The IR35 offset issue and why it matters

To fully appreciate the calls to fix the IR35 offset issue at Spring Budget 2023, a bit of case law is necessary. In particular, the principle of one taxpayer being able to offset the tax paid by another was established in Demibourne Ltd v Revenue and Customs, writes Danny Batey, senior consultant at Markel Tax.

Introducing the Demibourne Principle...

The case from 2005 acknowledged that the engagement of a Mr Bone by Demibourne Limited was not self-employment and therefore PAYE tax was due from the company. However, the company argued that tax and National Insurance Contributions paid by Mr Bone should be offset against the tax bill arising from his reclassification as an employee.

While there is no legislative right to set-off, the judge in the case concluded: “The parties [Demibourne and HMRC] are encouraged to arrive at a negotiated settlement to take account of the tax that Mr Bone has already paid.”

Thus, the 'Demibourne Principle' was established, and amended PAYE regulations followed, allowing HMRC to make a direction to “offset” tax self-assessed and paid by the individual against tax owed by the engager.

Deemed payment

In terms of IR35 from 2000, there was no real issue of “offsets” because the legislation itself provides its own step-by-step process for calculating deemed payment (and HMRC provides detailed guidance on this).

Importantly the deemed payment calculation includes 5% notional expenses and provides automatic considerations for the tax and NI already paid by the company (including PAYE on salary and corporation tax). This means that if an ‘outside IR35’ contractor were held to be ‘inside IR35,’ the deemed calculation allows for tax already paid to be offset against tax due. Undoubtedly, the redistribution of monies is made much simpler by the fact that the monies are all self-contained within the one entity (the PSC).

But now let us fast-forward to the public sector off-payroll working rules of April 6th 2017 and since then, the collective £268million which HMRC has levied upon a number of public sector bodies for IR35 compliance failures. How these settlements were calculated is not available, but it seems clear that the amounts do not reflect any tax paid by the PSCs caught up in those compliance failures.

Where the new IR35 legislation failed, and continues to fail

This is because the new IR35 legislation failed to address any offsets. Neither the existing IR35 legislation or the PAYE regulations contemplated “offsets” between independent corporate entities. So they provide no assistance.

Commentators have called for a set-off mechanism since the initial public sector off-payroll working consultation in 2016, but these calls have been studiously ignored by HMRC and HM Treasury. And when the legislation was then rolled out into the private sector on April 6th 2021, despite numerous amendments to the framework getting made, none addressed the offset.

The result, today in 2023? Well currently, double taxation applies (i.e. the very same monies get taxed by HMRC twice). While the public sector may not have taken HMRC to task on this, the private sector most certainly will. It will be an extra niggle to companies now that the Revenue has seen fit to take its guidance out of ‘implementation mode' and put it on an in-force footing, while in the background it continues to tax the same income twice. We can assure HMRC that neither agencies nor clients will settle for paying a penny more in tax than they are legally required to pay. Without action by the government though, the question is -- will there need to be a ‘Demibourne for IR35' in the private sector, to force the issue?

An IR35 offset mechanism is overdue

If rumours are to be believed, then this may not be necessary as there could very well be something in Wednesday’s Spring Budget. And incidentally, it is nothing that a simple legislative amendment could not resolve.

If there is a fix of the IR35 offset issue, it won’t be a moment too soon in our view.

It isn’t just a concern for fee-payers and clients either. Many contractors have signed contracts with end-clients and agencies which contain warranty clauses -- clauses which seek to pass on the fee-payer’s potential tax liability if the engagement is found to have been incorrectly determined as outside. While we have doubts these are enforceable, we do not make the law. But if they are enforceable, it will be in your interests (as a contractor) that the offset is applied to minimise your exposure.

Onus on Hunt to act, or else he'll add to the stack of off-payroll problems

Let us hope HMRC will address this issue soon without the need for the already overburdened tax tribunal to step in. But if HMRC doesn’t, or chancellor Hunt doesn’t on the department’s behalf, it could be troublesome for the government. The absence of an IR35 offset appears to have grown in the last few days into too high-profile an issue to ignore, adding to the already not insignificant list of off-payroll problems storing up for the future.