A contractor's dividends can indeed spark an IR35 enquiry

They were directed at the Lords, but my comments last month to the Personal Service Companies Committee that dividend levels are monitored by the taxman to identify potential IR35 suspects have, unintentionally, piqued the interest of contractors, writes Jason Piper, technical manager for tax and business law at the ACCA.

Ironically, it is this same turning of heads that happens inside HM Revenue & Customs -- specifically among its four IR35 compliance teams -- when they find that the ratio of dividends versus salary declared on a tax return to be disproportionate.

Less of a link, more of a correlation

To fully understand this potential IR35 enquiry trigger, the first thing to emphasise is that the way you extract cash from the company has nothing to do with how it got there -- and IR35 is based on how the cash got there. The rule effectively asks -- were you acting as a disguised employee when you earned the fees, or genuinely undertaking a standalone entrepreneurial business? It’s implicit in the IR35 enquiry process, contract-by-contract, whereas dividends are paid out of the aggregate residue of all your activities, after expenses. So there’s no causal link, although there may well be a correlation.

This means that the salary-dividend balance is not a risk indicator as such for IR35 but, as has been pointed out on the ContractorUK forum, it is a return indicator.

It’s all about the return

To explain: if you’ve paid every penny of cash out of the company as PAYE salary and matching pension contributions, then it doesn’t matter whether you’re working 9-5 with a slot in the company holiday roster, or a welder who’s been called in to fix a dodgy banister. Either way, HMRC won’t bother checking for IR35, because there won’t be any return if they do.

In the case that I alluded to in my comments to the Lords, IR35 wasn’t raised directly by HMRC. However dividend levels most certainly were, and the company return and accounts which apparently disagreed with the personal return were all filed online.

From a compliance officer’s perspective…

To understand dividends’ interaction with IR35 from HMRC’s perspective, let’s use an analogy in the shape of police officers looking for cars to pull over for roadside safety checks. The officers are quite likely to target cars with ‘go-faster’ stripes and DIY body kits. Neither feature will have any direct link to the state of the cars mechanics, but anecdotally you’d expect there to be a correlation between the two factors.

In fact, that’s an analogy you can apply to the IR35 Business Entity Tests; they are simply the risk analysis, not the test itself. So returning to our analogy, it’s true that a rusting 30-year-old Ford Fiesta is more likely to have a mechanical fault than a 3-year-old BMW. Of course it may be the case that the Fiesta belongs to an impecunious car enthusiast and is actually mechanically perfect, while the BMW is a death-trap that’s been run into the ground on its 4 bald tyres. But if you’re an officer, you can’t tell until you actually do the mechanical checks, and it’s the same with the BETs and IR35.

The 'appropriateness' of the low salary-high dividend mix

Meanwhile, those officers at the Revenue tasked with looking ‘under the hood’ of a PSC for IR35 and other compliance issues, may well ask the contractor, ‘Is paying yourself a low salary and high dividends an appropriate response to the tax system?’

It’s a question which gets towards some of the deeper waters around tax policy and the wider design of the system. To begin to answer it, both taxpayer and tax authority should consider the way the tax system is designed -- it rewards the returns on entrepreneurial labour more highly than it does the rewards on salaried employment

But by the same token, the social security system offers more protection to the salaried employee than it does to a self-employed tradesman. Yet there’s a further distinction even within the taxation of risk based entrepreneurial income, between returns on labour and returns on capital. And here, for whatever policy reason, a person pays less tax and NICs on a capital return (dividend) than they do a return on labour (salary/DI drawings) – and the capital return gives no social security rights whatsoever. So if you are a business, there is probably a tax benefit incorporating, and ‘buying’ the right to have the returns taxed as a capital investment, rather than a simple return on labour.

Dividends don’t decide your status under problematical IR35

The problem with IR35 is that it tries to tackle both areas, the employed/self-employed labour differential, and the capital/labour differential in one go. That’s probably more than we can really expect of one measure, unless it’s going to be so broad in scope that it inevitably offers enough discretion for things to start to go horribly wrong. Now, does that sound to contractors like the implementation of IR35 over the first few years of its life?! I'm sure it does.

Fast forward to the present day and contractors ultimately want to know if their drawings of dividends and salary will put them on HMRC’s radar. The underlying message is that dividend levels don’t put you inside or outside IR35 -- but they may pique the Revenue’s interest and prompt an enquiry.

If you’re low risk under the BETs, and have always paid legal and properly documented dividends, you should have nothing to worry about -- certainly what we’re hearing of the ‘new approach’ to IR35 is that low risk cases are being settled quickly and courteously where the contractor cooperates.

If you’re high risk, then I suppose paying yourself bags of salary would remove the enquiry trigger. But it would also mean that you wouldn’t owe anything under IR35 anyway. So at least in this sense, the measure will have succeeded in its protective effect for the Exchequer --  the latest value of which should also turn heads for coming in significantly higher than HMRC let on when its evidence was heard by the Lords.

Jan 22, 2014