IR35 Business Entity Tests

Peninsula Team

June 08 2012

After many months of waiting expectantly HMRC has finally started the process of overhauling its operation of the IR35 regime for personal services companies with the issuing of new guidelines getting out some basic risk factors that will affect a contractor’s chances of being investigated.

The Overview of Tax Legislation published in the March 2011 Budget laid out the terms of reference for the IR35 improvement project:

• To provide greater pre-transaction certainty, including a dedicated helpline staffed by specialists
• To provide greater clarity by publishing guidance on those types of cases HMRC view as outside the scope of IR35
• To restrict reviews to high risk cases carried out only by specialists teams; and
• To promote more effective engagement with interested parties through an IR35 Forum to monitor HMRC’s new approach.

The overhaul, with an initial pilot scheme, has been set up with three teams of around 36 specialist sta ff which will be based in offices at Salford, Edinburgh and Croydon.  When they pick up a case for enquiry, the teams will take into account a contractor’s reasoning and evidence why IR35 does not apply to them rather than asking for a long list of documents, HMRC said. The objective of the exercise will be to address the risk of avoidance of employment taxes, including National Insurance, according to HMRC. A spokesman for the HMRC confirmed this will mean that there will be an increase in the number of investigations opened for IR35 reasons over the coming year and subsequent years. As part of the process HMRC will also be strengthening its helpline/review service for contractors, which will be handled by specialist staff.

The new 47 page guidance notes set out 12 business entity test. HMRC said the tests are designed to build up a picture of how a contractor’s business works and how they provide their services. The tests and their scores include:

Business entity tests
Low risk: 20+ pts; Med risk 10-20pts; High risk <10pts

Business premises test  Does the business have its own premises? (Yes = 10pts)

PII test - Does contractor have PII? (Yes = 2pts)

Efficiency test - Can business increase revenue through efficiencies? (Yes = 10pts)

Assistance test - Does employ workers who bring in 25% of turnover? (Yes = 35pts)

Advertising test
- Has business spent £1,200+ on advertising in the past year? (Yes = 2pts)

Previous PAYE test - Has end client engaged contractor without changing working arrangements? (Yes = minus 15pts)

Business plan test - Does business have a regularly updated business plan and separate bank account? (Yes = 1pt for each answer)

Repair at own expense test - Would business have to bear cost of rectifying any mistakes? (Yes = 4pts)

Client risk test - Has the business failed to recover payments mounting to more than 10% of turnover in past two years? (Yes = 10pts)

Billing test - Does business invoice for work and negotiate payment terms? (Yes = 2pts)

Right of substitution test - Can the business send a substitute? (Yes = 2pts)

Actual substitution test - Has business hired anyone to carry out work in past two years? (Yes = 20pts)

The scores used to assess contractors’ risk profiles are as follows:

Less than 10 points         High risk
10-20 points                    Medium risk
More than 20 points        Low risk

The HMRC guide explains that the tests are not set in stone, and are an extension of the risk-based approach it extends to all of its investigations.
The new business entity tests are being seen by many as just a “diagnostic tool” and that the actual application of IR35 will always come down to employment status factors that must be tested against case law going back to the 1968 Ready Mixed Concrete decision. Initial comments suggest that many believe that as legislation and case law have not changed, so many of the tests are irrelevant to the factors a tribunal judge would consider to determine the nature of the notional contract that existed between a contractor and end client (particularly control, substitution and mutuality of obligation).

For many professionals who advise on IR35 this new guidance merely creates another layer of complexity. Office of Tax Simplification tax director John Whiting has said “Let’s see how the pilot tests work in practice, monitor the results, and then argue for abolition or retention of the system based on what happens.” 

The day to day reality for all concerned however is that for the time being IR35 is still with us, so we’ll have to comply with testing the new mechanism and pushing for further improvements or abolition when the results are in! 

For any further information on any of the issues outlined in this piece, please call the Advice Service on
01455 852555.

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