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IR35 Forum – Part 2: Targeting strategies to segment contractors into IR35 risk bands

ContractorCalculator examines possible targeting strategies that HMRC could adopt to identify those disguised employees that IR35 was originally designed to catch, whilst minimising the impact on genuine contractors. This is the second in a series of articles analysing the options available to the IR35 Forum as it determines how HMRC might better administer IR35.

The minutes of the inaugural meeting of the IR35 Forum revealed that HMRC is already well advanced in developing a strategy that segments contractors into broad bands according to their IR35 risk.

But HMRC is planning to apply these ‘high’, ‘medium’ and ‘low’ risk categories to contractors without actually telling contractors and their advisers what the risk criteria actually are. Nor has it yet indicated what sampling methodologies it plans to adopt to sift through the estimated 1.4m flexible workers in the UK and identify those worthy of inspection.

So just how does HMRC intend to tell disguised employees from genuine contractors? The blurring of boundaries between the two categories can make it very difficult indeed. After all, the ECR Consulting case clearly shows how genuine contractors and employees can, to all outwards appearances, appear to be doing exactly the same job. Yet, as the final ruling confirmed, one is legitimately a contractor in business and the other is an employee.

A contracting insider’s view on what constitutes a high risk contractor

Experienced contractors will be familiar with the three categories of contractor who most contracting sector insiders would acknowledge as being ‘disguised employees’ at high risk of falling foul of IR35:

  • ‘Permtractors’ – these workers start on a genuine project, but contract extension follows contract extension, until they find themselves part of the furniture, staying for years, sometimes decades, yet never officially joining the client’s workforce as an employee.
  • ‘Tail-end Charlies’ -- these workers are so-called because they are told by the client to take all the left-over work at the tail-end of projects, or pick up bits and bobs from other contractor’s or employees’ workloads. So, unlike a genuine contractor, they don’t focus on a contract-specific project with a set of clearly defined deliverables
  • The ‘Friday to Monday mob’ – these are usually highly paid senior employees who leave employment on a Friday, only to return on Monday to do the same job, often at the same desk, as a ‘consultant’ working through their own limited company.

So, what might be the lessons for the taxman? Well, HMRC could start segmenting contractors by publicly stating that they might be inside IR35: if they work for the same client for more than a set period; or they are not contracted on a specific project; or they have previously been employed by the client doing the same or a very similar role.

To better target these individuals, HMRC could develop questions on the P35, or on other tax forms, to identify: how long a contractor has worked for a client; if the project has specific deliverables; and whether the contractor was previously employed by the client in a similar role.

However, as the ECR Consulting ruling has demonstrated, things are rarely that simple: scratch the surface of what appears to be an obvious disguised employee and the true story may be quite different.

Situations are often not what they seem

After segmenting ‘high risk’ contractors based on questions on the P35, HMRC might consider that it has created a target-rich environment for IR35 investigations that will generate a good yield in unpaid income tax, National Insurance Contributions (NICs), fines and interest.

But, in all likelihood, the taxman is likely to find on further investigation that:

  • Many contractors, particularly those in engineering, may spend several years on a project simply because big things like chemical plants and airports take a long time to build
  • Some freelancers are hired as ‘trouble-shooters’ to help employees cope when times are busy, or simply to clean-up loose ends – their ‘project’ is to work across multiple projects and clean up other people’s messes
  • And many contractors and consultant’s start their freelance career by working for their former employer, simply because they know the organisation extremely well and it’s the first contract they’re able to win as a first-timer, or they have been made redundant but have been asked to complete a project or handover on a consulting basis.

Scratch the surface of what appears to be an obvious disguised employee and the true story may be quite different

Are any of the above types of contractor any less likely to be in business on their own account simply because of the peculiarities of their current assignment? And, more importantly, should contractors be penalised by paying more tax because their current assignment is lasting a long time, involves working on multiple projects, or is with a former employer?

Can the level of ‘control’ be used as a segmentation strategy?

IR35-savvy contractors increasingly understand that control is one of the key tests of employment applied by HMRC to determine whether a contractor is really a disguised employee who should be taxed accordingly.

But can a segmentation strategy based on control work for HMRC in today’s knowledge economy? The ECR Consulting ruling demonstrated that it is unlikely that a very highly qualified and skilled individual working on a contract can be deemed to be controlled. Of course a contractor expects to receive some direction from the client about project objectives and deliverables, but that does not constitute control over how to perform the tasks required to meet those objectives.

And the contracting sector knows how hard it is to prove control of a knowledge worker, meaning HMRC is increasingly likely to come up against well planned IR35 defences. Segmenting contractors into a high risk category on the basis that they are controlled is likely to leave HMRC with increasingly fewer targets.

Are there any workable IR35-risk segmentation strategies for HMRC?

So what new processes could HMRC adopt to catch more disguised employees? Specifically, what processes can segment high risk contractors (ie likely disguised employees) without netting a significant number of medium and low risk genuine contractors? And of these processes, which can HMRC effectively resource?

Is a blanket rule, such as ‘guilty unless certified’ the only solution, whereby an independent, and possibly commercial, body/bodies ‘audits’ each contractor and provides an ‘outside IR35’ certificate for each contract? Could simple rules for the high risk categories of ‘permtractors’, ‘Friday to Monday mob’ and ‘tail-end Charlies’ be combined with such a certification scheme?

Or are ‘in business’ or ‘gateway’ tests the solution? HMRC is investigating these as part of its remit on the IR35 Forum. But business tests can’t possibly offer a fair verdict on all flexible workers, as has been discussed in ContractorCalculator’s IR35 Solutions white paper, and as has been resoundingly proven by the Australian Personal Services Income (PSI) model.

And then, of course, there’s the overarching question: is any attempt by the contracting sector to offer workable IR35-risk segmentation options doomed to failure if HMRC refuses to share its IR35 risk criteria with the very community of taxpayers, agents and advisers it is planning to target?

Part 3 of ContractorCalculator’s IR35 Forum will highlight how the contracting sector views what form a better administered IR35 regime could take, and presents a wish-list of issues that a new style of administration could tackle.

Published: 23 June 2011

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