Why IR35 is disastrous for SMEs, taxpayer value and UK tech leadership

A policy change in response to IR35 has effectively banned SMEs from working with government, says Romy Hughes.

In the run up to 6^th April 2022, our company was facing a financial cliff edge: one of our longest-standing clients (a well-known government agency) had instigated a blanket ban on working with SMEs due to their fear of IR35 enforcement action by HMRC. This effectively meant they were unable to approve budgets for FY22/23 with any SMEs in their supply chain, despite these companies already being engaged in extensive, multi-year digital transformation activities.

The client themselves did not want to terminate these contracts; it knew our business was comfortably and categorically outside of IR35, and the sudden termination of these projects would have been disastrous for both the organisation and its broader transformation ambitions. The whole scenario made no sense to anyone, but was being promoted from those further up the chain due to fears of making an error in their IR35 determinations.

This was not an isolated incident, but a broader issue affecting many other public sector organisations and the professionals that work in them. It was an unofficial change of government policy, with significant ramifications for the sector and everyone it served (i.e., every taxpayer and recipient of public services).

Thankfully, for our sakes and that of our customer, they were able to secure an exception for us so that our critical projects could continue into the new financial year. But we count ourselves as the lucky ones: many weren't so fortunate. We were lucky enough to have a pre-existing relationship with a customer who was willing to fight for us, but the policy of banning small firms out of IR35 fears leaves no room for new SMEs to engage with the public sector in the future.

The background

As a recap, IR35 legislation was first introduced to tackle the issue of tax avoidance within the limited company contractor community. Initially, it was the responsibility of contractors themselves to determine whether they sat inside or outside of IR35, and would therefore be taxed as employees (in IR35) or off-payroll workers (outside of IR35).

More recently however, the legislation changed so that the responsibility for IR35 determination now lies with the organisation receiving the services of the contractor, rather than the contractor themselves. This meant that the organisation was now responsible for any taxes that should have been paid by their contractors if they were later deemed to have been operating within IR35. This change has already been very costly to some, with The Home Office, Ministry of Justice and Defra all having been hit with a combined tax bill for IR35 non-compliance totalling nearly £200 million in the last year alone.

A costly move for everyone

This new (and unofficial) policy change from April 2022 effectively places a blanket ban on SMEs working with the public sector, and I believe it is the direct result of HMRC's recent aggressive enforcement action. Organisations have responded with an over-cautious approach whereby it is simpler to just assume every supplier sits within IR35 instead of taking the risk of making an incorrect assessment.

The impact of this policy is that it forces government organisations to obtain the same services (and sometimes even the same staff) via the significantly more expensive Primes, potentially doubling their costs for the same outcome, in addition to the risk of existing projects failing due to the abrupt loss of service when the supplier is swapped out halfway through. Who knows how many projects were unceremoniously stopped on the 6^th April 2022 because of this policy.

There are many broader implications to this policy that need to be called out:

• Forcing SMEs out of the public sector is in direct conflict with the Department for Trade & Industry's SME strategy to make procurement easier for SMEs. The Government continually says it wants to work with more SMEs, and has introduced various frameworks to do this. This policy achieves the complete opposite.
• At a time when inflation is going through the roof, the public sector is willingly increasing its own costs in a way that is totally avoidable, unnecessary and disproportionate to the risk they are looking to avoid. They are willing to pay significantly more to eliminate the risk of a fine, even if that risk is minuscule.
• IR35 leads to a net increase in costs for everyone. It might net the Government approximately 6% more tax revenue,but all of this - and more - is offset by the additional costs borne on organisations to make their IR35 assessments, and for suppliers in turn to prove their compliance (which are often passed back to the customer).
• Digital transformation is a major priority for the Government. In fact, its new digital strategy with its new 'ambitious statement of intent' was launched just this month. Has the Government forgotten that SMEs play the largest part in the delivery of this strategy through the innovation they bring? This new IR35 policy will kill these projects and put the UK behind in this critical growth area.
• The effect is now spilling over to the private sector too: HMRC's pledge to take a 'light touch' approach to IR35 enforcement has now ended, causing many private companies to be just as cautious and ban SMEs from their supply chain in just the same way. This contagion affect must be stopped.

Why am I speaking out?

While I'm not the first person to be critical of IR35, I know that many more companies are a victim of this particular policy who may not be speaking out. Many SMEs will now be prevented from getting their foot through the door for the first time, and may be none-the-wiser as to the reason. It needs to be called out.

This policy will hamper the UK's digital transformation ambitions and digital leadership. As a supplier we have had to look at changing our business model in response. We use a lot of associates today due to the specialist skills required for our projects, and we have had to consider whether to bring these associates into employment. This is very difficult for us because public sector budgets are often only awarded on a quarter-by-quarter basis. It puts a huge financial burden and risk on an SME like ours.

For the sake of the UK's SMEs, our digital leadership as a country, and taxpayer value, I urge HMRC to consider the broader impact that its enforcement action is having. I also urge the public sector at large to commission a broad review into the overall value and impact of IR35 as a policy and to assess whether it's meeting its stated objectives. If it's not, no options should be off the table as to its future.

Romy Hughes is director of Brightman.