NAO findings on IR35 in public sector reflect key CIOT concerns

Although there were worrying findings in the NAO report, the NAO concludes that by changing its approach, both in the public sector and when extending the reforms to the private and third sectors, HMRC appears to have learned several key lessons and addressed some of the more significant challenges identified from the initial public sector rollout. This includes HMRC providing more support for affected parties and more time to prepare for the transition.

However, the NAO says questions remain about the system for addressing incorrect determinations, with routes of appeal untested and tax burdens in cases of non-compliance likely to fall on employers. There are also differences between the public and private sectors that increase the challenges in successfully rolling-out the changes to the private and third sectors.

As part of the investigation, the NAO met with stakeholders, including experts in taxation, payroll administration and freelance working, such as Chartered Institute of Taxation (CIOT) and Low incomes Tax Reform Group (LITRG).

The report supports CIOT’s call for improvements to the Check Employment Status for Tax (CEST) tool, with CIOT believing it should be more reliable, with more probing questions that adapt to different sectors, for example. The NAO findings also reflect CIOT’s concerns that guidance for the rollout to the public sector was issued too late and that the compliance cost for businesses was always likely to be higher than HMRC estimates.  NAO supports CIOT’s call for a better method for dealing with compliance errors. LITRG’s concerns about growth of ‘umbrella’ companies were also addressed, albeit briefly, in the report.

Among the NAO’s findings were that public bodies had little time with the new guidance and tools before the rules came into effect. The Government proposed reforms in the public sector in March 2016 and announced its decision to proceed in November 2016. HMRC published its guidance in February 2017, two months before the rules came into effect. Furthermore, it made available the full version of CEST in March 2017, with only one month to go. HMRC research in 2018 found that a little under half of surveyed public bodies thought they had enough time to prepare, but a similar proportion did not.

The NAO also found that when some workers disputed their IR35 status they did not have a clear route to appeal the public body’s status determination. Following the reforms, workers can raise a dispute with the organisation that made the determination, but there is not a clear legal route to appeal further. If workers believe they have been taxed incorrectly, their recourse is to use HMRC’s self-assessment and NIC reclaim routes. This is the same as for any worker considered an employee, but differs from the previous system whereby the worker’s PSC made the determination and so the worker would have no reason to dispute it.

HMRC’s 2018 research indicated that, shortly after the reforms, 46 per cent of surveyed bodies operating centralised payroll and 31 per cent of bodies operating their own payroll had at least one dispute with contractors or agencies regarding status assessments. In the NAO’s 2021 survey, 26 per cent of respondents from central government said that workers had frequently or occasionally challenged status determinations.

The NAO’s report also noted significant issues with public bodies’ compliance with the changes. The 2020-21 financial statements of government departments and agencies include a total of £263 million paid, owed or expected to be owed in additional tax for failing to administer the reforms correctly. In all cases of non-compliance, HMRC found that the public body had not taken reasonable care to prevent errors, including when answering questions in CEST. This said, HMRC did not set out how it would interpret reasonable care for the new requirements when they first took effect, and no public bodies have challenged the decisions in court so there is no case law to guide the definition.

Furthermore, it is clear from the report that HMRC’s current approach to correcting cases of non-compliance results in it collecting more tax in total than is due, and it does not yet have a plan to address this. To calculate the historic taxes that departments owe, HMRC estimates the amount that should have been paid at the time based on workers’ deemed wages. Its approach assumes that all workers will have fully used their tax-free personal allowance on income earned elsewhere. 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 HMRC told the NAO this was not allowed within the current legislation. This means that HMRC collects more tax in total than is due. 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 PSCs 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. But HMRC does not actively promote this, and it is unclear how many workers reclaim their taxes in practice.

The NAO found that while most public bodies found HMRC’s guidance and online tool helpful, some experienced problems using them. HMRC’s 2018 research found that 78 per cent of surveyed bodies operating centralised payroll (those administering payroll for multiple organisations) and 91 per cent of bodies operating their own payroll considered CEST helpful. But around half of all respondents found the reforms difficult to comply with. The most common reason given by bodies operating centralised payroll (21 per cent of those surveyed) was difficulties using CEST.

The report finds that, after the reforms, HMRC observed an increase in tax revenues and numbers of workers deemed to be employed for tax purposes. HMRC estimate that in the first two years, at least 50,000 additional individuals were on the payroll of public bodies having previously provided services through a PSC and paid less tax. HMRC initially assessed that an additional £550 million of income tax and NICs was collected in the first year. It later estimated that, offset against taxes that workers and their PSCs would have paid otherwise, the net increase in tax revenue was £250 million, more than HMRC had previously expected (£150 million). It is difficult to identify the exact extent to which this is due to the reform itself, as opposed to other factors. Some stakeholders have also expressed concern that some public bodies incorrectly assess people as being employed for tax purposes for fear of getting it wrong. However, there is not clear evidence to indicate how far this has occurred in practice, says NAO.

Other findings that raise concerns for the NAO:

• Public bodies have reported incurring additional costs and challenges in recruiting or retaining contractors
• HMRC may have underestimated the cost to employers of implementing the reforms; despite improvements HMRC has made to its guidance and tools, public bodies and other stakeholders told the NAO it could go further to support implementation and inherent differences between the public and private sectors mean that HMRC faces new and challenging risks with the wider implementation of IR35 reforms.

On impacts of implementing the 2017 reforms, the NAO reports that some public bodies avoid hiring contractors unless they are on payroll somewhere in the supply chain, to avoid the financial risk of non-compliance, and noted the increased use of the Public Service Resourcing framework contract to access contractors and contingent labour, rather than finding workers through other routes.

Additionally the NAO notes that HMRC have observed an increase in the number of people employed by umbrella companies. The Government’s 2021 call for evidence into the umbrella companies market (which covers concerns that there may be high levels of tax non-compliance) cited estimates that the number of such workers had increased from under 400,000 in 2015 to over 600,000 by 2021.

Among the recommendations is a call to (a) further develop the CEST tool and accompanying guidance to make it as easy as possible to use accurately and (b) assess the usefulness of CEST to different sectors. The NAO recommends HMRC identify and set out case examples of good implementation to promote compliance by helping organisations get determinations and tax deductions right first time. To do this, HMRC should work with stakeholders such as the Tax Centre of Excellence, the Government Internal Audit Agency, and tax and payroll experts, says the NAO.

Interestingly, the report suggests HMRC update its estimate of compliance costs to hiring organisations based on actual experience, to help all parties understand the scale of activity needed and how HMRC can best support implementation. It suggests that the tax authority develops a more effective and efficient system to ensure HMRC accurately collects the total taxes due from workers and hiring organisations when errors have been made.

The NAO calls on HMRC to develop a more effective and efficient system to ensure HMRC accurately collects the total taxes due from workers and hiring organisations when errors have been made. And the watchdog recommends that the tax authority builds on its improved collaboration with stakeholders to enable constructive discussions and to pre-empt challenges in the public and private sectors.

The February 10 2022 report is here.

By Hamant Verma, CIOT Senior External Relations Officer