How to Protect Yourself from an IR35 Investigation?

Do you want to avoid an HMRC IR35 investigation? So does everyone. Despite contractors’ efforts to comply with the IR35 legislation, HMRC may open an IR35 compliance check to review your daily working practices. This compliance check is done to determine whether the IR35 rules have been applied correctly.

Although it is fair that contractors should pay their taxes, HMRC investigations can still be stressful for those who followed the rules. Let’s understand how these investigations work and how to save yourself from them to protect your livelihood and hard-earned income.

What is an IR35 Investigation?

An IR35 tax investigation is a formal tax audit by HMRC to determine whether a contractor is genuinely an independent business or acting like one. HMRC reviews your contracts, working practices, correspondence, and supporting evidence to determine whether the engagement is genuinely one of self-employment or disguised employment.

If HMRC proves that your working practices and contract terms are employment-based while taking advantage of a different tax treatment than an equivalent employee, it will determine that the engagement falls inside IR35. This leads to unpaid Income Tax, National Insurance contributions, interest, and, where applicable, penalties.

When Does HMRC Initiate an Enquiry?

HMRC uses a risk-based approach to decide whether to open an IR35 investigation. During the enquiry, HMRC reviews your contracts, supporting evidence, and working practices to determine whether the IR35 rule applies. If HMRC proves that the engagement falls outside IR35, it may close the investigation.

Until 5 April 2015, HMRC used Business Entity Tests (BETs) to assess your IR35 risk. If you are in the low-risk band, you are not subject to further IR35 enquiries for three years. However, these tests are no longer used. Today, IR35 status is determined based on control, substitution, and mutuality of obligation.

How Does an IR35 Investigation Work?

An IR35 enquiry is a slow process, depending on the complexity of the case and the amount of evidence involved.

HMRC Opens Enquiry

HMRC opens an enquiry into your business or company if it finds IR35 risks through tax returns, compliance checks, or other information. You may receive a letter requesting information about the engagement.

The letter will ask you to explain your limited company or partnership’s income for a particular year. In addition to income information, it will ask you to provide copies of your written contracts for work during a specific year.

Information Gathering

The next step of the IR35 investigation is to gather documentary and practical evidence. HMRC collects evidence to understand the working relationship. It reviews contracts between the contractor and client, details of actual working practices, invoices and payment records, and information from the client or agency.

Status Assessment

During this stage, HMRC reviews the evidence against the key employment status tests before reaching a provisional conclusion.

Face-to-Face Meeting

After examining the contracts and evidence, if HMRC thinks that IR35 may apply, HMRC may send another letter asking for a face-to-face meeting with you. Accept this meeting invitation to conclude the IR35 investigation more quickly. Also, you need to answer the questions from HMRC immediately and clarify any confusion.

HMRC Finishes Enquiry

After reviewing all the information, HMRC concludes their enquiry. Once the investigation is complete, it issues its findings on whether IR35 applies to you. If you disagree with HMRC’s opinion, you have the right to object. However, if HMRC does not agree with your objection, it will issue a decision. It decides whether the engagement falls outside IR35 or inside IR35.

Note: When you are genuinely self-employed for tax purposes, you fall outside IR35. Moreover, when you fall inside IR35, you are treated as an employee for tax purposes.

Appealing the IR35 Status Decision

If you disagree with HMRC’s decision, you have the right to challenge it through HMRC’s review process or by appealing to the Tax Tribunal. If you think the decision is not fair, you can appeal directly to a Tax Tribunal. You can also ask HMRC to review the decision. If the HMRC reviews and appeals team still decides IR35 applies, but you don’t agree, you can still take your case to a Tax Tribunal.

For a detailed IR35 investigation process, visit the official HMRC website.

Who Holds the Financial Liability?

An IR35 status determination and bearing financial liability depend on the size of the end client and the applicable off-payroll working rules.

Small Private Clients

If the end client qualifies as a small private business, the contractor’s Personal Service Company (PSC) determines that IR35 applies and holds the legal and financial risk. This means that if HMRC finds out that the engagement falls inside IR35 after an IR35 investigation, the PSC is liable for unpaid tax, National Insurance (NI), and penalties. As a result, HMRC focuses its investigation on the contractor and their company.

Medium or Large Private Clients

If the end client qualifies as a medium or large private organisation, the IR35 status enquiry depends on the client.

The client determines IR35 status and holds the legal and financial risk. The client must issue a Status Determination Statement (SDS) explaining whether working practices fall outside or inside IR35.

If HMRC decides that the IR35 rules were applied incorrectly, the fee-payer is responsible for deducting Income Tax and NI where the engagement is inside IR35. If obligations are not met, the liability may transfer elsewhere in the labour supply chain, depending on the circumstances.

How HMRC Determines IR35 Status?

During the IR35 investigation, HMRC looks at the working relationship between the contractor and the client and decides whether IR35 applies. HMRC assesses whether the contractor is working like an employee or is really self-employed. It considers the following key factors:

Control

HMRC investigate how much control and supervision the client has over the work. If the client decides where, how, and when to work, the engagement falls inside IR35.

Right of Substitution

The right of substitution is another factor HMRC considers to decide whether IR35 applies. A genuine self-employed contractor has the right to send a substitute to carry out the work. If the work demands that the contractor must personally carry out the work, it may indicate employment.

Mutuality of Obligation (MOO)

HMRC considers whether the client is obliged to offer work and whether the contractor is obliged to accept and complete it. This obligation can suggest an employment relationship.

There are other factors too that HMRC considers during an IR35 investigation. These factors include the provision of equipment, financial risk, and integration into the client’s business.

What Should You Do During an IR35 Investigation?

If HMRC opens an IR35 investigation against you, you need to respond quickly. You need to handle the situation carefully to avoid making mistakes that make you look guilty. Follow these tips to protect your business:

• Notify your professional advisors, like an accountant or an IR35 expert, immediately, before you respond to HMRC.
• When you receive the HMRC investigation letter, check the target of the investigation. If your client is medium or large, they are responsible for liability.
• If you are confused and have no idea how to respond, request all correspondence in writing. You can also formally appoint your tax specialist to speak to HMRC on your behalf.
• Gather your evidence and provide it on time when HMRC asks for it.
• Review your daily working practices

How Long Does an IR35 Investigation Take?

The length of an IR35 investigation varies based on the complexity of the case. If the investigation is straightforward, it may conclude in a few months. Nonetheless, if there are more complex cases with multiple contracts or extensive evidence, it can take a year or longer. You should keep accurate records and respond promptly to reduce delays.

The Bottom Line

An IR35 investigation is a formal compliance process that occurs when HMRC believes that there is a risk that the IR35 rules have been applied incorrectly. If HMRC is satisfied that the engagement falls outside IR35, it will normally close the enquiry without further action.  You can protect yourself from HMRC IR35 tax investigations by using clear and accurate contracts, ensuring your actual working practices match the contract terms, and regularly reviewing your IR35 status. Review your compliance status or seek professional advice if you are unsure about the process.

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