Investigation into the IR35 reforms launched by the National Audit Office (NAO)

Understanding the directors loan account. Directors current account
Written by Phil Ainley
Last updated February 22, 2022

A recent report by the National Audit Office (NAO) has stated that Her Majesty’s Revenue and Customs (HMRC) faces new challenges in implementing the IR35 regime more broadly in 2022 and beyond.

The investigation set out to cover how HMRC introduced the IR35 reforms in 2017, the approach it has taken since then to improve compliance, and the lessons HMRC has learned from the public sector and applied to its roll-out of the IR35 reforms to the private sector and the third sector (1).


Why was IR35 introduced?

The off-payroll working legislation, more widely known as IR35, was first introduced in 2000 as a way of preventing tax avoidance by so-called ‘disguised employees’. A ‘disguised employee’ is one who does the same job, in the same way, as an employee but who avoids tax and national insurance contributions by providing their services through an intermediary, such as their own limited company, also known as a personal service company (PSC).


IR35 in the public sector

In April 2017, the reform was rolled-out to the public sector, making public bodies responsible for determining the employment status of the employees hired via intermediaries. This was introduced to tackle a high level of non-compliance which HMRC estimated cost the exchequer £440 million in 2016/17. The government introduced the reforms after previous changes between 2007 and 2015 had proved to be unsuccessful in improving compliance with the rules. For example, in May 2016 HMRC estimated that only 10% of PSCs were applying the IR35 rules correctly (2).

On the back of the perceived success of IR35 in the public sector, the reforms were later introduced to the private sector and the third sector in 2021 after a 12-month delay to the original date due to the Coronavirus pandemic (1).


Public sector as a failed IR35 test-bed

HMRC published its guidance for the public sector in February 2017, less than two months before the roll-out of the reform in April 2017. HMRC’s key tool for helping public sector bodies comply with the reforms, Check Employment Status for Tax (CEST), was only launched in March 2017. Bearing in mind the reform became live on April 6th 2017, this gave the public sector very little time to get to grips with, and fully understand the reform and how CEST worked.

As a result, HMRC’s own research in 2018 found that nearly half of all the bodies surveyed found the reforms difficult to comply with, with CEST being cited as one of the most common reasons for the difficulties (1).

HMRC launched an updated version of the CEST tool in 2019 which changed some of the features that users had said were causing them difficulty. Technical guidance was also updated and HMRC also began working more collaboratively with public bodies and other stakeholders, such as central government’s Tax Centre of Excellence.

Despite the reforms and the updated version of CEST and the improved collaboration, government public sector bodies still made errors that cost them dearly in IR35-related tax bills. The Department for Work & Pensions (DWP) was hit with a huge £87.9 million tax bill for historic errors in the way it assessed the IR35 status of contractors, while the Ministry of Justice and the Home Office have also been hit recently with hefty IR35 tax bills.

Two key points that we highlight about CEST from the investigation report summary

  1. “Users found some questions in CEST difficult to interpret correctly. For example, the tool asked whether the hiring manager would “ever reject” a substitute of equivalent skill and security clearance. If they answered that they would always accept such a substitute and also that the worker had to pay the substitute, CEST determined that the worker was self-employed. However, if the recruiting organisation always had a right to reject any substitute, they should not have answered that they would always accept one even if they would in practice.” (2)
  2. “CEST is not designed to produce a clear outcome in all cases as some are too marginal for a tool to determine. HMRC estimates that, between March 2017 and October 2019, the tool delivered an ‘unable to determine’ outcome in 15% of cases. Since the tool was updated in 2019, this has risen to 20%.” (2)

Surely these two findings should have been enough to review and overhaul CEST as a tool to improve its accuracy, efficiency of use and its effectiveness?


Scope of the National Audit Office’s investigation

The NAO’s investigation covered five key points:

  • The new IR35 requirements for public sector bodies from 2017;
  • What HMRC did to mitigate risks regarding compliance, public sector bodies and workers, guidance and support, monitoring and adaptation;
  • What impact IR35 had on the public sector;
  • How HMRC assesses public sector bodies’ IR35 compliance;
  • And how HMRC had adapted its IR35 implementation based on lessons learned from the experience of the public sector.

NB: The investigation did not look for value for money, nor did it look to evaluate the design or policy intent of the reforms or the processed applied by public sector bodies.


What was the impact of implementing the IR35 reforms?

HMRC estimated that in the first two years of the IR35 roll-out more than 50,000 additional individuals were added to the payroll of public sector bodies having previously provided services, and paid less tax, through a PSC.

HMRC estimated that is equated to an additional £500 million of income tax and NICs collected in the first year. This was later estimated to be a net increase in tax revenue of £250 million, after taking into account the tax those PSCs would have paid (£150 million more than HMRC had originally expected) (2).

To caveat this, it is unclear how many workers were incorrectly determined as employees for tax purposes as the public sector bodies feared getting it wrong.

Also, many workers disputed their status determination but did not have a clear route to appeal. Following the reforms, workers can raise a dispute with the organisation that determined their status. Previously this was not the case as the PSC determined its own status so would have no reason to dispute the status determination (2).

One of the key negative impacts of the IR35 reforms has been the increasing difficulty of finding contractors, which includes rises in fee rates as contractors do what they can to maintain their lifestyles and income, while also (one suspects) identifying and taking advantage of a supply and demand issue in the market.

“HMRC’s 2018 research found that 32% of bodies operating centralised payroll and 22% of bodies operating their own payroll reported increased difficulty in filling contractor vacancies after the reform. Public bodies we interviewed and surveyed provided examples of difficulties finding contractors and rates increasing, particularly in sectors where specialist skills are in demand.” (2)

While IR35 was considered to blame in part for the difficulty in finding contractors, it was acknowledged that Covid-19 and the UK’s exit from the European Union (EU) were also partly to blame. Another reason cited was that the private sector was still IR35-free, so contractors were more likely to engage a private sector company than a public sector body.


Problems with public sector compliance results in large HMRC tax penalties

As mentioned earlier in this article, government departments’ difficulties in understanding and complying with the IR35 reforms has resulted in errors and hefty financial penalties from HMRC, including losses recently coming to light for:

  • Department for Work & Pensions – £87.9 million
  • Ministry of Justice group – £72.0 million
  • Home Office – £29.5 million
  • Department for Environment, Food & Rural Affairs – £19.0 million
  • NHS England – £4.2 million
  • Three government bodies yet to be confirmed – £50 million
  • NHS Dental – £4.3 million

A total of £266.9 million so far (2).

In all the cases of non-compliance, HMRC found that ‘reasonable care’ had not been taken by the public sector body to prevent errors. The most common errors made by the public sector bodies were wrongly considering they would always accept a substitute when they had the right to reject the substitute, and overestimating the extent of the financial risk that the contractors bore.


HMRC claiming more tax than is due and putting the onus on the contractor to claim money back

One point that stood out from the NAO’s investigation report was that to calculate historic taxes that departments owe, HMRC estimates the amount that should have been paid at the time based on the workers’ deemed wages. This approach assumes that all workers have fully used their tax-free personal allowance on income earned elsewhere. HMRC then collects the tax due based on the law in force at that time.

It does not offset the total amount against tax the worker or their PSC has already paid, citing that offsetting was not allowed within the current legislation. This means that HMRC collects more tax than is actually due, with the worker then having to claim back the tax that they and their PSC have already paid.

An issue with this system is that if the worker does claim back the tax they or their PSC have already paid, then they effectively pay no tax on that income because the taxes are borne in full by the non-compliant public sector body (2).


Lessons learned

HMRC appears to have gradually learned some lessons from the public sector IR35 reforms when extending the reforms to the private sector and third sector by addressing some of the difficulties and providing more support.

Questions are still being raised about the system for addressing incorrect status determinations in terms of untested routes of appeal. Plus the tax burdens in cases of non-compliance likely falling on employers to cover is causing concern among the private sector.

Larger and more complex labour markets in the private sector also provide HMRC with risks that make it harder to identify, monitor and address non-compliance. These risks are key and will need to be closely managed if HMRC is to ensure the IR35 reforms are successful in the private and third sectors.

According to the investigation report, key points HMRC learned from and applied when implementing IR35 for the private sector include:

  • HMRC setting up a dedicated programme team to actively manage the changes… it did not do this in 2017 for the public sector IR35 roll-out.
  • HMRC continued to improve its guidance, focusing on more educational activities to help raise awareness and understanding of the reforms.
  • Allowing the private sector a one-year grace period during which companies will not have to pay penalties for mistakes unless HMRC finds evidence that the non-compliance is deliberate.
  • HMRC also introduced changes to address aspects of the 2017 reforms that were not working as intended, including:
  1. a) Measures to mitigate alternative arrangements used to work around the IR35 rules, such as multiple workers each with a small stake in the same jointly owned company.
  2. b) A more formal process by which recruiter were required to communicate status determinations to workers to resolve disputes.


Cost to employers underestimated by HMRC

When implementing private sector IR35, HMRC thought administration costs would be relatively small. This idea was based on what HMRC considered to be the minimum effort required for compliance. HMRC did not take into account the need to use external consultants or assessment tools.

HMRC also thought that resource requirement within organisations would dimmish over time, probably due to getting used to the new reforms and internal company process become more efficient. However, good practice from the public sector has emerged suggesting that investment could be required in contracting organisations to set up dedicated staff, independent reviews and formal approval at senior levels.

Public sector bodies that were interviewed for the investigation explained that a lot of administration time had to be put in by staff to maintain ongoing compliance. Similar commitment by companies in the private sector would incur significant costs, which could result in those costs being passed on to a) customers, and b) the contractors engaged by private sector companies.


Improvements could be better

When interviewed, many public sector bodies found the improvements to the CEST tool and guidance welcome, but said they could go further. Opportunities to refine the guidance and the CEST tool include making the tool easier to use accurately (making relevant parts of the guidance more accessible within each question), ensuring the CEST questions genuinely relate to the role assessed, and providing more clarity on what good implementation of IR35 actually looks like.


New challenges and risks posed by the private and third sectors

Despite the lessons learned from the public sector IR35 reforms, stakeholders have identified some key challenges posed by the private sector:

  • Labour markets in the private sector and third sector are much larger than the public sector. It is estimated that 180,000 PSCs will be affected by the 2021 IR35 reforms, almost four times that of the public sector in 2017. This creates a bigger challenge for HMRC when it comes to identifying and monitoring non-compliance.
  • Complex supply chains, including those that cross international borders and involve overseas workers can complicate matters when it comes to companies correctly determining tax status.
  • Uncertainty surrounding HMRC’s approach to non-compliance in the private sector due to its assessments and penalties having not being thoroughly tested yet. So far it has only found central government bodies to be non-compliant, none of which have challenged the non-compliance in court, so there is no case-law to work from (2).



The National Audit Office’s summary was that the 2017 reforms in the public sector have achieved their aim of reducing non-compliance and increasing tax revenue, while also providing a test-bed to iron-out any issue prior to the launch of IR35 to the private and third sectors. However, due to the lack of understanding and guidance and the difficulties caused by the original CEST tool, mistakes were bound to be made, some of which have proven to be very costly indeed.

Despite learning many lessons and implementing changes based on those lessons, HMRC faces new challenges that will likely see more lessons needing to be learnt and further improvements to ensure the reforms are successful and a high level of compliance is maintained.


Opportunities and recommendations

The NAO highlighted opportunities for HMRC to further improve the customer experience and compliance…

  1. Further develop the CEST tool and guidance to make it easier to use accurately.
  2. Assess the usefulness of CEST to different sectors, because the current questions weightings are not relevant for all roles and sectors.
  3. Help organisations get determinations and tax deductions correct first time and set out case examples to follow that show good implementation, all of which will improve compliance.
  4. Help all parties understand the scale of activity needed to achieve compliance by updating its estimate of compliance costs to hiring organisations.
  5. Develop a more effective system for collecting total taxes due from workers and organisations when errors have been made.
  6. Enable more constructive discussions to pre-empt challenges across all sectors (2).

You can download and read the full investigation report here or download and read a summary of the investigation report here.




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Understanding the directors loan account. Directors current account
Written by Phil Ainley
Last updated February 22, 2022

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