IR35 update: HMRC consultation on proposed mechanism for off-setting tax liabilities

At the time of writing, there is less than a week to go until the closing of HMRC’s most recent consultation on the off-payroll working rules (commonly known as “IR35”). Draft legislation has been published, following on from the Autumn Statement 2023, to implement changes to the rules to resolve a commonly-encountered problem in IR35 disputes – namely to allow taxes historically accounted for by a personal services company (PSC) or worker to be offset against the PAYE liability of an end-client, in circumstances where there has been an error in the determination of the worker’s status for tax purposes. Draft guidance has also been released, with comments invited by 22 February. This briefing aims to provide an overview of the issue and some commentary on the draft legislation.

Background

By way of background, the IR35 rules apply (very broadly) where an individual provides services to a business (the end-client) through an intermediary (typically a personal service company or PSC) in circumstances where, had the services been provided directly, the relationship would have been treated as one of employment for tax purposes. The effect is to require PAYE and NICs to be accounted for on payments to the PSC. 

Historically, the liability and the responsibility for making the determination of employment status fell on the PSC.  However, in recent years, there have been significant changes to the rules. These took effect from 6 April 2017, where the end-client is a public authority; and from 6 April 2021 where the end-client is a medium or large enterprise in the private sector. In such cases, the responsibility for making the determination of employment status (and so deciding whether the rules apply) falls on the end-client. The associated payroll tax liabilities falling on the person who actually makes the payment to the PSC, which can be the end-client, or potentially another agency involved in the supply chain.

The issue

Consider the following scenario. An end-client (which is a large business subject to the new rules) enters into a new contract with a PSC and takes the view that IR35 does not apply, on the basis that the engagement would not be treated as one of employment if the worker were engaged directly (often known as “outside IR35”). The end-client will pay the PSC gross. Assuming the PSC is a company and all parties are UK resident with the work done in the UK, the PSC will pay corporation tax on the fees received, and possibly also PAYE and NICs (both employer’s and employee’s) on any salary paid to the worker. The worker will also pay income tax on any dividends received from the company.

Fast forward a couple of years and imagine HMRC start investigating the end client. The case is a finely-balanced one but eventually it is agreed that IR35 should have applied as the engagement was akin to an employment relationship. HMRC will therefore raise assessments for PAYE and NICs against the end-client. However, as the rules currently stand, these assessments will simply treat the whole amount paid as employment income, without any credit or offset for the fact that tax has already been paid in respect of the relevant amounts, albeit by another person. That effectively gives rise to double taxation.

There is a mechanism in the current rules (section 61W Income Tax (Earnings and Pensions) Act 2003 (ITEPA)) designed to prevent this. However, this is designed to work primarily in “real time” – i.e. where the fee-payer deducts payroll taxes when it makes the payment – and not when liability is established after the event. Its effect is also to allow the PSC and/or worker to reduce their tax liability, not the fee-payer.  

Arguably, it is possible to achieve the right result overall under this provision, but this requires a somewhat convoluted series of steps to be taken by the relevant parties: for example, the fee-payer paying the payroll taxes in full, claiming from the PSC under an indemnity, and the PSC / worker then seeking a repayment from HMRC. Even this does involve a relatively broad interpretation of the statutory wording and there may be mismatches in timing between HMRC’s ability to assess the fee-payer and the worker / PSC’s ability to claim a repayment. One party will always be on risk that the process does not work as expected.

The current state of affairs is clearly not satisfactory. It is this that the new draft legislation seeks to fix.

The draft legislation

As mentioned above, the draft legislation is a welcome development. It seeks to resolve an issue that can cause real difficulties in practice, particularly as it often arises at the end of a long-running IR35 investigation.

Broadly, the legislation introduces a mechanism to allow the taxes paid by the PSC and/or the worker to be offset against any tax liability of the fee-payer. This mechanism applies (broadly) where:

• on or after 6 April 2024, HMRC serve a determination or receive a settlement offer in respect of an IR35 liability;
• income tax or corporation tax has been paid or assessed in respect of a payment received by the PSC; and
• HMRC have received a tax return from the worker or PSC which includes such liabilities.

In such a case, HMRC can direct that the liability of the fee-payer can be reduced by the taxes already accounted for. This will be done on the basis of HMRC’s best estimate of the taxes that have been paid. The taxes available for set-off do seem to be quite narrowly defined in the draft legislation: it is not clear for example how income tax on dividends paid by the PSC is included.  

However, the draft guidance adopts a broader, more sensible, approach. This states that the taxes available to be offset are income tax on remuneration received by the worker (so far as it related to the arrangement), income tax on dividends, corporation tax and NICs (employees’, Class 2 and Class 4). HMRC consider that they have the ability to offset NICs under existing NICs regulations (Regulation 51 of the Social Security (Contributions) Regulations 2001). VAT and employer’s NICs cannot be included in a set-off, however.  

If HMRC do make a direction, the worker and/or the PSC is not able to claim a repayment of the tax in question, nor set it off against other tax due. A worker / PSC has the right to appeal on various specified grounds. Conversely, there is no right of appeal for the fee-payer. That said, the draft guidance states that if a fee-payer disagrees with the amount of set-off which has been calculated, it can provide evidence that a different amount of set-off is due, which HMRC will review and consider amending the direction.

The draft guidance suggests HMRC will take a pragmatic approach to establishing whether tax has been paid by the PSC and/or worker so as to allow a set-off. It says that where HMRC can establish that tax has been paid but are not able to identify accurately the amount relating to the particular engagement in question, it will make the best estimate it can based on the information available. However, it is clear that if HMRC are unable to establish that tax has been paid on the income in question, no set-off will be available. If HMRC do decide that no set off is allowed, then it will contact the fee-payer, but they state that they will not be able to provide reasons (citing taxpayer confidentiality).

Conclusion

Overall, this draft legislation is welcome news, and provides a sensible means of resolving an inconvenient problem. The draft guidance is also helpful and suggests that HMRC will take a pragmatic approach. There are places however where that guidance does appear to go further that the somewhat narrowly-drafted legislation, and it remains to be seen how HMRC will actually apply these rules in practice. In any case, end-clients entering into engagements with or involving PSCs should ensure their contracts are robust and contain sufficient protection for them in the event of an incorrect IR35 status determination.