It is a well-known fact that being inside IR35 leads to higher income tax and National Insurance contributions. However, there’s something that’s worse. If contractors are aware of being inside IR35 and yet decide to hide it, or if contractors are found inside IR35 as a result of an investigation from Her Majesty’s Revenues and Customs (HMRC) investigation, they may have to pay penalties in addition to taxes. In this article, we understand the IR35 penalties in detail using the example of Tim, a fictitious contractor.
In April 2009, HMRC introduced some stringent penalties for non-payment of taxes as opposed to the earlier method where settlements were negotiated. Earlier, tax advisors of contractors could negotiate a contractor’s tax liability and minimize their payments.
Her Majesty’s Revenues and Customs is allowed to charge a penalty to a taxpayer for any inaccuracies in the tax return or other tax document, which has resulted in a taxpayer paying less tax than what is due.
All penalties charged by the HMRC are calculated as a percentage of the unpaid taxes. The percentages for calculation of penalties vary depending on the reason for inaccuracy.
In the context of IR35, if Tim knows he is inside IR35, and yet does not fully declare the tax liability due from him, he will be subjected to penalties. The penalties are applicable in various scenarios as listed below.
The penalty is different for all the three scenarios.
Let’s try and understand the penalty calculations with an example.
Example 1: Tim works for 40 hours a week for 48 weeks in a year. His hourly rate is £30, which results in an annual income of £57,600. Tim pays himself an annual salary of £8,000, and he has annual business expenses of £12,000.
As most of us are aware, being inside IR35 results in a higher tax liability as opposed to being outside IR35.
Assuming there’s no VAT, with the same income Tim’s take-home pay inside IR35 is £38,148.21, and the take-home pay outside IR35 is £50,070.50. For any of the three reasons mentioned above, Tim declares his tax payable to the HMRC as per outside IR35 calculations. As a result, Tim is paying £11,922.29 (£50,070.50 - £38,148.21) less because of incorrect tax calculations.
Let’s look at the penalty from the three different scenarios:
If Tim takes reasonable care in filing his tax returns and files the returns on time, he will not have to pay a penalty even if he makes some errors. Also, if the penalty for failing to take reasonable care, HMRC can suspend the penalty for up to 2 years to allow Tim to make the necessary changes to the documents. Once the necessary changes are completed, HMRC may even cancel the penalty at its discretion.
How can a contractor take reasonable care?
As a Limited Company contractor, Tim needs to take the following steps to demonstrate reasonable care.
As you can see, if a contractor is inside IR35 and avoids the tax due, it can lead to serious financial implications. Contractors should avoid such a scenario at all costs and take reasonable care as mentioned above.
As a first step, you should determine whether you are inside IR35, to eliminate any risk of penalty due to carelessness. You can calculate your IR35 risk by using our Business Entity Tests calculator. At the end of the test, you will get your IR35 risk score in a graphical, and easy-to-read format.
If the tests show you as being inside IR35, use our IR35 calculator to calculate your take-home pay and tax payable. If inside IR35, it is best to pay the applicable taxes to avoid any penalties from HMRC.
If you are a contractor / freelancer and you are looking to find the right, compliant and tax effective accounting solution then either request a callback on contact us on 0203 137 9246. Avoiding tax penalties is just one of the advantages of using our accounting and payroll services