How to handle an IR35 investigation
The vast majority of IR35 disputes start as Employer Compliance Reviews and then escalate to status investigations of the contractor's engagement(s). Whilst the mechanics of the IR35 investigation which follows may not change unduly in the future, recent amendments to the way contractors report information on their returns to HMRC combined with the new powers that HMRC will be introducing with effect from April 2009 could bring about a distinct advantage to HMRC for their enquiry work into IR35.
How does the IR35 enquiry process start?
Currently the whole process is slightly misleading. When HMRC approach contractors to arrange an Employer Compliance Visit, no mention is ever made of IR35 and for the uninitiated; the matter is portrayed as a 'normal' PAYE visit. And yet, consider the Top 10 areas that HMRC are looking for in a 'normal' Employer Compliance Review:
- Termination payments
- Status issues when the business engages workers
- Expatriate payments
- Company Cars & Fuel
- Construction Industry Scheme
- Personal incidental expenses
- Aggregation of earnings
- Travel & Subsistence
- Long Service Awards
How many of these issues are relevant to a contractor? In fact how much paperwork is involved in maintaining the PAYE records for a contractor? Assuming, that these are even held by the contractor – most will surely be reliant upon their accountant for the completion of the payroll and the P11D and P35 returns that need to be completed.
The reality is that HMRC know this as well; furthermore, HMRC will have undertaken background work to establish the principle activity of the business, the company's turnover, details of the directors, dividends received and anything else that they consider relevant. So why, when HMRC already know so much, have they investigated contractors by using the pretence of an Employer Compliance Review?
Well, an Employer Compliance Review is not only an excellent opportunity to view current and recent PAYE records, but may also present an opportunity to meet with the director(s) of the business and quiz them in much greater detail than would ever be possible via correspondence. It has therefore been HMRC's policy to write to the contractor and indeed more recently to make contact by telephone to arrange a meeting.
Unfortunately, not all contractors are aware that they are under no obligation to meet with HMRC and, as yet, HMRC cannot insist on visiting the business premises. Nevertheless, we still hear the odd horror story of a contractor meeting with HMRC who guesses at answers, says what they think the Inspector wants to hear, or feels pressured into giving a certain answer and then to compound matters, signs the notes of the meeting – leaving themselves with nowhere to go if they subsequently wish to dispute anything that was said.
Despite the current position being that no meeting is required, HMRC does have statutory powers to inspect PAYE records and so they must be made available. We suggest that they are done so at the accountant's or adviser's office, or posted on to HMRC. Any questions that HMRC then have can then be put in writing.
From Employer Compliance Review to IR35 dispute
Although the premise of the review is to check the operation of PAYE, the main focus will soon become the engagements undertaken so that HMRC will request copies of contract(s) for the current and previous tax year and the Compliance Officer may refer to IR35 and suggest that the contract(s) is/are caught - this is almost the default setting for HMRC.
Assuming that the contractor does not accept the Compliance Officer's decision, then further information or documentation including further contracts and more details of the working practices will be requested and passed on to a Status Inspector.
Moving the dispute on
Typically, the Status Inspector will want to obtain more information or documentation increasingly from third parties such as the agency (if one is involved) and particularly the end client.(Recent successes for HMRC have come from making contact with the engaging organisation – Island Consultants and Dragonfly Consultancy to name but two – and comments made to the Revenue by managers at the end clients have been instrumental in helping HMRC to prove its argument).
Opinion is then given by the Status Inspector and if an impasse is reached, HMRC will raise Regulation 80 Determinations (for Tax) and a Section 8 Notice (for NIC) using the deemed calculation. An appeal can be made against the Determinations and Notices within 30 days with a request for the collection of the additional duties to be postponed pending resolution.
The Appeal is made to either the General Commissioners, or more likely because of the technical, legal nature of the argument, before Special Commissioners. The papers are then referred to the HMRC Appeals Unit, although further dialogue will take place to try to resolve the matter before the Appeal is referred for a Personal Hearing before the Commissioners. This is a long drawn out process!
How to avoid an IR35 investigation
There are no guarantees, but one very good guiding principle is to 'Get your defence in place now'.
Avoid setting up companies with £2 or £100 share capital; consider issuing £1,000 worth of share capital – it suggests a more 'substantial company'. Consider the level of salary/dividends paid; don't make yourself a target for a Status Inspector looking to maximise the tax potential for HMRC.
Clarify your understanding of the engagement with the end client – if at the start of any enquiry, HMRC can be shown a signed letter by the end client as to their understanding of the relationship between the two parties and the working practices of the assignment, providing it confirms that the contractor is independent and able to show that this really is a contract for services, it doesn't leave HMRC with much room to develop their arguments. Certainly this has proved successful in stopping the Revenue in its tracks on a number of occasions.
Consider the marketplace at the end of each contract and keep records of all contract negotiations, successful or otherwise. You may not have substituted, but keep records of potential substitutes whom you could use; similarly, maintain details of matters which show financial risk such as contracts which were terminated prematurely, periods without work and financial losses that you may have made (e.g. on fixed price work).
Ensure records are in place, such as mileage logs and expenses payments. Apart from being needed to prove business expenses claimed, they may help prove that you had control over the 'when' and the 'where' because they evidence that work was not always undertaken on-site – Dragonfly proved that just having control over 'how' work is performed is not enough.
Consider having engagements reviewed so that both the contractual terms and the working practices are considered against the key factors of personal service, control and mutuality of obligation, as well as the secondary issues relating to business to business factors and financial risk. If these contracts are deemed to be 'outside of IR35', then consider insurance to cover the potential liability that may arise.
Ultimately you may not be able to avoid an enquiry but, if one does commence, whatever you do get good representation; this is not a battle that you should consider fighting on your own.
The future of investigations
We have already indicated that the new style Self Assessment Returns contain questions identifying whether your company is a 'service company'(assume that for the 2009 Returns you will have to answer this) and the amounts received in dividends. These are designed to pull together information that HMRC already held, albeit in different files, and whilst contractors won't necessarily be targeted as a result, the point is that the new style SA and P35 returns make contractors easier to identify.
However, that is not our primary concern: from 1 April 2009, HMRC will be able to inspect records and visit premises, bringing the Revenue's powers in line with those which already exist for VAT. We believe that this could also provide additional opportunities to undertake enquiries into contractors.
Requesting information or documents
Schedule 36 of the 2008 Finance Act allows HMRC to give written notices to taxpayers ("taxpayer notice") or third parties ("third party notice") requesting information and/or documents which are reasonably required for the purpose of "checking the taxpayer's position". Information can be requested in advance of any return being submitted which is a big change for both income tax and corporation tax and must be supplied within a "reasonable time" as specified in the notice.
HMRC do not need prior consent from either First-tier or Upper-tier Tribunals (which will essentially replace the General and Special Commissioners) to issue taxpayer notices, although there are appeal procedures. No taxpayer notice can be given in respect of a period where the taxpayer has submitted a return, unless: a) that return is under enquiry; b) HMRC suspect that insufficient tax has been charged; or c) it is required for checking the taxpayer's VAT or PAYE position (and we have to assume that this will include IR35).
What is interesting is that HMRC do not seem to have an obligation to provide tax advisors with copies of notices sent to their clients, although it is possible that this will happen automatically providing the accountant is registered with HMRC as the contractor's agent. In order to ensure that there are no sad stories, it will be even more important to make immediate contact with your accountant in the future if such a notice is received.
HMRC must have the permission of either the taxpayer or the First-tier Tribunal before they can issue a third party notice and a copy of such a notice must be sent to the taxpayer. Where the Tribunal agrees to the issue of the Notice (and the taxpayer is not allowed to be present to argue against its issue), the Notice cannot be appealed and so one wonders how often this method will be employed to request the 'Upper Contracts' and any other documentation that the end client holds in relation to the nature of the engagement.
Inspecting business premises
HMRC will have the power to enter business premises and inspect the premises and business assets and records kept there, where the inspection is reasonably required for checking the tax position. HMRC cannot enter premises that are solely used as dwelling houses. If for example, a contractor keeps records at home, HMRC will be able to enter the premises and view that part of the contractor's home where the records are kept.
HMRC should give the occupier of the premises 7 days notice of the inspection, but it does not have to be in writing. However, they also have the power to show up unannounced.
Appeals against information notices
Appeals against taxpayer and third party notices are to be made to the First-tier Tribunal in writing and within 30 days of the date the notice was given and must state the grounds for the appeal. However, where the information or documents form part of the statutory records, then again, no appeal is possible.
There is a standard £300 penalty for failure to comply with an information notice or for obstructing an officer of HMRC, unless there is a reasonable excuse. Penalties of up to £60 per day (daily default penalty) can also be charged for continued failure after the standard penalty has been issued.
In addition, HMRC can apply to the Upper Tribunal for a tax-geared penalty to be imposed for continued failure to comply with an information request. The Upper Tribunal will determine the amount of any such penalty.
Penalties must be issued within 12 months of the date to which the failure relates and these can be appealed against by giving notice in writing within 30 days of the date of issue. Again, reasons for the appeal must be given.
How the new powers will work in practice
We cannot assume that HMRC will undertake visits all the time and we might expect to see more use of written questionnaires and telephone calls. HMRC has only a finite set of resources so these new powers may lead to a reduction in the enquiries in other areas.
However, if they use these powers in a targeted way, it could make life much easier for HMRC to get the outcomes it is seeking i.e. the information needed to mount successful investigations; including into contractors under IR35.
It will not change the strategies one can employ to avoid being selected for IR35, nor the paperwork that one should keep or the importance of getting good representation in the event of an enquiry.
However, what has become clear from anecdotal evidence and the claims experience that we have witnessed is that all new enquiries in the current tax year have fallen away and increased efforts are being made to settle ongoing cases. It seems that the New Compliance Regime is the signal for a 'Big Push' in 2009 and unfortunately there is no reason to suppose that contractors will escape in next year's spring offensive.
Article written and provided by Paul Mason, Manager of the Contractor Division at Abbey Tax Protection.
Editor's note: Further reading: What triggers an IR35 investigation, Am I service company, as form P35 asks?