What triggers an IR35 investigation?

How exactly the taxman decides which contractors are akin to direct employees and therefore potentially liable for employment taxes under IR35 is a well-guarded secret.

It is known, however, that Revenue and Customs selects contractors who its officials suspect of being 'disguised employees' for an IR35 test through two channels.

The first route a contractor's IR35 status is officially probed is via 'random selection', where HMRC unscientifically plucks one out of 1,000 tax returns for scrutiny.

Experts at the Professional Contractors Group, the contractor trade body, said HMRC's random choice leads to a full enquiry, where the taxpayer's entire return is reviewed.

This is unlike an aspect enquiry, where HMRC only reviews a specific section of the return, and includes a request to overturn all books and records for the relevant period.

The enquiry is then handled by officials in exactly the same way as so-called 'risk-assessed selections'- the second way contractors' IR35 status can be called for review.

This more targeted, considered approach by the Revenue to taxpayers potentially caught by IR35 is where the visibility of how the authority operates begins to cloud.

ContractorUK asked HMRC what triggers it to think a worker may fall within Chapter 8 of ITEPA without them having treated any income as deemed employment income.

A HMRC spokesman responded: "Any individual who provides his/her services through a service company to an end client potentially falls within IR35.

"HMRC seeks to narrow those cases subject to investigation by considering a range of factors, including, but not exclusively, sectors, engagement patterns and the nature of the service company."

These 'traditional' areas of assessing IR35, say IR35 experts, imply the criteria HMRC uses to identify subjects for review will not alter when new compliance rules come in next month.

Partly, the IR35 review criteria will not change because HMRC can determine the likelihood of taxpayer liability to IR35 with just a "brief glimpse" of their accounts - before or after April 1st.

Such was the warning yesterday from Bob, the retired tax inspector, who outlined the typical appearance of a taxpayer the agency's IR35 inspectors might approach.

"Someone operating through a limited company who has relatively low turnover; is the sole director; has minimal expenses; pays [themselves] the minimum wage but has large dividends."

A company that has a spouse as a shareholder is "another potential giveaway" to a taxman enforcing the IR35 rules, he said, as is a company that only shows minimal outlays on its accounts.

"If a person is truly self-employed they will find their own customers, risk their own capital, purchase materials, and potentially have their own premises," Mr Jones explained.

"It follows therefore that the statement of account on the self-assessment tax return should have a number of separate deductions from the turnover - the fewer the deductions the more likely IR35 will apply".

Worryingly for affected taxpayers, Jones said the Revenue's computer could be programmed to flag up those with few deductions as a way of identifying subjects for IR35 scrutiny.

Few deductions, among other activities on a firm's account, indicate the company is "merely a vehicle for convenience" – which would raise the Revenue's suspicions, the PCG said.

"If HMRC see any indication that the company is merely a vehicle of convenience for the freelancer, and they are not really in business [of their own account], they will go for those freelancers first," explained John Kell, its policy manager.

"Any freelancer thinking 'the company is just a vehicle of convenience for me' is likely to give this away in their behaviour, and more likely to be investigated by HMRC."

Kell agreed that the exact basis of HMRC's risk assessment for IR35 remains under wraps, but cited behavioural factors and irregularities [in relation to all tax enquiries] that put taxpayers at 'high risk' of liability according to HMRC.

These include changeable turnover, fluctuating or low gross profit rate, dividends that seem too low to account for the drawer's lifestyle, and cash inserted in a company with no clear origin.

Yet overall, "it's hard to say" what factors specifically set "alarm bells" ringing in the ears of HMRC when it assesses taxpayers for liability under IR35, the PCG said.

"We do know, however, that HMRC have to prioritise between cases, and there are ways of keeping your head below the parapet," Mr Kell advised.

"A less obviously-named company than 'Joe Bloggs Computer Services Ltd' such as 'High Window Ltd' might attract less attention [from the Revenue]…

"Out of a 'High Window Ltd' and 'Joe Bloggs Computer Services Ltd' it's obvious which one a typical HMRC inspector, often with a suspicion and misunderstanding of freelancing, would look into."

He added: "More obvious tips also apply: ensure your company presents itself in a businesslike way, with a company letterhead for all correspondence, [particularly] with HMRC".

Further reading:

IR35 Employment status factors

How to handle an IR35 investigation

How to Avoid IR35

Friday 3rd Apr 2009