IR35 compliance letters – contractor guidance on how to respond

Contractors receiving a IR35 compliance letter from HMRC should seek professional assistance and respond promptly. IR35 processes used by HMRC means going it alone is a high-risk strategy, and could result in a simple status enquiry escalating into a full blown HMRC IR35 review.

IR35 reviews are now directed and guided by experts from one of HMRC’s dedicated, specialist compliance teams. These factors make it even more important that contractors don’t try to deal with their compliance letters alone.

IR35 compliance letter format

Letters from HMRC initiating IR35 reviews of one person limited companies used to be thinly disguised, by stating the primary purpose was an employer’s Pay As You Earn (PAYE) compliance review or, on rare occasions, a corporation tax investigation.

But that’s no longer the case, and the letter sent to clients follow a common theme, making it more obvious what HMRC is looking for. HMRC will confirm that its interest is not in corporation tax or PAYE and will typically ask for three items. These are:

1. Documents and spreadsheets that provide a breakdown of the gross income for a specific accounting period. HMRC usually focuses on a particular financial year, which it requires to be supplied within 30 days
2. Copies of contracts that give rise to the income breakdowns requested in item 1. This means HMRC want to see all of the contractor’s contracts for the financial year under review, also to be supplied within 30 days
3. Finally, HMRC will ask an IR35-specific question, which will be a variation on: Please can you tell us whether you have considered the possibility of your contracts being subject to IR35? If you believe that IR35 has not applied in the year in question, please explain the basis of how you arrived at these conclusions.

Clearly it is the final question that is key, but it does potentially allow a contractor to close down an investigation before it gains momentum, if an expertly prepared dossier is promptly despatched in response.

How not to respond to HMRC enquiries

Contractors who try to go it alone manage to dig themselves into costly IR35 holes. Here are some examples of contractor ‘bloopers’ and important ‘don’ts’:

• Supplying too much information: where contractors have chosen to ‘carpet bomb’ HMRC with documents, which have included organisation charts and internal telephone directories not identifying the individual as a contractor, and generic internal rules and regulations which did not apply to contractors, but were not explained properly, and therefore led HMRC to conclude that they do apply to the contractor
• “I’m doing pretty much the same job now as I was when I was previously employed by my client”: Yes, a contractor really said this to an HMRC inspector, suggesting that the contractor did not actually leave their job but incorporated for tax avoidance purposes
• “Before I got the job, I had to submit my CV and attend a job interview”: HMRC will seize on employment-like terminology, which should be avoided
• “My contractors are just bums on seats”: The inspector was told by the contractor’s project manager that the contractors were no different from employees. After expert intervention the client retracted the statement. Get the client onside and on message from the outset is the lesson from this example
• “I’m so expert it’s unlikely that the client could replace me”: A contractor proudly told HMRC that he was irreplaceable, as no one else had his level of expertise, so substitution was impossible. The case hinged on personal service so the response was to track down the 25 contractors in the UK similarly qualified and so prove that, in principle, a right of substitution was possible
• “If I complete the project ahead of schedule, my client finds me something to do until the contract period is over”: This statement implies there is a mutuality of Obligation (MOO) between the contractor and the client, which is a strong indicator of employment and IR35
• “I guess my line manager tells me what to do during office hours of 9-5, Monday to Friday”: It needed to be ensured that HMRC recorded that the contractor’s work was overseen by a project manager and that the contractor had flexibility over when the work could be completed, not that the contractor was controlled by a manager during office hours, as the recorded statement implied
• Agreeing to a meeting: HMRC likes meetings because it is easier to catch out contractors. They typically record contractors using employment terminology and revealing more information than is legally required. Taxpayers are not obliged to attend meetings and can conduct an entire investigation via correspondence, and preferably via their professional adviser
• Taking calls: Experienced HMRC inspectors are effective at coaxing contractors to describe their situation, such as working arrangements, in employment terms. Contractors do not have to deal direct with HMRC over the telephone; they can conduct their case via correspondence or their professional adviser
• Signing meeting notes: On rare occasions, with a confident and savvy contractor has a strong case, a meeting can be agreed because there is the potential to close down an investigation quickly. But it is advisable against signing the notes about the meeting which HMRC will prepare, because this may prejudice a future defence if the investigation escalates.

Contractors should not try and respond directly to HMRC: Despite the new processes, HMRC still uses the same tactics designed to ensnare contractors. A professional adviser not only ensures that the correct, non-employment, terminology is used, but also protects a contractor’s rights as a taxpayer.

Preparing a formal response to an IR35 compliance letter

Having been contacted by a contractor in receipt of an IR35 compliance letter, the advisor should implement the following steps:

1. Assembles and reviews the contracts under investigation by HMRC
2. Extracts the information about actual working practices from the contractor, and possibly their client
3. Creates a dossier providing evidence that the contractor is outside IR35.

The dossier assembled to send to HMRC for contractors will include the documentary evidence that focuses on the requirements of the IR35 legislation. It will detail all of the positive pointers, which is why it is so important for contractors to adopt IR35 best practice at all times, and at every stage of each contract.

HMRC’s next steps after receiving an ‘at risk’ contractor’s response

HMRC’s next steps will very much depend on the strength of the evidence supplied by the contractors: If the contractor has strong evidence that other employment status factors put them outside IR35, then HMRC should accept the evidence and halt the review.

However, contractors unable to provide convincing evidence are likely to be subject to a full-blown IR35 review. HMRC’s next step in this scenario is to contact the client, and to request a client’s contact name and address from the contractor.

HMRC will assemble a list of questions for the client, which they may share with the contractor if they or their IR35 adviser requests it.

Get the client onside at an early stage

Ideally, the contractor will have got their client onside from the moment they first received the compliance letter, explaining that they are under investigation and asking if the client would allow the contractor’s IR35 adviser to make contact.

Clients are not obliged to attend a meeting with HMRC, although communications from HMRC neglect to mention this fact when requesting one. If the client confirms the evidence that the contractor is outside IR35, then HMRC should halt the investigation.

But, clients can also be the cause of the initial investigation escalating into a full blown IR35 review.

The key to contractors succeeding in this new regime is to respond promptly and with professional assistance. The vast majority of genuine contractors will then find that their professional adviser will close down the review before it gets off the ground.