IR35 penalties are a fact of life limited company contractors need to be aware of. Contractors working on contracts that they know to be inside IR35 must pay significantly higher tax and National Insurance Contributions (NICs), resulting in a steep reduction in their net earnings.
However, contractors who know their contract is inside IR35 and choose to conceal it, or who are subsequently found inside IR35 following an HMRC inspection, face steep IR35 penalties.
And, although IR35 is being reviewed by the Office of Tax Simplification as part of a wider review of small business taxation, IR35 penalties will still apply to contracts completed while the legislation was in force, whatever the OTS recommends as IR35’s successor.
HMRC’s IR35 penalty regime
A tough new penalty regime was introduced by HMRC in April 2009 that did away with the previous negotiated settlement. In the past, a contractor’s tax adviser could negotiate away much of a contractor’s liability and reduce payments; but the new system introduced the concept that taxpayers must exercise ‘reasonable care’.
IR35 penalties will be levied when a contractor under-declares their tax liability by not calculating their deemed payment of additional tax and NICs as a result of being inside IR35. These penalties will be still be payable whether the contractor introduced the inaccuracy by being careless, by deliberately not calculating the deemed payment when they know they are inside IR35, or by deliberately under-declaring and concealing the facts.
The penalty is 30% of unpaid tax if HMRC considers the contractor to have been careless. But the IR35 penalties are really steep if HMRC believes the underpayment to be deliberate: 70% of unpaid tax if the contractor knew they were inside IR35 but deliberately did not make the deemed payment calculation; and 100% of unpaid tax if the contractor knew they were inside IR35, deliberately did not calculate the deemed payment and attempted to conceal the underpayment.
Deemed payment: an IR35 penalty
Because of IR35’s ‘deemed payment’ rules, contractors can pay up to 25% more tax and NICs if they are found to be a disguised employee and their contract is inside IR35.The rules allow a 5% allowance for expenses and then the rest of a contractor’s gross earnings for the contract inside IR35 are subject to income tax and NICs, seriously penalising those contractors affected.
IR35 penalties will be levied when a contractor under-declares their tax liability by not calculating their deemed payment of additional tax and NICs as a result of being inside IR35
However, the extra tax calculated under the deemed payment is considerably less than not declaring IR35 status and then being caught inside IR35 by HMRC. Contractors can use Contractor Calculator’s IR35 Calculator to work out how much being caught within IR35 could cost them.
A duty to take ‘reasonable care’
The IR35 penalty regime also requires taxpayers to exercise reasonable care. According to HMRC’s guidance, “’Reasonable care’ varies according to the person, their circumstances and their abilities. But we expect everyone to make and keep sufficient records for them to provide a complete and accurate return.”
Crucially for contractors, HMRC goes on to say that to demonstrate reasonable care, a taxpayer should check “the correct position when you don’t understand something”. This suggests that contractors who choose to undergo an IR35 contract review for each assignment could be demonstrating reasonable care.
IR35 penalties can be costly, time consuming and stressful for contractors, particularly if the case is taken to a tax tribunal and the courts, so implementing best practice to avoid IR35 should result in contractors remaining firmly outside the scope of the legislation.