Business entity tests: What you need to knowby
Some of the people closest to the IR35 improvement project have been trying to soothe angry reactions to the publication of HMRC’s pilot business entity tests.
The business entity tests that were published on Wedensday 9 May were discussed extensively by the IR35 forum, and were welcomed by Office of Tax Simplification tax director John Whiting for the collaborative way they were developed. “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,” he said.
Whiting’s view was echoed by IR35 Forum member Kate Cottrell, who said: “The tests are a minor part of the improvements made to the administration of IR35, but are being blown out of all proportion by some.”
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)
Source: HMRC Business Entity Tests
That’s not to say that Cottrell supports the tests (see right) - “I still think that they add an additional layer of complexity to IR35, which is most unhelpful” - but they were what the government promised to deliver back in 2010.
The business entity tests open a new chapter in the 13-year IR35 debate. This article will sketch out the main arguments that have been raised about the tests. Feel free to join AccountingWEB’s IR35 reform discussion group if you would like to continue debating the following issues in more detail:
- Project scope
- Internal focus rather than taxpayer experience
- Targeting accuracy
- Legal basis
- Political fallout
In its 2010 small business taxation review, the OTS argued for a suspension of IR35, but due to the potential risk of lost revenues, the government would not sanction the suggestion. Instead, it adopted the principle that letting businesses “self certify” their IR35 status could potentially offer them more certainty. The OTS commented: “If the government commits to integration of income tax and NICs the OTS was that this option is a viable short term measure to moderate the problem of IR35.”
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.
To give the department its due, this is precisely what it has delivered.
As part of the IR35 improvement package, around 36 specialist staff will be organised into three teams based in 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 department will also strengthening its helpline/review service for contractors, which will be handled by specialist staff.
The government’s original rationale for the OTS was to lessen the burden on taxpayers and make the tax system work better for them. But with IR35, what started as a review of dysfunctional legislation became an exercise to improve efficiency within HMRC - a classic case of bureaucratic capture.
HMRC confirmed that consolidation and specialisation will lead to an increase in the number of IR35 investigations. In their defence HMRC and its Treasury masters would argue that more efficient risk assessments, based partly on the published tests, will mean that only those most likely to be abusing the tax system will be investigated.
John Whiting supported this view: “Consolidation into three teams is constructive: investigations should be undertaken on the same principles and pursued by people who know what the rules are. They will certainly be able to undertake more reviews, but they will be focused on more real reviews: looking into 10 real cases rather than annoying 100 people and ending up with five.”
But the PCG and many AccountingWEB said the business entity tests added to the complexity surrounding IR35 rather than simplifying it. “HMRC appear at this stage to have opted for a risk-averse approach that will not deliver the improvements that are so clearly needed,” complained PCG chief executive Chris Bryce. Ann Swain of APSCo added that several external members of the IR35 Forum were exasperated by HMRC’s reluctance to listen to their advice concerning the new tests.
AccountingWEB member Ringi accepted the principle that HMRC’s tests could help if they put contractors into low risk category. “However I don’t see how they help with most contractors/freelancers as they all mostly still in the grey area… My clients tell me that none of them are offered any assistance by these tests,” he wrote.
The clients in question generally work from home, do not advertise, work without dependence on assistants and so on. “Are they now to be considered more high risk under existing case law than this time last week? Hardly I would say.”
Several of the tests come in for individual hammerings, but FCSA’s representative Martin Hesketh and Dave Chaplin of ContractorCalculator.co.uk felt the entire package was compromised. “The net has been cast so wide that anyone who is providing personal services by a limited company is considered medium or high risk. They could just replace all the tests with one question: Are you a service company? If yes, then you are potentially at risk,” said Chaplin.
The test questions are not based on the most important aspects of IR35 case law, yet seek to draw a conclusion about IR35 risk. And the implication that anyone who isn’t in the low category is at risk of IR35 “is a bit like trying to locate people in Europe by considering anyone who doesn't live in China”, he added.
AccountingWEB member Roland195 came up with this: “I imagine there are all sorts of creative types coming up with business directories that cost £1,201 to list in (and offer surprisingly generous free gifts & other incentives) and we will no doubt hear of 3-bed semis that 500 workers have rented work space in (at the same time) and there will be ‘IR35 Compliant/Proof Business Plans’ that will have HMRC officers experiencing the strangest feelings of deja vu. That's 13 points already and into the medium risk category.”
The bad debt test, meanwhile, perplexed Taxwriter, who wrote: “I can't believe HMRC think you have to have 10% bad debts to demonstrate that you are self-employed. If any of my clients had 10% bad debts I would be sending them back to school or telling them to get a job. 1% seems like a more reasonable figure.”
The debates that took place within the IR35 Forum reportedly got quite heated, and the PCG has complained that some of the tests it put forward were ignored. AccountingWEB member mfwiniberg picked up this theme by asking why some of the following points were not included within the business entity tests:
- supplying goods to your clients at a profit.
- providing your own equipment and running costs to do the work
- working for multiple clients and controlling the hours you work for them
- charging by time worked
- working for clients without a contract verbal or written.
“There is a reason that these are no longer mentioned by HMRC,” answered FrustratedwithHMRC. “This is that HMRC have an irritating habit of losing tribunal hearings and court cases when these things are mentioned…
“While HMRC continues to inhabit its fantasy dream-world of risk profiles and online tests they will continue to lose case after case to those lawyers and tax attorneys whose feet is firmly bedded in the reality of law and legal precedent.”
FrustratedwithHMRC and other critics argue that the business entity tests are based on a fallacy. 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 contarctor and end client (particularly control, substitution and mutuality of obligation).
“These are clearly written by people who have never ever run a service business,” wrote Neil W. “10 points if you rent an office and then this: ‘Does the business have the right to send a substitute? (2 points if yes)’.
“That is and always has been a 100% killer in case law. Employment *requires* personal service. If you can delegate work to anybody you choose then that is the end of the matter.”
The cynical interpretation, to which there are many adherents, is that the legally dubious business entity tests are designed to convince individuals that they fall within IR35 after using what they perceive as official guidance on the subject.
“Are they hoping these documents push taxpayers to correctly appraise and self-assess liability to IR35 and come forward?” asked Andrew Driver. “I suspect like numerous other disclosure opportunities there will be very poor returns in this field. They still seem like they are clutching at straws and until they start winning some tribunal cases enforcing IR35 I don’t think contractors will be too concerned by these announcements.”
The technical debates around the points raised are likely to continue for the next 12 months. But long-term opponents of IR35 are faced with a choice between participating in the pilot process, or stepping up their opposition on the political front.
“Appeasement never works,” argued NeilW. “That the Chancellor has refused to amend the law, and instead has set attack dogs in motion again is entirely the problem. The law is unworkable and needs scrapping. There is far too much ‘striving to make it work’, when the simple and fair solution is to put the risk onto the clients. If you treat your contractors like employees, then that is what you will get.”
Following the pasty tax furore, “granny” tax and botched child benefit changes, the last thing the Chancellor needs is another tax policy embarrassment.
But as NeilW hinted, avoiding income tax and NICs by using intermediary companies is already a political issue because of the controversy over senior civil servants acting as contractors to government departments. Many commentators pointedly asked if HMRC will be assessing these 2,000 people against the published risk ratings.
IR35 won’t get as many headlines as some of the other issues, but the issue does have the potential to hurt the Chancellor while he’s vulnerable. AccountingWEB members pointed out that he has reneged on a campaign promise to shelve IR35 and effectively undermined tax simplification efforts.
The political reality is that IR35 is still with us, so we’ll have to heed those who advise testing the new mechanism and pushing for further improvements when the results are in. But as we go through the process, the Chancellor will be further alienating some of his party’s key supporters: independent contractors and quite a few accountants who work on their behalf.
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