alongside Nicole Newbury, Director for Wealthy and Mid-Sized Business Compliance.
Upon being quizzed on this matter, Newbury confirmed, "We do not have any legislative capacity to set off the amount paid by the personal service company or the contractor, so we collect the full amount from the public sector body. What then happens is that the individual contractor and their personal service company can make a claim for repayment."
The Chair of PAC, Meg Hillier, asked Harra, "So there is a big risk that the taxpayer could be funding the tax of private contractors?" He responded, "I am afraid that is the case."
HS2 may be unaware of this legal roadblock because their Accounts state, "…the Company will review whether there is cost that can be recovered from the suppliers to offset the tax liability." The reality is - they cannot. Not unless they plan on suing their suppliers, which would be a long drawn out litigation battle, and cut off their talent supply.
Is the flaw an 'incentive'?
Harra also told the Public Accounts Committee on 21st Feb 2022, "From our point of view, it is very important that there is an incentive on the engager to get these determinations right. The fact that they can end up liable for the tax if they do not take reasonable care is a key incentive in the regime to encourage them to get this right."
Despite describing this design of the legislation as an "incentive", when this finding was reported in the Financial Times, HMRC admitted that "it had been working with stakeholders to identify options to address the issue."
Chaplin says: "The 'incentive' Harra refers to increases the tax payable by the firm to almost four times the perceived amount that is avoided, and is perhaps better described as a 'threat'. The only incentive is for contractors to agree the determination was wrong because they then end up paying zero tax."
Public Sector IR35 does not work
"The off-payroll working rules do not work in the public sector, " explains Chaplin.
"If a public sector firm tries to hire an in-demand contractor and classifies them as 'inside IR35', then the contractor's rate increases by about 30% to cover the extra tax bills, which then circulates back to the Treasury, and the contractor earns the same after tax. Of course, HMRC can claim they are collecting more tax, but it's just circulated money.
"In the second scenario, the Treasury loses money if the public sector body hires 'outside IR35', and HMRC intervenes and reclassifies the relationship. The cause is the offsets problem - the contractor pays zero tax, and the public sector body and HMRC recirculate money again.
"Until the offsets problem is fixed, HMRC enforcement in the public sector loses the Treasury money. It's like the police turning up at a bank and packing the swag bags for the robbers."
Due to HMRC enforcement of around £270m, there are potential tax refunds available for contractors in the region of £230m.
What about the private sector?
"A similar issue exists in the private sector," says Chaplin, "except the private sector firm will be left with a disproportionate tax bill if HMRC overturns an 'outside IR35' assessment.
However, firms that have taken a robust approach to their IR35 compliance should not be too concerned because HMRC cannot willy-nilly override the agreed contractual terms, particularly after the Atholl House Court of Appeal ruling.
But, Chaplin says there is danger where firms have used CEST because it relies on what he calls "unicorn assessments", as explained in an IR35 Shield webinar in June 2022. As Chaplin states, "CEST sets the bar very high, and typically only hands out 'outside IR35' assessments by triggering irreducible minimums, which an HMRC inspector is unlikely to accept."
Quantum IR35 status
According to Chaplin, there is another gaping anomaly that firms should be aware of. "This occurs where firms have used CEST and been over-reliant on the right of substitution – because once CEST is told a right of substitution exists, it ignores all the other answers given and lulls the users into a false sense of security."
In this instance, because the firm's opinion on status is not binding, there is nothing to stop the contractor from re-assessing the engagement as "inside IR35" and declaring the income for that engagement as net of tax, and therefore pay no tax. At this point, neither the hirer nor the contractor has paid any tax.
The consequence could cause HMRC quite a dilemma. HMRC would need to decide whether to challenge the contractor and claim the engagement was "outside IR35", which could be appealed by the contractor. Or HMRC could agree with the contractor and go after the client claiming it was "inside IR35", which could be appealed by the client. HMRC could not issue protective assessments to both parties without contradicting themselves.
Chaplin concludes: "This situation highlights the farce created by HMRC by pushing out incomplete legislation. We pray they fix the offsets problem soon. They've had long enough, and there's plenty of incentives to do so."