Are you a service company? Contractors face IR35, MSC probe on P35 tax return

HMRC are asking ambiguous tax-related questions that IT contractors fear are a data-grab to spotlight those of them ripe for MSC or IR35 investigations.

The new questions, which have been added to P35 forms, firstly ask whether the employer is a "service company" and "if so" whether they operate either of these tax laws.

Experts say this two-part probe, no. 6 on the form, aims to isolate for HMRC taxpayers who provide services via a limited company that believe they are outside the two legislations.

Despite advisers' efforts to determine a 'service company,' there is conflicting advice about how self-employed contractors outside the MSC/IR35 laws should answer part one.

Much of this uncertainty is because 'service company' is not spelt out in HMRC's guidance CWG2, to which P35 refers, or the employers' helpbook E10.

"The first part of question 6 is, quite simply, meaningless," Roger Sinclair of Egos Ltd, a legal advisory for IT contractors said last night, pointing to a P35.

"It asks if the company is a 'service company' - but there is no clear meaning or common understanding, let alone statutory definition, as to what a 'service company' actually is.

As ever, tax uncertainty causes fear. In this case, it stems from both legislations, which taxpayers are effectively being asked to self-assess their exposure to, requiring the retrospective payment of employment taxes.

One limited company IT contractor said the Revenue's question – are you a service company and if so, do you operate the MSC/IR35 legislations – has his "alarm bells ringing."

"What will the Revenue do if you answer 'yes' to the first part and 'no' to the second?," he wondered. "Will… [the answers] be used by HMRC to determine which limited companies require further investigation?"

A spokesman for HMRC responded yesterday, ominously hinting that such an answer would suggest the taxpayer is potentially within the scope of the IR35/MSC laws.

He said: "In broad terms 'yes' to part 1 and 'no' to part 2 indicates a business which falls within the general ambit of Chapter 8 or 9 ITEPA but which has not treated any income as deemed employment income."

Mr Sinclair said this official line, rather than serving to clarify, was confusing and inappropriate.

"Either business income falls within the IR35/ MSC legislation - or it doesn't," he said. "There's no third 'general ambit' alternative."

The PCG, the contractors' trade group, said before question 6 emerged, it called on HMRC to revise both dimensions of the probe because its wording was, and remains, "ill-considered."

"We don't think giving a 'yes/no' answer will cause anyone any problems [with HMRC]," the group advised yesterday, seemingly at odds with the broad implications outlined above by HMRC.

"For one thing, it is in line with the advice we received from three independent sources of professional advice, and for another HMRC have said they will not be using the questions for any compliance checking".

The Revenue spokesman confirmed: "There is no question of HMRC using the data to risk profile individual businesses."

Even if they wanted to, it is pretty clear that HMRC "will not be able to get much useful data" from Q6 because responding taxpayers are confused by its framing, said John Kell, PCG's policy officer.

"It's unclear which response HMRC would regard as being 'incorrect' for an outside-IR35 contractor anyway: 'yes / no' or 'no/blank'," he added.

Despite contractors' concerns, Mr Kell believes it is unlikely the question is a prelude to HMRC investigating contractors who see themselves as working outside the IR35 and MSC tax rules.

"They were not about to use this information to launch some sort of crusade on IR35, attacking every limited company contractor who claimed to be working outside it," Mr Kell reassured.

"For one thing, they could already get hold of that information (just not quite so easily); and for another, we know HMRC don't have the resources to do that."

Bob, an ex-tax official, is not so sure that the answers taxpayers provide will not form the basis for future IR35/MSC investigations.

"HMRC are quite clear that they are not going to risk-profile employers for a compliance review but if HMRC are not going to use for risk profiling why are they asking the questions?

"They say it doesn't matter if you have already answered the questions incorrectly – 'no need to amend it' – [suggesting to me that] they can always get you next year," he said.

Simon Dolan, managing director of SJD Accountancy said the outcry to question 6 should be more about its ambiguity than its intentions, hidden or otherwise.

"I don't think it is part of any big Revenue conspiracy – I believe the legislation and the changes to the P35 were rushed through without much thought", he said.

"For example, the guidance notes for completing the online P35 were different in terms of definition of a service company than the definition that appears on the self-assessment return guidelines."

The UK's leading chartered accountancy body is another adviser who believes "widespread uncertainty" has resulted from the framing of the question (the first part in particular), for which HMRC has now apologised.

According to the ICAEW's analysis, taxpayers should answer 'no' to the first part of Q6 unless you are: "a personal service entity (IR35) within the terms of Chapter 8 – of Part 2, ITEPA 2003."

The group believes taxpayers should also answer 'no' they are not a service company unless they are: "a managed service company within the terms of Chapter 9 – Managed Service Companies – of Part 2, ITEPA."

Their advice appears to be at odds with the PCG's recommendation. However both groups are in agreement that the safest option is for those taxpayers who answer 'no' to the first part of the question, as they need not answer the second part.

The ICAEW added: "If you are applying the IR35 or running managed service companies then you are likely to be able to work out quite easily that you should answer 'yes' to both questions."

Since the debate, the Revenue has issued guidance for taxpayers on its website, designed, in part, to "explain the implications of answering yes to part one."

Asked whether the tax authority plans to record employers' answers to question 6, now and in the future, the spokesman said: "HMRC will analyse the responses to the two questions at question 6 on all P35s."

This, the Revenue explained, will allow it to reach a "general view on the number of businesses within the general ambit of Chapters 8 or 9 ITEPA and of those, the number which actually treated income as deemed employment income."

However, HMRC stressed that "given the misunderstanding as to the meaning of the question, such an analysis will be treated with the necessary caution."

The spokesman also insisted the department would not use the data it gleans from responses to question 6 to risk profile individual businesses.

Taxpayers must accept the government agency's claims at face value, according to Mr Sinclair.

"HMRC assure the public that the answers to the first part of question 6 will not be used to risk-profile individual employers for a compliance review; one must take them at their word."

He issued some advice to contractors, which supports the ICAEW's analysis .

"It seems, for this year at least, that if the answer to the second part of Q6 (which, broadly speaking, asks if the IR35 deemed employment payment has been applied, or if the company is within the MSC legislation) then the answer to the first part is 'yes.'

"Otherwise, 'no' would appear to be the correct answer," he said, before noting that HMRC now appear to say that both 'yes' or 'no' are equally acceptable.

Mr Sinclair reflected: "Some might say there is little point in asking a question, where the question itself is so meaningless that the answer doesn't matter."

According to the Revenue's own guidance, part one of Q6 should be answered 'yes' if:

-an individual personally performs services for a client and the services are provided not under a contract directly between the client and the worker but under arrangements involving the limited company, limited liability partnership or general partnership (the service company)

-the limited company, limited liability partnership or general partnership's (the service company) business consists wholly or mainly of providing the services of individuals to clients

HMRC said the second part of Q6 should only be answered 'yes' if income has been treated as deemed employment income and PAYE /NI deducted in accordance with the Managed Service Company (MSC) or Intermediaries legislations.

The Revenue has no plans to remove the question, but vowed to consult with industry so it is "fully understood" by P35 form fillers in the future.

"It might be that… [answers to Q6] will not be used this year for the risk-profile but I am sure that there will be someone somewhere [in HMRC] interested in the response," said Mr Jones, a former Inland Revenue tax inspector.

"It seems that in answering the questions 'yes' and then 'no' the employer is saying - 'Dear HMRC - look at me - I am a company that is providing services to an end-user under... a contract for services which I am assured avoids IR35.' I think that HMRC should come clean - I cannot accept that there is nothing simmering beneath the surface."