What triggers an IR35 investigation?

It is safe to say that every business-owner dreads receiving that infamous brown envelope with HMRC’s logo in the corner, writes Nikola Nowak, a tax consultant at Markel.

As most businesses have felt the squeeze of having to tighten the belt during the ongoing cost-of-living crisis, for some businesses an HMRC enquiry, and in particular an IR35 investigation could cause serious distress, financially and otherwise.

It’s a daunting prospect to one day find yourself at the start of a tax enquiry, especially if you’ve always followed the rule book.

So what exactly could prompt HMRC to open an enquiry? And as many contractors often ask us related to this – What triggers an IR35 investigation?

Tax returns

To point out the obvious, it would be an impossible task to check every single tax return.

Instead, HMRC accepts all returns at the point of submission with the condition that they reserve the right to open an enquiry into that return in the future, should they need to. The enquiry window for this is usually 12 months from the date of submission.

Some errors and irregularities that may set off HMRC’s alarm bells and prompt an enquiry, include

• Persistently late returns
• Sudden rise/drop in expenses claimed
• Large fluctuations in reported income
• Businesses with large income and disproportionately small number of employees

If a limited company lies dormant but files tax returns, HMRC still reserves the right to open an enquiry.

Even if a company is closed and struck off Companies House, if HMRC suspects fraud or criminal activity, it has the power to reinstate the company and start an investigation. There is no time restraint on doing this, though this reinstating to investigate is extremely rare.

What triggers an IR35 investigation?

Most IR35 investigations start as an Employer Compliance Check.

HMRC will be interested in looking at all the employer records to ensure that taxes have been paid correctly and on time. HMRC will also be keen to see if benefits and expenses have been reported correctly (and where applicable, how CIS is operated).

Some employer compliance checks are random, but the majority are selected with the help of HMRC’s Risk and Intelligence Service.

The RIS aims to collate accurate information to support HMRC in its enquiry endeavours, which means that HMRC never goes in ‘blind.’

It is no longer true that an employer should expect a compliance review approximately every six years. It is quite normal for businesses to go many years without hearing from the Revenue, and it’s quite possible to never be subject to an enquiry – IR35 or otherwise.

Under the Intermediaries legislation of 2000, found at Chapter 8 ITEPA and often referred to as the ‘old’ IR35 rules, the investigation would typically start as a compliance review into the limited company contractor.

What about an OPW rules investigation?

Under the new Off-Payroll Working (OPW) rules, found at Chapter 10 ITEPA – which came into force in the private sector on April 6th 2021 – the client would be the starting point of the HMRC enquiry.

We have not seen any off-payroll investigations into private sector clients at the time of writing, though presumably they will follow a similar process to public sector off-payroll enquiries by HMRC.

In fact, as the economy trudges on following covid and the multitude of prime ministers intent on austerity, HMRC’s overall activity has been relatively quiet on the IR35 front.

To us, this comparatively low level of IR35 investigation activity begs the question whether HMRC is gearing up for a targeted campaign of off-payroll /IR35 investigations, or whether the Revenue is just too busy getting their teeth stuck into enquiries under the Managed Service Company legislation? It might be wise to expect the former – that a bullish HMRC could be around the corner, at least on the IR35 front.

A change in status might be an IR35 investigation trigger

A change in IR35 status may turn HMRC’s head. This is arguably an easy target for the tax office, as they could compare the terms of the previous engagement to the current, and argue there was not enough of a change in circumstances to warrant a change in employment status.

This could be particularly troublesome where before the April 6th 2021 changes to the IR35 legislation, limited company contractors in the private sector were deeming themselves as ‘outside’, then following the changes, the client deemed the engagement as ‘inside’. HMRC may well be interested in following up on the reasoning behind such a change, most likely favouring the ‘inside’ determination. 

What puts you at high risk of an IR35 investigation?

Sectors and industries which are considered ‘high-risk’ tend to attract HMRC enquiries more frequently. Regarding IR35, these sectors include Construction, Oil & Gas, Technology, IT and Computing, and (HMRC’s most recent favourite) Media.

Unsurprisingly, the taxman may be particularly interested in limited companies where the contractor has a high income with a low salary and high dividend split. This would generate the highest tax revenue for HMRC, making it a worthwhile target for an IR35 investigation.

It is also a risky move – under the April 6th 2017/2021 frameworks -- to have contractors and employees carrying out the same (or even similar) roles. Where two people are doing the same job but with a different employment status, this effectively serves the entire argument to HMRC on a silver platter. The obvious question in HMRC’s mind which may well trigger an IR35 investigation is, ‘Which worker is being taxed correctly?’

However, we would expect there to be a significant difference between the way a contractor operates, and the way an employee is engaged – both contractually, and in practice.

What triggers an IR35 investigation? The answer might not satisfy

The bottom line is that HMRC does not have to give a reason for opening an enquiry, or an IR35 investigation, or an OPW enquiry, so there is no way of ever knowing exactly what provoked the Revenue’s scrutiny. What has to be remembered is that HMRC has access to an ever-growing database of information to aid them in their ultimate goal -- ensuring that every taxpayer in the country contributes the right amount of tax to the pot, and contractors clearly aren’t an exception.