Updated The UK government's own employment checker tool and guidance has led to wrong calls on the tax status of freelance workers, costing £120m across two Whitehall departments.

According to recently published financial reports, the [1]Ministry of Justice and the Department for [2]Environment, Food and Rural Affairs [PDF] are facing combined additional tax bills of at least £121m due to incorrectly determining the status of their contractors, despite following Her Majesty's Revenue & Customs' "accompanying guidance" and using HMRC's Check Employment Status for Tax (CEST) tool.

What is IR35?

IR35 is a reform unveiled in 1999 by the UK tax authorities. The latest regulation change – which came into force in April 2021 – forces medium and large businesses in the UK to set the tax status of their contractors and freelancers. Previously this was set by the contractors themselves.

Contractors found to be within the scope of the legislation – i.e. inside IR35 – will have to pay more tax than they might expect.

The reforms are part of the government's crackdown on so-called disguised employment, where workers behave as employees but avoid paying regular income tax and national income contributions by billing for their services through personal service companies (PSCs), which are taxed at lower corporate rates.

The measure came into effect in the public sector in 2017. The British government hoped the reforms would recoup £440m by bringing 20,000 contractors in line.

HMRC reckons that only one in 10 contractors in the private sector who should be paying tax under the current rules are doing so correctly. It estimates the reforms will recoup £1.2bn a year by 2023.

The Ministry of Justice (MoJ) owes £72.1m and the Department For Environment, Food & Rural Affairs (Defra) owes £48m.

The government introduced changes to the IR35 rules that came into force in April 2021 and made large and medium-sized businesses responsible for determining the employment status of contractors for tax purposes, rather than the contractors themselves (see box). For the public sector, it has been in place since 2017. The use of the tax rules has been widespread among IT contractors across the economy.

After reviewing Defra and the MoJ's accounts, Dave Chaplin, CEO of tax advisory firm IR35 Shield, said: "Both Defra and the Ministry of Justice would have received considerable help and guidance by HMRC to implement the off-payroll reforms. Both committed to using HMRC's CEST tool and followed HMRC's guidance. This is a farcical and alarming situation."

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Meanwhile, HMRC found that the MoJ had been "careless" in its application of the off-payroll working rules. "As a result, it imposed a penalty of £15 million. That penalty has been suspended for three months subject to certain conditions and is therefore not included within the losses total," the MoJ accounts said.

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Chaplin said: "HMRC provided the advice and guidance and populated the minds of those conducting the assessments, yet HMRC is now claiming its 'customers' are effectively negligent. It's like the police training people how to drive properly, then fining all the trainees for reckless driving when they get out on the road."

[6]IPSE: More than a third of freelancers have quit contracting since IR35 reforms

[7]Another UK government limb that can't get IR35 right: Court service pays taxman £12.5m

[8]Tech contractor loses IR35 tribunal appeal: 'Right' to substitute didn't mean he could, say judges

[9]It's the UK contractor tax factor: IR35 outsiders gaining leverage in skills market, survey finds

"Surely, the time has come for HMRC to finally now acknowledge that CEST is not accurate and is not fit for purpose."

In August [10]Her Majesty's Courts & Tribunal Service owed the UK tax collector £12.5m due to incorrect assessments regarding the employment status of contractors under IR35 rules.

Its annual report said the payments were a result of a challenge from HMRC to the Ministry of Justice's handling of IR35 between 6 April 2017 and 5 April 2020, which had concluded workers were operating outside of the off-payroll working rules.

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Meanwhile, the IR35 rules have been driving contractors to join the permanent workforce. In October a survey by the Association of Independent Professionals (IPSE) revealed [12]more than a third (35 per cent) of contractors in the UK have become permanent employees, retired, shifted to work overseas or are "simply not working" since the tax legislation was revised.

HMRC has been contacted for comment. ®

Updated to add at 1625 UTC:

An HMRC spokesperson said: "HMRC will stand by CEST's results provided accurate and correct information is used, in accordance with our guidance. The tool was rigorously tested against case law and settled cases by officials and external experts."

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[1] https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/1041825/moj-annual-report-and-accounts-2020-21-accessible-version.pdf

[2] https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/1037320/defra-year-end-accounts-2020-2021.pdf

[3] https://pubads.g.doubleclick.net/gampad/jump?co=1&iu=/6978/reg_offbeat/legal&sz=300x50%7C300x100%7C300x250%7C300x251%7C300x252%7C300x600%7C300x601&tile=2&c=2YcIIQ9bBsULlrX4OMukIdAAAANU&t=ct%3Dns%26unitnum%3D2%26raptor%3Dcondor%26pos%3Dtop%26test%3D0

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[6] https://www.theregister.com/2021/10/22/ipse_more_than_a_third/

[7] https://www.theregister.com/2021/08/23/uk_court_service_ir35/

[8] https://www.theregister.com/2021/06/15/techie_robert_lee_loses_ir35_tribunal_appeal_to_hmrc/

[9] https://www.theregister.com/2021/06/02/ir35_outsiders_getting_leverage_in/

[10] https://www.theregister.com/2021/08/23/uk_court_service_ir35/

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[12] https://www.theregister.com/2021/10/22/ipse_more_than_a_third/

[13] https://whitepapers.theregister.com/