What the IR35 offset consultation by HMRC means for hirers, agencies and contractors

Under today’s off-payroll working rules, when a contract has erroneously been deemed to be outside IR35, HMRC will seek to recover the full liability of employment taxes due under PAYE, despite the fact that some of this has already been paid by the contractor and their Personal Services Company (PSC).

This creates a situation in which some taxes are being paid twice; hardly the basis of a fair and just tax system, writes Matt Fryer, managing director of Brookson, a People 2.0 company.

All about Aprils

Yet what is effectively double-taxation by HMRC has been the status quo since the changes to IR35 were first introduced in the public sector on April 6th 2017 and the private sector on April 6th 2021, in the shape of the off-payroll rules.

Now, a long-overdue HMRC consultation proposes a solution to this problem through an offset mechanism, with contractors, agents and hirers being asked for their views on the detail. The consultation opened on April 27th and runs for eight weeks.

But there’s another timeline to note. The envisioned changes to the off-payroll rules – to stop the same income being taxed twice -- will likely come into effect on April 6th 2024, in time for HMRC’s current investigations into non-compliance with the current off-payroll working rules to mature in the private sector. This is, of course, no coincidence.

Why set-off is sure to be well-received

Despite current uncertainty, the introduction of a “set-off” is expected to be widely welcomed by contractors’ hirers and agencies, because it will greatly reduce the tax and NIC bill for any errors. And the consequence of the set-off will hopefully be that supply chains become less risk-averse to using contractors working through PSCs, unlocking access to talent in the sectors where this is still an issue and creating more outside IR35 roles for highly skilled self-employed workers.

This consultation and its main proposal to introduce a sett-off “mechanism” to “address the issue of [it] over-collecting tax” is therefore expected to be welcomed by contractors too.

Let’s explore exactly what the government is consulting on, and what this means for the contractor sector.

What happens when HMRC deems an outside IR35 contract as inside IR35?

As it stands today, if a contract is assessed by the end-client as being outside IR35, it is likely that that contract will be fulfilled by a contractor working via their own company and the company will be paid gross of any PAYE deductions. The company and it shareholder(s) and director(s) will pay any associated income tax on any profits or salary taken from the company.

Should HMRC subsequently find the contract to be inside IR35, it will pursue the end-client for the total amount of tax and NIC arising (or will pursue the 'fee-payer'-- typically a recruitment agency) if the client is found to have not taken "reasonable care" in its assessment of status. 

Under the current rules, the contractor and their limited company would be able to claim a refund of the tax and NIC that they had paid. For many reasons, this is not a practical approach and HMRC are now proposing a possible alternative option.

The alternative option which government is consulting on...

HMRC are consulting on a more practical approach to this issue which will allow an offset of taxes already paid by the contractor and their PSC against any subsequent tax or NIC that arises as a result of the outside IR35 determination being proved to be incorrect by HMRC (or tax tribunal).

This approach already exists in other areas of tax legislation, which perhaps begs the question why it was not originally thought to be the preferred approach!

This proposed approach is not perfect however, as it is difficult for HMRC to know the amount of tax paid by a contractor and their PSC on each contract as it depends on many factors including:

• the amount of expenses claimed;
• the number of shareholders in the company;
• the levels of salary paid to any employees. 

What information will be needed with a set-off mechanism?

The offset will therefore need to be based on a number of assumptions, and there is therefore likely to be an appeals process available to any party who disagrees with the calculations.

One check that HMRC is keen to make is to ensure that the contractor and their PSC have submitted their tax returns for the year(s) in question and that tax has been paid. 

To do this they will need information from the client about the contractors that it has engaged. Collection of this information will impose an increased overhead on clients, and is likely to result in them wanting some degree of comfort from the supply chain that the worker and their PSC are operating in a compliant manner.

How do the calculations work?

This is perhaps best explained using an example (which I have taken from HMRC’s consultation): 

In this example a client engages a worker through their PSC and agrees to pay a fee of £50,000 for their services. The client has assessed the contract as outside the off-payroll working rules and therefore pays the gross fee of £50,000 to the PSC. The PSC then pays the worker in the most tax-efficient way, being a salary up to the Class 1 NICs primary threshold and the rest as a dividend. The PSC will pay corporation tax on their business profits and the worker will pay income tax on their dividends.

Subsequently, HMRC carries out a compliance check into the client’s IR35 determination and concludes that the determination is incorrect, and the engagement should have been inside the off-payroll working rules. This means that the engagement should have been determined as ‘employed’ for tax purposes, and the client (or in some cases agency) should therefore have operated PAYE on the £50,000 payment and paid the net amount to the PSC.

Therefore, the client is liable for the income tax and NICs that should have been paid under PAYE; which is calculated to be £23,256. However, HMRC will have already collected £10,003 in PAYE and corporation tax from the contractor and their PSC. Without any offset, HMRC has collected £10,003 too much, whereas with the proposed offset HMRC has collect the correct amount.

It should be noted that under the proposals any HMRC penalty due by the client will be calculated as percentage of the total liability (£23,256), as opposed to the net liability after the offset (£13,253).

What are offset’s benefits for end-hirer organisations?

Once applied, the offset will significantly reduce the financial risk of engaging PSCs to deliver outside IR35 contracts. 

For those clients that have imposed a blanket ban, it may be enough for them to reconsider their position -- therefore opening up the market to more skilled resource. 

A new obligation on clients would be the provision of information to HMRC regarding the contractors that they engage. Most of this information is currently collected by recruitment agencies and submitted to HMRC on a quarterly basis, so it should be readily available for clients who utilise recruiters.

IR35 offset mechanism – what it means for staffing agencies

Recruitment agencies and other intermediaries are, in some cases, at risk of the same tax liabilities as hirers.

If HMRC deems that the hirer has taken “reasonable care” in managing the off-payroll rules, but has incorrectly determined the status of some of its contracts, it is the recruitment agency that bears the tax risk. As noted above, the proposal reduces this liability for agencies and with hirers becoming more open to the use of PSCs it can only be good for business. It will allow recruiters to throw the net wider for talent on any given project.

As with the introduction of IR35’s changes in 2017 and 2021, agents will have a key role to play in educating their clients about the benefits of the offset, reducing fear of independent contractor use, and challenging any residual blanket bans still in place.

How might the new IR35 offset impact contractors?

Given the proposals are likely to make it easier for those risk-averse clients and supply chains to get comfortable engaging PSCs on outside IR35 contracts, on the whole this is good news for contractors. A potential downside would be sharing of information with the client to help HMRC facilitate the offset. However, I don’t see this as controversial.

One final contractor impact to note is that in instances where the contract is inside IR35, tax is deducted at source from the payment to the contractor and this is known from the outset -- allowing a higher contract rate to be negotiated (or at least attempted to be). 

Under the proposals, if an outside contract is subsequently deemed to be found inside IR35, it is too late for this negotiation to happen so the contractor is effectively contributing to some of the client’s tax bill. 

This is the only potential downside I can see to the proposals, but if they do result in a resurgence of outside IR35 contracts across the market it may well be that contractors accept this position as they are effectively back in the position they were in pre-April 6th 2021, but without the risk of additional taxes being due.

Still not out the IR35 woods

The proposed option in HMRC’s off-payroll working consultation does not however, alleviate all risk. The fact that HMRC is correcting this error in time for 2024 indicates that they are paving the way to progress their compliance activity. As a result, clients and their supply chains should not take their eye off the risk, and must still ensure they comply with the complex rules.

Unfortunately, it is also just another example of the piecemeal way in which legislative changes within the contractor sector have been introduced over the last 20-plus years. A new consultation on regulation of the umbrella market was also teased recently -- another problem which is long overdue the government’s attention. And still, we wait.

We can only hope that the failures of this whack-a-mole approach to keeping up-to-date with the changing ways of working in the UK leads to a root-and branch review of the system that the contractor industry has been calling for. It’s high time the government stops layering on sticking plasters and considers a different approach to unlocking the UK’s skilled flexible workforce. The Agent of Record and Employer of Record models used in the US and many other countries would perhaps be a good place to start.