HS2 is the latest public sector organisation to have fallen foul of the Off-payroll legislation as it faces a £9.5m tax bill for getting its IR35 assessments wrong. HS2’s accounts for the last year have revealed that the government body did not carry out employment status determinations on several contractors because a third-party provider supplied them.

Dave Chaplin is CEO of tax compliance firm IR35 Shield and says the case highlights why it is so crucial for end-hirers to conduct their due diligence when they have a consultancy in their supply chain. Here he outlines the nuances between the original IR35 legislation and its new version, and how it requires careful navigation to avoid later perils, as we see with HS2.

IR35 v Off-payroll
The original purpose of the new Off-payroll legislation (Chapter 10 of ITEPA 2003), which rolled out to the private sector in April 2021, was to be a wholesale replacement of the longstanding Intermediaries Legislation (Chapter 8 of ITEPA 2003) from 2000, commonly referred to as “IR35”.

However, following consultations, Parliament felt the burden on small companies (as defined by the Companies Act) would be too onerous, so it introduced a “small companies exemption”. Whilst designed to ease the burden on small businesses, it has added considerable complexity because the original legislation remains but only applies to contractors working for those small companies. The newer version of Off-payroll applies to the public sector and private sector companies that are medium or large. Both are somewhat confusingly referred to as “IR35”, and firms must understand the differences to avoid accidental exposure.

The differentiators
The common element is assessing whether the relationship between the contractor and the “client” is one of “deemed employment”, colloquially referred to as their “IR35 status”. But, where firms have fully outsourced service delivery to a consultancy, the consultancy is the “client.” Then, if that consultancy is small, the contractors bear the tax risk under the old rules, giving them a better chance of fair tax treatment.

In this instance, their consulting client has hired them clean, with no longer-term potential balance sheet tax risk. The risk for the contractor is minimal too. Savvy contractors are prudent, HMRC rarely investigates, and it loses more cases than it wins when it does. And if HMRC wins, the contractor can offset the taxes already paid.

The new Off-payroll legislation is very different. If HMRC issues a determination to the client,  multiple contractors can be simultaneously targeted, leading to potential contagion. The total tax risk is two lots of national insurance contributions and income tax, roughly equal to 50% of the gross payments made. Currently, there is no clear path to reverse any offsets of tax the contractor has already paid, so it is little wonder that many firms have blanket banned the use of limited company-based contractors.

Therefore, medium and large clients prefer to fully outsource work to a consultancy because the consultancy is the “client” for Off-payroll purposes and carries the tax risk.

Where are the dangers?
Firstly, just because small companies can leverage the exemption doesn’t mean they can ignore the IR35 legislation, nor can the contractors. While the contractors are legally liable for the tax and self-assessments, procurement departments still expect consultancies to conduct assessments to help protect all parties.

The larger hiring firm’s other concern is a fault line in the Off-payroll legislation, where HS2 fell foul. If the hiring firm wrongly considered the consultancy to be providing fully contracted out services, then the new legislation is in play. In that instance, because the hiring firm hasn’t conducted assessments and passed the Status Determination Statement (“SDS”) to the worker, they are liable for the unpaid tax, not the consultancy. The belt-and-braces approach to protect against this is to conduct assessments for all contractors and ensure the contracts are spot on – which isn’t expensive.

There is much discussion about the reasonable care requirements in the new legislation. Still, no statutory reasonable care provision protects the hiring firm which reasonably decided the consultancy was the client and not them.

That said, providing firms have the proper contractual paperwork in place that demonstrates the provision of services, not people, then courts should support that position.

The complexity of assessments
Assessments can be a daunting challenge for firms, particularly when assessing large numbers of contractors quickly, effectively, and consistently. An incorrect evaluation could result in a significant tax hit for companies that get the determination wrong.

Because of the complexity of the underlying case law, which relies on considering the contractual paperwork and conduct of the engagement, the status evaluation can potentially be arduous and time-consuming. Resolving this burden requires a blend of human expertise and automation.

Where is the proof?
The other hurdle to overcome is collating enough material evidence during the contract to combat any future investigation by HMRC. After all, turning up in court with your voice but no evidence makes it very difficult to discharge your burden of proof. Quality evidence is everything when defending cases and stopping them reach the tax tribunal. Oddly, it’s a piece of the puzzle missing from many firms’ compliance processes.

Firms should gather evidence during the contract to help shore up the original status. Then, if a dispute arises many years later, the firm isn’t scrambling around to locate corroborating evidence to back up the initial determination.

The full compliance life-cycle
Successfully implementing a robust Off-payroll regime is ultimately about accurate status determinations and collating the evidence to support them. Where there is a consultancy in the supply chain, it’s essential that the hirer, in this instance HS2, conducts due diligence to ensure that the consultancy is providing wholly outsourced services and not labour.

Firms engaging with consultancies should carefully examine their arrangements, and typically the answer is found in the contract between them and the consultancy.

We have seen many genuine consultancy arrangements in practice, but the legacy paperwork is more akin to one of an agency providing labour, which can be fatal in an IR35 investigation.

HS2 will be saddled with the entire tax bill, and the contractors’ earnings will be net of tax due to the flaws in the legislation. The overall effect is that the Treasury will lose money.

HS2 is one more shining example to support calls, along with a growing plethora of evidence to ditch legislation that has a hugely damaging impact on contractors, the firms that hire them and the economy as a whole. And the fact that HS2 is one more public sector organisation facing a tax bill in a long line of others proves the legislation is unworkable.