Are taxpayers footing the bill for government departments IR35 mistakes

Engagers that incorrectly classify contractors working via their own worker’s intermediary entity (usually a personal service company (PSC)) as self-employed for tax purposes, and hence outside the IR35 off-payroll working requirements , must pay the income tax and National Insurance contributions (NICs) lost as a result of the incorrect classification. This has resulted in several government bodies recently settling demands totalling £263m from HMRC. The figures are so high that the bill will no doubt ultimately be suffered by ordinary taxpayers when funds have to be raised to provide additional budgetary support to those departments.

This problem arises when the status of a worker is reclassified by HMRC to ‘deemed employed/inside IR35’, as opposed to ‘self-employed/outside IR35’, making the engager, or other person paying the worker’s intermediary , liable for income tax and NICs on fees paid to the worker’s intermediary.

More importantly perhaps, there is no mechanism for offsetting tax paid by a worker’s intermediary (or tax paid by the worker on dividends drawn from a PSC) against the engager’s or fee-payer’s income tax/NICs liabilities. Because of this mismatch, HMRC may receive tax twice on the same amounts.

Although there are statutory provisions for the worker’s intermediary and/or the worker to claim repayment of overpaid taxes in such circumstances, such repayments are made to the intermediary and/or the worker, not to the engager or fee-payer. However, it is the engager or fee-payer that has suffered the income tax and NICs, plus the interest and penalties that are charged following a successful challenge by HMRC. As a result, tens of thousands of contractors could ultimately end up paying no tax at all.

This potential outcome is in stark contrast to the position for self-employed workers not providing their services through an intermediary, where a statutory offset mechanism was introduced following the Demibourne tax case many years ago, to ensure all parties bear their fair share of tax. HMRC’s manual states, ‘It follows the principle that HMRC should not recover more tax from both contractor and subcontractor than is correctly payable by the subcontractor. That is why the relief is sometimes known as ‘double taxation’ relief.’

A recent National Audit Office (NAO) report highlighted the fact that HMRC is well aware of the problem, confirming that, ‘HMRC collects the amount due in accordance with the law at that time. It does not offset the total amount against any tax the worker or their PSC already paid and told us this was not allowed within the current legislation. This means that HMRC collects more tax in total than is due.’

The NAO report continues, ‘Once the non-compliant client organisation accepts that its determinations were incorrect, the workers become entitled to claim back the tax that they and their PSC’s have already paid. If they do, they in effect pay no taxes on that income because these are borne in full by the non-compliant public body’.

There is an urgent need for these rules to be corrected so that engagers and fee-payers are not unfairly penalised. This would entail workers and their intermediary entities only being able to reclaim taxes paid in excess of what they should have actually suffered, and engagers and fee-payers being able to offset amounts incorrectly paid by workers and their intermediary entities against their own liabilities under PAYE. This should not be difficult, as the similar legislation referred to above already applies in relation to self-employed engagements where there is no worker’s intermediary entity.

Until the rules are changed, engagers and fee-payers should enter into contracts with their contractors on terms that ensure any tax monies claimed back by them due to a reclassification are returned to the engager/fee-payer to offset the amounts they have had to pay. Public sector bodies must also do this to greatly reduce the funds they need from government (and ultimately taxpayers) to cover any mistakes made in the assessment of worker status under the IR35 rules.