If you fraudulently, negligently or mistakenly fail to pay the tax or National Insurance Contributions that are due then you may be liable not only for the outstanding tax and NIC; but also for interest (currently at 5%) and penalties on the outstanding balances.
IR form IR73 on investigations (see http://www.inlandrevenue.gov.uk/pdfs/ir73.htm) states, in reference to penalties:
"How are the penalties worked out?
The penalty figure will normally be a percentage of the tax underpaid or paid late. In strict law it could be 100% of the tax, but in practice it will always be less in a negotiated settlement. The Inspector starts with 100% of the tax and that figure is reduced by an amount which depends on whether you disclosed all the details of your tax affairs, the extent to which you co-operated over the whole period of the enquiry and the gravity of the offence. The reductions are as follows
· Disclosure - a reduction of up to 20% (or even up to 30% for voluntary disclosure).
If you have made a full and voluntary disclosure before the Inspector challenges you, you will get a considerable reduction of the penalty. If you deny until the last possible moment that there is anything wrong, you will get little or no reduction for disclosure.
Between these two extremes a wide variety of circumstances is possible. The Inspector has to consider how much information you gave, how soon, and how that contributed towards settling the investigation.
· Co-operation - a reduction of up to 40%.
If you supplied information promptly, attended interviews, answered questions honestly and accurately, gave all the relevant facts and paid tax on account when it became possible to estimate the amount due, you will get the maximum reduction for co-operation.
You could get none at all if you put off supplying information, avoided attending interviews, gave untrue answers to questions, did nothing until formal action was taken against you and generally obstructed the course of the investigation.
Between these extremes there is a wide range of possible circumstances and the Inspector has to compare the extent you have co-operated with the co-operation he or she believes possible.
· Gravity - reduction of up to 40%.
Your actions may amount to a premeditated and well organised fraud or something less serious. The Inspector has to take into account what you did, how you did it, how long it went on and the amounts of money involved. The less serious your offence, the bigger the reduction of penalty you can expect.
Penalties and IR35
For most freelancers the main issue is their IR35 status. Hence the Revenue, in recognition of the uncertainty about status under IR35, issued a clarification regarding the application of penalties under IR35.
This Revenue statement (see http://www.inlandrevenue.gov.uk/ir35/penalty.htm), says :
"... if you, in your capacity as employer, act prudently by taking all reasonable steps to understand and ensure that your intermediary service company or partnership meets its obligations under the service company legislation, no penalty will be imposed (my emphasis) should an incorrect return (P35) be submitted."
This statement was first issued in February 2001 and its continued application was confirmed again early in 2002. We have not yet heard if they will re-affirm its application in 2003, nearly three years after the introduction of IR35.
However, it seems clear that, even under the normal treatment of penalties, a freelancer may expect to have any penalties reduced considerably if they have made a genuine attempt to comply with the regulations but have, nevertheless, genuinely reached a different conclusion about their IR35 status from that which the Revenue reach.
Penalties and FO35
FO35 provides freelancers with more than just an insurance policy. It sets out in detail the information a freelancer needs to determine his or her own status under IR35. This starts with looking at the status of each contract. However, it recognises that, for many reasons, it is not always possible to have a contract that is clearly and unequivocally outside IR35. Hence FO35 also provides guidance on the main issues that demonstrate that a freelancer is in business on his or her own account.
More than just guidance, it provides a system for recording and evidencing all the many attributes that go to distinguish a freelancer, in business on his or her own account, from a disguised employee or temporary employee.
Hence, in situations where the contract status may be borderline or even caught by IR35, FO35 enables the freelancer to show that when their overall picture is considered (and tax status case law has clearly shown that tax status must be determined by looking at the overall picture not just the narrow contractual terms) they are in business on their own account.
The whole aim of FO35 is to enable a freelancer to move themselves to a position outside IR35 – not by mere form of words in a contract - but by providing positive evidence of the many aspects of their operations that make them a business. This in turn should ensure that the freelancer can validly claim to have taken all “reasonable steps” to determine their IR35 status. This, by itself, should ensure no penalties but, just to be sure, FO35 has included penalty insurance within its tax enquiry cover. This is a unique feature which is only possible because FO35 provides the necessary risk management to reduce the possibility of penalties ever arising.
Penalties and Route 35
Inevitably, comparison have been drawn between FO35 and PCG’s Route35 product. However, they appear to address very different issues. Route 35 is being marketed as something that will cover any freelancer no matter how weak their IR35 case is. Regardless of whether the freelancer has taken “reasonable steps” Route 35 will support the freelancer’s case up to the Commissioners.
Not surprisingly, however, it does not cover penalties. Looking at the criteria for mitigating penalties, as set out in form IR73, it is perhaps easy to see why.
Using these criteria I think the typical freelancer would qualify for the up to 40% discount for an offence of less gravity - one not involving fraud. But a weak case fought under Route 35 all the way to the Commissioners seems unlikely to qualify for much of a reduction for co-operation and the discount for voluntary disclosure is not likely to apply. So it seems quite possible that a freelancer using Route 35, who deliberately flouts IR35, and does not take reasonable steps to ascertain their position, could end up with penalties of up to 40-50%.
So what exactly do we mean by reasonable steps? In 2001, when I was working with the PCG, I met with John Hinton and the Revenue’s IR35 team at Somerset House and we clarified what the Revenue meant by “reasonable steps”.
They are confirmed that, in their opinion, a taxpayer would not be considered to have been negligent merely because he or she failed to use either the Revenue’s voluntary contract opinion or failed to consult with a legal or tax expert on the application of tax legislation, especially in the area of employment status case law.
However, they would expect the individual to have satisfied himself or herself that IR35 did not apply by considering his/her position in the context of the legislation and the relevant case law. “Reasonable steps” would include the following:
· Familiarising yourself with the relevant legislation. In the case of IR 35 this could include being aware of the main aspects of the legislation (which is available on the Revenue’s IR 35 web site at (http://www.inlandrevenue.gov.uk/ir35/index.htm.) and
· Familiarising yourself with guidance as to the main status tests and issues relating to employed and self employed status. This could include:
o Reading the Revenue’s February 2000 Tax Bulletin: Guidance on the application of employment status rules to workers using intermediaries and the Revenue’s IR 35 FAQ’s (also available on the Revenue’s IR 35 web site http://www.inlandrevenue.gov.uk/ir35/guidance.htm)
o Following the guidance in FO35
o Following the IR35 guidance given on various web sites including Shout99, the PCG or Accounting Web
· Armed with this background you should then consider where you stand with regard to IR 35, looking at both your current contract(s) and your general business and personal circumstances. Again FO35 provides a clear structure for doing this.
· You should then document what your view is of your status and what are the key factors that lead you to this conclusion. This is extremely important, as it may be six years before you are asked by the Inland Revenue to explain why you think you are outside IR35. It is important to note that this "self assessment " approach must be carried out objectively. Again FO35 provides the tools for doing this.
It would not be acceptable just to go through the motions without any realistic attempt to reach an objective conclusion. Mere window dressing will of course be insufficient.
In business on your own account
Obviously demonstrating you are in business on your own account is a key requirement. It creates the overall picture that enables contractors to show that, even where an individual contract may be caught within IR35, their overall picture is that of a real business. This was the factor that enabled the “Charlotte” example in the original Revenue guidance document (see above) to be judged to be outside IR35.
Again FO35 provides guidance as to the many issues a freelancer need to consider and document to provide the necessary evidence. This may include, for example:
· Whether your company is able to work for more than one client at a time?
· Details of any other business activities the company has engaged in. – for example selling systems, creating web sites?
· The steps your company has taken to market itself to potential clients, for example using yellow pages, direct marketing, a company web site etc.
· Whether the company has invested in training or in research and development of new products or services in recent years.
· Whether the company has office facilities and the typical badges of corporate identity like:
o Company stationery?
o Company phone/fax/e mail addresses?
o Company business cards and marketing material?
o Company web site?
· Whether the company is registered for VAT?
· Any corporate registrations such as a company data protection registration?
· Any corporate insurances such employer’s and public liability insurance and, possibly, professional indemnity insurance?
· Whether the company has received any Government grants or loans that are available only to businesses or sole traders and not to employees.
Taking “reasonable steps” is absolutely essential in dealing with IR35. Failure to do so could expose the freelancer to substantial penalties. Any freelancer can take “reasonable steps” but what we have provided in FO35 is a structured system to ensure that the freelancer can demonstrate this, backed up by insurance. If there are any changes in case law or the law itself, which would affect this approach, we will consider them and send out updates as required.
We hope that FO35 will enable freelancers to focus on what they do best –selling their skills and expertise in the marketplace.
To order Freelancers Outside IR35