Managing HMRC IR35 enquiries: tips for UK businesses

There is no uniform approach to how enquiries commence. HMRC tends to request a wide range of information, broadly focused on a business’ IR35 compliance processes and status determinations. The first contact from HMRC may involve a generic information gathering exercise, with no indication that a protracted enquiry could follow. However, initial communications often precede more formal exchanges asking targeted questions.

To manage risks and reduce the scope of a possible HMRC enquiry, businesses should seek advice before responding to any IR35 information request from HMRC. Businesses should maintain comprehensive IR35 compliance procedures, which are regularly reviewed to ensure they remain robust.

Background to IR35

IR35 targets the use of ‘personal service companies’ (PSCs) to avoid employment taxes. Broadly, where a business engages an individual ‘off-payroll’ and through an intermediary such as a PSC, the individual can achieve employment tax savings, whilst the business is not required to pay employer national insurance contributions (NICs) – currently at 13.8%.

When a business engages with an individual through a PSC, IR35 requires that the individual should be taxed as an employee, if they would have been deemed to be an employee for tax purposes if they had engaged directly with the business.

From 6 April 2021, when a business engages with an individual through a PSC, the business is required to determine if the engagement falls ‘inside IR35’ – that is, whether the individual would be an employee for tax purposes if they had engaged directly with the business. The engaging business, known as the ‘client’, is also required to issue a ‘status determination statement’ (SDS) to the individual worker and any other intermediary the client contracts with, confirming its determination and providing reasons.

If the client determines that an engagement falls inside IR35, the worker should be paid through the Pay As You Earn (PAYE) scheme. Employer NICs in respect of payments made to the worker will also be due. Where the client engages with the PSC indirectly through another intermediary, such as a recruitment agency, the agency, known as the fee payer, will be responsible for deducting and accounting for PAYE taxes and NICs.

How should businesses manage their IR35 compliance responsibilities?

IR35 risk management strategies vary according to the nature of the engaging business. However, HMRC will expect all businesses engaging off-payroll workers to have considered IR35. Prior to April 2021, HMRC repeatedly advised businesses to review their contractor populations and introduce IR35 compliance programmes. Prior to engagement, PSC workers should be identified, status determinations completed and SDSs issued to the workers and relevant third parties in the contractual chain. IR35 compliance procedures should be regularly reviewed to ensure that they remain fit for purpose and that individuals responsible for compliance receive adequate training.

The changes to IR35 created significant compliance challenges for businesses, particularly those with complex supply chains that are heavily reliant on flexible labour to meet resourcing needs. To manage IR35 tax risks, many businesses sought to engage all PSC workers through third party recruitment agencies whereby the agencies, as the fee payers, would be responsible for paying any taxes on fees paid to PSC workers determined as falling ‘inside IR35’.

Need to take “reasonable care”

Using a recruitment agency doesn’t eliminate IR35 risks. The engaging business remains responsible for making IR35 determinations and issuing SDSs for all PSC workers engaged indirectly by an agency. Responsibility for paying IR35 related taxes, and any interest and penalties that may become due, can also transfer back up the supply chain to the engaging business if it hasn’t taken reasonable care when making IR35 determinations and issuing SDSs. Therefore, ensuring that a business has taken reasonable care is pivotal to an effective IR35 risk management strategy, particularly when a business engages PSC workers through third party agencies.

Reasonable care is not defined. HMRC guidance provides a non-exhaustive list of ‘behaviours’ indicating whether reasonable care has, or has not, been taken when making status determinations. Primarily, HMRC expects a business to undertake a ‘complete and thorough’ assessment to determine whether a PSC worker should have been an employee for tax purposes if engaged directly.

Test for employment status for tax purposes

There is no codified legal test to determine employment status for tax purposes. The test has been developed through court decisions and is based on several factors – including whether there is a mutuality of obligation between the parties, the level of control that a business has over the worker, whether the worker can provide a substitute, how integrated the worker is in the client’s business and whether the worker is in business on their own account. HMRC has published detailed guidance and has also developed the ‘Check Employment Status for Tax’ (CEST) tool to determine employment status for tax purposes of specific workers.

HMRC has said that it will stand by a CEST determination, as long as the information inputted remains true and accurate. CEST may not always provide a determination and is estimated to fail in 15% of cases.

HMRC expressly lists the ‘accurate’ use of CEST as indicative of taking reasonable care when making status determinations. Therefore, using the tool as part of a comprehensive IR35 compliance programme may be beneficial if HMRC raises an enquiry.

How does an HMRC IR35 enquiry typically commence?

HMRC confirmed that it would not impose penalties other than for deliberate non-compliance for 12 months after implementation of the new IR35 rules. Consequently, HMRC compliance activity tends to focus on the tax year beginning April 2022.  Initial communication from HMRC may arise in the following circumstances:

• offering the business support with IR35 compliance, accompanied by a questionnaire;
• asking targeted questions as part of a wider employer compliance review;
• asking targeted questions through the business risk review process (for large businesses);
• asking for completion of a general questionnaire about off-payroll working to help HMRC better understand how businesses are engaging with IR35; or
• raising enquiries with the business in respect of specific workers.

Generic off-payroll working questionnaires are increasingly followed by targeted HMRC questions, which may seek more detailed information about IR35 processes and how status determinations are made. HMRC may also request to review a sample of contracts with PSC workers and their status determinations.

At the outset, it’s important to manage the wider risks of an enquiry commencing. On this basis, businesses should consider seeking specialist advice upon receiving any IR35 or off-payroll working related communication from HMRC.

Recommendations to manage IR35 compliance risks before an HMRC information request

• Regularly review IR35 processes to ensure they remain robust and fit-for-purpose.
• Supervise the completion of status determinations and SDSs.
• When devising and managing IR35 compliance processes, involve different business functions including tax, HR, procurement and legal and ensure processes are documented and effectively communicated across the business.
• Regularly refresh IR35 training for staff completing status determinations.
• The IR35 compliance programme should allow sufficient time in the procurement process to identify PSC workers, undertake IR35 determinations and issue SDSs prior to engagement.
• Periodically review contractual arrangements with agencies and employment businesses to ensure that they manage IR35 risks and detail how IR35 compliance requirements will be met.
• Ensure there are controls to monitor IR35 compliance by the third parties - for example, if a supplier cannot supply a PSC worker without prior written consent, check that that is actually happening.

Recommendations on receiving an HMRC IR35 information request

• Seek professional advice before responding to any HMRC IR35 information request. It is vital that businesses proactively manage HMRC IR35 information requests and don’t passively provide information to HMRC!
• Be prepared for an IR35 enquiry to take time – it’s unlikely HMRC will ask questions and be happy with the first set of answers.
• Be as cooperative as possible – HMRC may need convincing about the IR35 position of the business and having a functioning relationship will greatly improve the prospects of a satisfactory outcome.
• Involve the business senior leadership team at the outset – it is helpful for HMRC to see that the HR, tax, procurement and legal functions are involved.
• Start to formulate a strategy for reviewing the PSC worker population – should this involve retesting the entire population, or would proportionate sampling suffice?
• If sampling is needed, ensure that the sampling method will enable the business to utilise the PAYE set-off mechanism available from April 2024.
• Appraise the level of risk the business is exposed to – what’s the maximum exposure and what level of risk/quantum would the business be prepared to accept?
• Undertake an internal review and once completed, disclose any irregularities to HMRC and stand by IR35 determinations that the business considers accurate.
• Be prepared for HMRC to test boundaries and/or be incorrect. The test for employment status for tax purposes has not been amended since the IR35 rules changed, and therefore doesn’t envisage that businesses rather than the workers are making the status determinations.