HMRC publishes guidance on 'business entity' test for when contractors will be taxed

Out-Law News | 11 May 2012 | 12:05 pm | 2 min. read

New guidance intended to clarify the risk that a contractor will be caught by a controversial anti-avoidance rule aimed has been published by HM Revenue and Customs (HMRC).

The guidance (47-page / 146KB PDF) sets out 12 tests for determining whether a particular business or engagement falls under the intermediaries legislation (IR35), which is intended to stop contractors in "disguised employment" from reducing their tax and national insurance contributions. The tests determine whether there is a low, medium or high risk that IR35 will apply to that arrangement.

However contractors have criticised the guidance, describing it as a "missed opportunity" by HMRC to clarify a particularly complex area of law.

IR35 was created to combat what the then-Government saw as a growing problem of contractors using limited companies to avoid paying tax and national insurance. The law ensures that contractors have to pay tax and national insurance as employees, even when they are working via a limited company.

The Government announced that it would "commit to making clear improvements" in the way IR35 was administered as part of the 2011 Budget, stating that "abolition would put substantial revenue at risk".

An engagement will score points under the new business entity tests on factors such as whether it operates from a separate location to the client's premises, the need for professional indemnity insurance and whether it has spent more than £1,200 on advertising over a 12-month period.

Contractors in the 'low risk' band are asked to keep evidence to support their answers to the tests, which should be sent to HMRC if it checks whether the legislation applies. The department will close its review and "undertake not to check again whether IR35 applies to you for the next three years" if it is satisfied by the evidence, provided that the information given is accurate and the contractor's working arrangements do not change in that time.

The department said that its questions would enable contractors to self-assess their employment status and that the risk bands would provide guidance on how best to proceed. However, it said that the document was by no means a "comprehensive guide" to the legislation.

Tax law expert Chris Thomas of Pinsent Masons, the law firm behind Out-Law.com, said that a risk-based approach was consistent with HMRC's wider policy to target limited resources and incentivise compliant behaviour in recent years.

"In principle, this should be good news for 'innocent' contractors but in practice the tests are unlikely to provide much comfort in most cases," he said. "Whilst one can see what HMRC is driving at, the weighting is very subjective and – by its very nature – the tests focus on just one of several considerations that a tribunal would take into account. There must, therefore, be a risk that many contractors will end up being categorised as medium or high risk when in reality IR35 is unlikely to apply."

However Chris Bryce, chairman of the Professional Contractors' Group (PCG), said that the scoring of the new business entity tests was "unfair" and did not reflect "the realities of how businesses operate". PCG was one of several bodies representing contractors, freelancers and small businesses who worked with HMRC to develop a new approach to the legislation as part of an 'IR35 Forum' last year.

"HMRC's new guidance demonstrates their fundamental lack of courage and commitment to improve the operation of IR35," he said. "While the external members of the Forum have worked tirelessly to develop innovative solutions, HMRC appear at this stage to have opted for a risk averse approach that will not deliver the improvements that are so clearly needed.