Getting it wrong is costly!
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IR35 Getting it wrong is costly! |
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An example of how much tax
can build up, if IR35 is incorrectly ignored. IR35 - Home page IR35 explained |
Take a typical IR35-type contractor (the worker), who supplies
his engineering services through his own intermediary company.Engagements are based on short term contracts lasting three to six months. During the year ending 5 April 2002, our worker undertook two six month contracts with different clients, both of which were arranged directly between the intermediary and the client. An 'IR35-friendly' contract was purchased from a reputable Internet source, to protect the worker from IR35. The total net fee income billed by the intermediary to the two clients was £60,000 for the year. We shall ignore VAT for the purposes of this exercise. During the second year ending 5 April 2003, the same worker undertook another three contracts. Again similar IR35-friendly contract arrangements were used through his intermediary company. Total net fee income for this year was £65,000. The worker took professional advice, researched the regulations and decided that all the engagements were borderline IR35 cases. He elected to ignore IR35. The worker was the sole director and shareholder of the intermediary. It was arranged that the worker would pay himself a monthly gross salary of £800, and take the rest of the company's profits as dividends during these two years. This saved him and the company having to pay a significant amount of employee's and employer's National Insurance tax. Expenses were low, and the company did not make any pension contributions during the same period. Now, let us assume that the intermediary company receives a PAYE tax compliance visit in early May 2004. After inspecting the 'IR35-friendly' contracts, and in the absence of any further written evidence to the contrary, the visiting tax compliance officer decides the way the income has been treated under IR35 has been incorrect. The Inland Revenue accept that the strict application of the terms of the legal contracts used for each engagement would have resulted in them falling outside the scope of IR35. But after further investigation, which included contacting the clients concerned, the Revenue decide that the actual working relationship between the worker and the client was different to the legal form of the contract. IR35 taxation should have been applied for both years. Substance over legal form is expected to unravel some of the best planned IR35 avoidance schemes. Some of these so-called 'IR35-friendly' contacts, present such a weak case they would probably fall at the first hurdle. Any one intent upon relying upon such a contract, must exercise extreme caution. That is not to undermine the importance of always trading under a sound and legally binding contract that has been prepared with IR35 avoidance in mind. One just has to be sensible and retain realistic expectations of just how effective these contract can be in avoiding IR35. Assuming that professional mediation fails to convince the Inland Revenue to change their mind, the company will receive within a matter of weeks of the compliance visit, a very unwelcome back-duty assessment to PAYE and National Insurance, based on two deemed payments amounting to £79,869 (2002 - £37,637 and 2003 - £42,232). These have been derived as follows:
The final tax payable on the deemed payments of £38,246 and £42,766 in this example will depend upon many factors. But assuming that the worker has no other income and is entitled to his full personal tax allowance each year, an additional assessment on the Company to PAYE of £23,538 and National Insurance of £13,710 is not beyond the realms of possibility. There will be the opportunity to mitigate some of the overall tax burden on the individual worker. The tax they would have suffered on the dividends they will have taken in place of salary will be recredited. That said, the company still has to find the £37,248 to pay the PAYE and NI demand. And that is before we start considering penalties and late payment interest. Following the PCG's Appeal against IR35 in the High Court in December 2001, the Inland Revenue immediately published a statement that the period of uncertainty over IR35 had ended. They also announced that that they will apply penalties on all undeclared IR35 tax situations from 31 January 2002. Considering the heavy handed tone of this statement, and the size of the possible penalties involved, any taxpayer with undeclared potential IR35 income would be very wise to carefully reconsider their position. Returning to our example, there is some more good news in that adjustments will have to be made to the corporation tax computations. The prospect of a repayment of tax to the shareholder in respect of the dividends that will now be treated as quasi 'IR35 salary' payments (Finance Act 2000, 12 Schedule 13) will help ease the financial stress of meeting the final additional IR35 tax bill. Of course our imaginary taxpayer could always consider contesting the decision, but the odds are very much against him. That is, unless he has retained the documentary evidence to support the argument that IR35 does not apply. Which, if you remember, is where we came in. Footnote It would be easy for you to assume we are overstating the risk for our borderline IR35 worker and his intermediary company. There are very mixed opinions within the accountancy profession about what borderline clients should be advised to do. Some authorities are suggesting that it is relatively easy to stand up to the Inland Revenue, and reverse any IR35 back-duty assessments that may arise. Provided you take proper professional tax planning advice, you should be prepared to tough-it out. Others are urging prudence. They feel the size of the potential back-duty assessments are large enough to drive companies and individuals into insolvency, if the wrong call over IR35 is made. You only have to ask yourself could you raise £37K to pay an unexpected tax bill to appreciate why. It seems sensible to try and take the middle ground and reduce any risk you may take to an absolute minimum. You can do this working with us, to assemble the best possible case for supporting your claim that IR35 does not apply. This involves you collecting togther the information we suggest. Then you should seek a written confirmation that IR35 does not apply from the Inland Revenue. This should be done well in advance of the 5 April in any tax year, so that the you can exercise any available tax-planning options should the Inland Revenue decide that IR35 does apply to your particular engagement. If you wish to have your contract approved by the Inland Revenue, then you should send a copy of the contract and relevant documentation to: LP10 |
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