The IR35 disconnect between HMRC and the contractor sector is stark; here’s why

The House of Lords Finance Bill Sub-Committee’s review of IR35 is currently underway, and the evidence submitted by HMRC has shocked many – with the tax authority stating that most clients find operating the new IR35 rules ‘easy’ and ‘reasonable to apply’.

Well, it’s clear from the industry’s reaction to this evidence that there is a disconnect between HMRC’s views on the adoption of IR35 reform and the impact the revised legislation is having on contractors and end-hirers, writes Matt Fryer, head of legal services at Brookson Legal.

Tracking the IR35 disconnect

But why does this disconnect around the off-payroll rules exist? Some have even suggested the disconnect is not just stark but it’s also massive – existing between HMRC and almost everybody else. Can businesses feel confident that they are in the right, and not the Revenue? And with the rules themselves, can businesses feel confident they’re getting them right?

Let’s go back to what’s been submitted to the Lords. HMRC’s view (which it put in writing) is that the new IR35 legislation has been easy for hirers to adopt. This may seem optimistic but based on our own research, it could actually be a reasonable conclusion. However, that’s only the case if businesses’ feedback is taken at face value.

We too have found businesses feeling on top of IR35

Data from our research, Reassessing IR35: The unspoken opportunity for growth shows that a hefty 88% of medium-sized to large companies believe they understand “reasonable care,” and are confident they’re IR35-compliant. Based on this alone, it’s easy to think that IR35 has been fully adopted and correctly implemented throughout the flexible workforce. However, when delving further into the data, the IR35 approaches those businesses have implemented show that this is clearly not the case for all.

Most companies appear to be using multiple solutions and applying different approaches to manage different contractor populations. Many organisations stated that they have determined their contractor status’ through the use of CEST (47%), or other automated online tools (42%), and have relied on such tools.

The trick is getting a trio right

However, as has been said time and time again, CEST alone is not sufficient to determine a contractor’s status. These tools are only as reliable as the people inputting the data, who need to understand both the rules behind employment status and the contract provisions -- oh and the working practices. Understand all three, and they stand a chance of achieving the right outcome.

Of greater concern, though, are the 31% and 35% of companies which have asked agencies and contractors, respectively, to make the IR35 status assessments themselves!

‘Pass it on,’ some of the well-placed are worryingly saying

The legislation and HMRC are very clear that assessing IR35 status is now the responsibility of the end-hirer, who in many cases, are the party best-placed to understand how the contract will operate. We heard this sentiment (that end-hirers are “well-placed” to gauge status) again from HMRC in its oral evidence to the Lords this week (See from approx. 16:53:50 here).

All of these approaches , whether it’s reliance on tools or getting agencies and contractors to assess status, carry significant risk for end-users, and even used just in isolation are unlikely to demonstrate the ‘reasonable care’ expected by HMRC.

Engager confidence with IR35? It looks false

So there appears to be a false sense of confidence, with many clients believing they are compliant, doing the right thing and therefore protected against HMRC penalties and tax bills.

Ironically, it was this fear of tax penalties and bills that was initially thought to be driving hiring business behaviour surrounding IR35 – framing the legislation in a largely negative light – and resulting in quick-fix and risk-averse solutions being implemented, such as contractor blanket bans or blanket inside IR35 status determinations. It may surprise some contractors to discover that only 27% of the businesses we spoke to said that they had taken a blanket approach to IR35. That said, it is likely that the 53% of businesses which told us they have not engaged a professional adviser to help with their IR35 processes could be taking short cuts of one form or another. The most likely effect of this is that more contractors have been determined to sit inside IR35 than should have been the case.

More disconnects, bad solutions, more contractors

Broadly speaking, and based on CEST determination figures, approximately 49-56% of contractors are being determined outside IR35, whereas our data shows that approximately 72% of status determinations as outside IR35. However during the IR35 consultation process, HMRC said it anticipated approximately one-third of contractors would be inside IR35 and classified as employees for tax purposes. This doesn’t tally.

Positively, however, end-hirer understanding of IR35 has progressed since the off-payroll working rules were introduced earlier this year. In fact, in a multiple choice question asked in our research, commercial risks such as contractor costs (53%), talent attraction (42%) and project delays (42%) have been identified by business decision-makers as higher risks of a ‘bad’ IR35 solution than unforeseen tax bills (31%).

This aligns with the intention of 90% of medium-sized to large companies to extend their use of contractors over the next 18 months to support business growth. We’ve seen this trend in previous economic downturns, with the flexible workforce and experienced contractor talent used to deliver projects on time, and we expect it to play a key role throughout the pandemic recovery. However, a growing national skills shortage has compounded the challenges and resulted in a competitive hiring environment. Recruitment of contractors is now proving difficult for hirers, with 77% of organisations finding hiring flexible workers to be ‘challenging’ (48%) or’ very challenging’ (29%). 

Rate increases

Our research found that since the introduction of the new IR35 rules in April 2021, more than three-quarters of firms (87%) that use contractors have been forced to increase pay rates to attract talent, with three-quarters (75%) forced to raise these rates by more than 10%.

The impact IR35 is having on organisations and contractors is complex – with a number of factors influencing these rate rises. However, despite a competitive hiring landscape, this figure is significantly higher than the 4.9% increase in employee wages reported by the ONS in the year  to November 2021, so is likely that much of this difference is making up the shortfall in take-home pay inflicted by inside IR35 determinations. How much of this increase in rates contractors are pocketing remains to be seen.

The first test of 2022

Although many businesses feel confident in their approach and believe they are IR35-compliant, the key January hiring period may prove as a type of ‘test case’ for businesses that have the most attractive and robust IR35 policies in place.

This will provide contractors with an opportunity to explore the jobs market and build positive relationships with new organisations that can demonstrate their IR35 compliance - for example by including IR35 status on job advertisements or contract specifications. Those hirers that can’t evidence this are unlikely to secure the contractor talent they need.

We would hope that this struggle to recruit talented contractors, while facing increasing costs, will act as motivation for end-hirers who have taken shortcuts to review their approach to IR35 and implement a solution that enables roles to be offered outside IR35 -- where appropriate.

The end of the soft-landing is coming -- April 2022

The New Year and 2022 more widely will also bring with it the next step on the IR35 journey - the end of HMRC’s ‘soft-landing’ period for the off-payroll reforms.

Treasury minister Lucy Frazer said in her oral evidence to the Lords on Monday: “At the moment, we’ve got a very light-touch penalty system but after 12 months [from April 2021], we will be taking compliance action where that is appropriate.”

This could spur another round of companies to revisit the IR35 solution they put in place in April 2021, ahead of the new enforcement period beginning shortly. In the meantime, it’s important that contractors allow for flexibility in their set-up to maximise opportunities in the New Year – a flexibility that for engagers implementing IR35 reform, will soon expire.