NAO exposes ‘gaping holes’ in IR35 reform

HMRC has been slammed for its ‘rushed’ and ‘haphazard’ rollout of IR35 reform in the public sector

The National Audit Office (NAO) has published its “damning” findings following its comprehensive review into IR35 reform in the public sector. 

The 60-page report states that because public sector bodies had “little time to prepare”, it made it “highly likely” that many would make mistakes.

It highlights that IR35 reform, which shifted the responsibility of determining IR35 status from the contractor to the end-client, was proposed by government in March 2016 and given the go ahead soon after, in November 2016.

HMRC only pushed out its guidance for the changes in February 2017 – two months before the rules came into force. And the full version of CEST was only made available in March 2017 – one month before the changes arrived. 

IR35 roll-out was ‘haphazard’ and ‘difficult to comply with’

The investigation found that more than half of public sector bodies said IR35 reform was “difficult to comply with” and the most common reason cited was using the CEST tool.

Many criticised the tool as too broad, with the questions difficult to interpret. In 15 per cent of cases, the tool was unable to make an IR35 status determination. And despite HMRC improving CEST in 2019, this number has risen to 20 per cent.

Meg Hillier, chair of the Public Accounts Committee, described HMRC’s handling of the initial roll-out as “haphazard” and meant “public bodies were confused by the changes and had no time to prepare.”

This, she said, “contributed to high levels of non-compliance by government departments.”

The report goes on to highlight that according to the 2020-21 financial statements, central government departments have been hit with a total of £263m in tax bills for failing to implement the IR35 rules correctly.

HMRC failed to set out ‘reasonable care’ interpretation 

The Department of Work and Pensions faced the largest bill at £87.9m. Other departments included the Ministry of Justice group (£72m), Home Office (£29.5m) and the Department of Environment, Food and Rural Affairs (£19m).

NAO goes on to add: “In all cases of non-compliance, HMRC found that the public body had not taken reasonable care to prevent errors, including when answering questions in CEST.

“However, it had not set out how it would interpret reasonable care for the new requirements when they first took effect.”

The report also pointed out that not only did contractors have no legal route of appealing an IR35 decision, but that the changes have “broadly had the intended effect” of increasing tax revenue.

It noted: “HMRC initially assessed that an additional £550 million of income tax and NICs was collected in the first year. It later estimated that, offset against taxes that workers and their PSCs would have paid otherwise, the net increase in tax revenue was £250 million, more than HMRC had previously expected (£150 million).”

Report makes clear CEST is ‘deeply flawed’

Responding to the report, Seb Maley, CEO at Qdos, said: “This investigation is damning and exposes many of the gaping holes in HMRC’s plan for IR35 reform.

“It shows that public sector changes were rushed, the tax office’s IR35 tool (CEST) is deeply flawed and that contractors had next to no chance of appealing unfair IR35 status decisions.

“The fact that public sector reform brought in £100m more in tax than even HMRC expected is, in my opinion, inextricably linked to the sheer number of contractors wrongly placed inside IR35, where they are taxed as employees. 

“Private sector businesses can learn a lot from this investigation. It makes clear that CEST should not be relied on to assess IR35 status and that HMRC has no hesitation in issuing staggering tax bills for non-compliance, evidenced by the £263m owed by public sector bodies.”

The report comes just days after HMRC published its own report into the 2017 reform, which found it had only a “minimal” impact with many claiming it was “quick and easy.”

What does this mean for contractors?

Contractors are well aware of the impact of IR35 reform in the public sector, with many being told by their client that they must operate via umbrella companies or become employees. It has been a similar story in the private sector, following the changes in 2021.

However, and despite IR35 reform, HMRC retains the right to open up retrospective IR35 investigations, focusing on completed contracts prior to the changes. With this in mind, contractors are advised to hold IR35 defence insurance, which helps mitigate the risks presented by the rules.