Back to Blog
In 2017, HMRC introduced changes to the IR35 rules, which determine how off-payroll workers are classified in the UK. While this initially only applied to public sector companies, it was expanded into the private sector in April 2021. This has had a huge impact on large and medium organisations that work with independent contractors and consultants.
The stakes are high: companies that get it wrong will be held responsible for 100% of the unpaid taxes and charges due on each engagement, plus additional penalties of up to 100%.
But determining a worker’s tax status is not always simple — particularly in large organisations with complex supply chains. In this article, we’ll share seven common IR35 pitfalls that FTSE 250 firms should be aware of, and our advice on how to avoid them.
What is IR35? What large businesses need to know
IR35 is another name for the ‘off-payroll working rules’ in the UK. These are a set of rules designed to ensure workers who provide services through intermediaries such as personal service companies (PSCs) pay approximately the same Income Tax and National Insurance contributions as they would as employees.
Broadly speaking, workers engaged through intermediaries can be either ‘inside IR35’ or ‘outside IR35’.
If a worker is classified as inside IR35, they should be paid through the PAYE system, with taxes deducted at source and National Insurance Contributions (NICs) and the Apprenticeship Levy paid on their income. They are employees for tax purposes, even if their contract or agreement says otherwise.
Those who are outside IR35, on the other hand, are deemed to be operating a genuine independent business. They wouldn’t be classed as employees if they were engaged directly by the end user, which means they don’t need to pay employer NICs.
As of 2021, it is now the responsibility of private sector end-user clients to correctly determine whether workers are inside or outside IR35. While there’s an exception for small businesses, FTSE 250 firms fall outside of this by definition. That means IR35 compliance is a key consideration for FTSE 250 firms.
The financial impact of inside IR35 status
Under the new rules, end-user clients are responsible for making IR35 determinations, and fee payers are responsible for deducting the relevant payroll taxes and paying employer NICs (and, where applicable, the Apprenticeship Levy).
The end user is the party that ultimately benefits from the worker’s services, and the fee payer is the party immediately above the intermediary in the contractual chain. In some cases, the fee payer and the end user are the same organisation. However, the fee payer may also be another party, such as an agency.
Even if the end-user client is not the fee payer, tax liability can pass up the contractual chain to the end user if the intermediary doesn’t meet its obligations. This can have a significant financial impact on a business since it can result in liability for taxes, NICs and the Apprenticeship Levy. HMRC can also demand back payment of these taxes going back several years, plus penalties and interest.
What is ‘reasonable care’?
HMRC requires that employers take ‘reasonable care’ when determining whether a worker is inside of outside IR35. Although there are still penalties for accidental misclassifications, they are much harsher when a business is shown to have been negligent or deliberately misleading in its determinations.
According to HMRC, reasonable care means that clients must act in a way that would be expected of ‘a prudent and reasonable person in the client’s position’. That means that what counts as ‘reasonable’ depends on each individual business’ circumstances. For example, HMRC has stated that it expects a higher degree of care from large, multinational employers with internal finance teams than much smaller entities.
The risks of getting IR35 determinations wrong
Getting IR35 determinations wrong carries serious risks for an employer. First, they can be held responsible for all of the unpaid taxes that should have been paid to HMRC during the course of a worker’s engagement. They can also face fines of up to 100% of this amount plus interest depending on the degree to which HMRC deems they have deliberately withheld information.
However, there are also other non-financial consequences, which can be just as damaging to a business. These include:
- Reputational damage: HMRC may publish details of organisations that are found to have made inaccurate determinations, which can have a serious impact on a company’s reputation.
- Competitive disadvantage: Organisations that are known to take a poor approach to IR35 determinations are like to be at a competitive disadvantage to companies that are more diligent in their assessments. For example, these companies may be excluded from applying to government contracts and removed from preferred supplier lists.
- Contractual breaches: Organisations that fail to comply with the IR35 rules may be in breach of contract with their clients, suppliers, or partners. This could leave them liable for indemnities and warranties.
- Problems with talent attraction: As companies become known to take a law approach to IR35 determinations, they may face problems attracting contingent talent. Agencies and individual workers may be reluctant to work with organisations that are perceived to be involved in tax avoidance and opt to work with competitors instead.
Core challenges for FTSE 250 firms
Here are some of the key challenges FTSE 250 companies face as they navigate IR35 compliance:
- Correctly classifying workers: There’s no one key factor that determines a worker’s tax status. Instead, it’s based on a range of factors including working practices, the details of the contract and how the worker is paid (for example, whether they receive benefits such as health insurance, paid holidays, company discounts, gym memberships, etc). Making these determinations is not always simple, particularly for large organisations.
- Building adequate compliance processes: HMRC expects businesses engaging off-payroll workers to have comprehensive compliance processes in place to manage IR35 determinations. FTSE 250 firms must ensure they have the necessary resources and internal expertise to complete status determinations accurately and compliantly.
- Managing complex supply chains: Under the new rules, the end-user client is responsible for IR35 determinations. However,when supply chains are more complex, it is not always clear who the ‘client’ actually is. Large companies with complex supply chains must have robust processes in place to correctly identify the relevant parties and manage their exposure to IR35 risk.
- Navigating HMRC investigations: HMRC can issue information requests to companies to review their IR35 compliance. This may begin as a general information-seeking exercise with no indication that a deeper enquiry will follow. However, these initial communications are often the first step in a more formal investigation. Large organisations need to tread carefully when responding to any requests from HMRC.
7 Key IR35 pitfalls (and how to avoid them)
Getting IR35 compliance right isn’t easy — especially for large organisations. Here are some of the most common pitfalls that FTSE 250 firms encounter when navigating IR35 determinations, plus the steps you can take to avoid them.
1. Over-reliance on HMRC’s CEST tool
The ‘check employment status for tax’ (CEST) tool is an online resource provided by HMRC. It takes users through a series of questions and provides a decision on whether an engagement constitutes employment for tax purposes. HMRC has stated employers can rely on the results of the questionnaire as long as it was answered accurately, honestly and with ‘reasonable care’.
However, many of the questions the tool asks are open to misinterpretation and misunderstanding. That means there’s always a chance of error, even if you’re acting in good faith. In this case, HMRC would not stand by the CEST decision since they’ll argue that the information given was inaccurate.
In many cases, the CEST tool is unable to make a determination at all, with HMRC’s own data showing the result is ‘undetermined’ in around 22% cases. For this reason, organisations need to use a combination of the CEST tool and their own judgement to make IR35 determinations.
2. Making blanket determinations for all contractors
When an organisation engages a large number of contractors, it can be tempting to take a blanket approach to IR35 determinations, classifying all workers as either inside or outside IR35.
However, employment statuses will almost certainly differ from one contractor to another depending on the facts of each case. For this reason, this approach does not meet HMRC’s ‘reasonable care’ standard, and may be treated as deliberate behaviour when it comes to applying penalties. To avoid this, organisations must take the time to assess each case individually to ensure the correct status is assigned to each contractor.
It’s also important to remember that many contractors do not want to be classified as inside IR35, especially if this doesn’t match the reality of their situation. Businesses that try to take a one-size-fits-all approach will likely see problems with contractor engagement and retention.
3. Treating determinations as one-and-done
Many organisations make the mistake of thinking that they don’t need to worry about IR35 once they’ve made a determination and issued a Status Determination Status (SDS). However, it’s common for worker-client relationships to take on new dimensions as a contractor’s role expands.
If a worker’s working practices have changed or you’ve negotiated a new contract with a worker, it’s vital that you re-check your IR35 determination to see if the worker’s tax status has changed. It’s also good practice to reassess determinations periodically to keep everything up to date and avoid liability.
4. Not having a process for appeals
Workers and deemed employers (fee payers) have the right to disagree with a determination made by an end-user client. And, if you don’t have a set process in place for handling disagreements, this can cause problems for your business.
HMRC requires that businesses put in place formal procedures for dealing with appeals, which involve considering the reasons the worker or deemed employer disagrees and deciding whether to maintain the determination or change it. Employers must respond to appeals within 45 days. They should also keep detailed records of the determinations they make and the reasoning behind them, and document any disagreements too.
5. Failure to provide adequate training
In large organisations, the contingent workforce is almost never managed by one individual or department alone. Yet, many organisations leave IR35 compliance entirely to HR, finance, legal, procurement or another department. This is a mistake, as these people may not be wholly aware of the recruitment of independent workers that goes on in their organisation and the way those workers are managed.
Instead of relying solely on one department for IR35 compliance, it’s best practice to ensure anyone with the ability to hire contractors is aware of the rules and understands the need to complete a status determination for each worker. Providing such training ensures the relevant parties are equipped to identify potential issues and understand the tax and legal implications at stake.
6. Passing responsibility to intermediaries or contractors
End-user clients may have trouble using worker classification tools such as CEST, or otherwise making status determinations because they lack the necessary information about contractors and their work practices. For this reason, many organisations ask contractors or intermediaries to carry out determinations and simply approve the outcome without assessing how it has been reached.
As we’ve said, HMRC requires organisations to use ‘reasonable care’ when carrying out status determinations — and this approach is unlikely to meet this standard. This means it could lead to misclassifications and result in end-user clients being held responsible for payroll taxes.
To avoid this, organisations should put in place clear processes that require intermediates and/or contractors to provide the necessary information for accurate status determinations. They should also ensure this information is updated periodically throughout the contractual relationship. When supply chains are complex, it’s also important to require contracting parties to include the same provisions in their agreements down the contractual chain.
7. Using schemes to avoid IR35
Since the reforms to the IR35 rules in 2021, many schemes have been set up to help organisations manage compliance or to help workers increase their take-home pay. For example, umbrella companies employ contractors and take on the responsibility of paying their salaries, making the appropriate deductions and providing benefits like paid annual leave. At the moment, the IR35 rules are unlikely to apply in this situation.
However, while many of these schemes are legitimate and compliant with IR35, others are tax-avoidance schemes. For example, some schemes pass on earnings to workers through means other than salary, often making payments in the form of a ‘loan’. While this may help workers reduce their tax bill, any savings are usually negated by the fees these organisations charge for their services.
It goes without saying that these schemes are illegal and should be avoided. Before signing up for any scheme, both end-user clients and workers must carry out proper due diligence to ensure they understand the contractual chain involved.
Moreover, an overhaul of the rules surrounding umbrella companies was announced in the Autumn budget 2024 and will come into effect from April 2026. Under the new rules, agencies that use umbrella companies will be responsible for ensuring that the correct tax and NICs are deducted and paid to HMRC.
When there is no agency in the chain, this responsibility will pass to the end client. Employers that currently employ workers through umbrella companies should be aware of the upcoming changes and how their operations will be impacted.
Navigate IR35 compliance with confidence with CXC
At CXC, we understand the stakes of IR35 compliance. We also understand that getting it right isn’t always easy — especially for large organisations with complex supply chains.
We support our UK clients by building comprehensive and robust processes for IR35 determinations, helping to develop communication plans and escalation procedures and even providing regular training sessions for internal stakeholders.
Want to find out more about how we could help your company to meet its IR35 obligations? Contact our team today.
