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Hi Olga
To be clear these comments are made from my personal experience as a contractor (and Director of a Ltd company) and do not relate to my qualifications or membership through ICB. IR35 is something I have had to deal with for the last 7 years!!  It is all about whether you are doing business on your own account....
The self employed status does depend very much on what your friend does and how he carries out his business. For example a plumber who gets most of their jobs from a single builder but does all their work at a fixed price (however long it takes), provides all the tools and materials, has control over when and how the work is done and has to make good any work that is faulty or not satisfactory at their own expense would normally be considered self employed by HMRC. (Although there may be other implications e.g. CIS but I am not discussing that here...). If they turn up each day and are told what they should do for a fixed payment each week / month and are still paid if there is no work for them to do they would probably be seen as a disguised employee by HMRC and not self employed.
If the example was for an office type service (e.g. computer programmer, business consultant) things are a little more "blurred". Here the contract would normally be for a specific period and the work to be done would be detailed. However normally in an office environment there are core hours to work, you have to use the clients equipment and computer system for security reasons and may use facilities that are provided for staff. From an HMRC perspective these roles are more likely to be deemed inside IR35 (treat status as an employee and not as self employed), particularly if the contract(s) duration is for two years or more and there is only one main client. For personal service companies I would always recommend the contract is reviewed by a professional and they will confirm whether they believe the contract would be deemed self employed by HMRC, there are lots of things to look for and I have only listed some of them here.
I would suggest your friend does the HMRC test (or contacts a specialist) to determine his status and then you will be able to clarify how to treat mileage and other expenses.
As long as income is treated as it should be for tax purposes, either as self employed or deemed employment, there is no issue. If you do 3 contracts in a year, one is deemed to be not self employed and the other two are you just make sure you pay the appropriate tax and NI for the two different types of income and of course do the bookkeeping correctly!
I would also agree with the other comments - your friend should ask for receipts on purchases and provide a receipt where an invoice has not been issued for work done. As long as the income has been documented then there is no reason to believe there is any wrong doing intended. Cash in hand jobs that there is no intention to declare, this should start alarm bells ringing! Tax avoidance is legal, it is the tax evasion which we should be worried about as it is illegal and should be reported whenever suspected!
Sorry for the long post folks!!!
Karen
Edited at 10 Aug 2011 10:23 AM GMT
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