This article provides a useful overview of the tax legislation known as IR35: what it is, what it means to you as a contractor or client, and what action you should take to avoid heavy financial penalties. By the end you should have a clear understanding of your rights and responsibilities, but should you need it further advice is available from The Contract Doctor at email@example.com
What is IR35?
IR35 has been much discussed since its inception in 2000, but what actually is it?
IR35 is named after the ‘Inland Revenue 35’ leaflet, which announced the change and is contained in the Finance Act 2000. Prior to its introduction, an employee or self-employed worker could set up a limited company, and then provide services to their employer in exactly the same way as before, but with many additional tax and national insurance benefits. This was essentially a legal form of tax evasion, and resulted in millions in lost revenue for the Government.
Was it really that big a deal? Absolutely! An employee could leave work on a Friday, set up a limited company over the weekend, and return to work on Monday as a contractor performing exactly the same job role, sitting in exactly the same seat and reporting to exactly the same management team, and HMRC were powerless to do anything to stop them. Not only does the employer then have no national insurance obligations for that worker but the worker could also withdraw a small salary as a limited company, thereby preventing any (or limited) PAYE from being due, and potentially stopping national insurance contributions altogether. On top of this, dividends, which have another tax-free allowance and a tax rate of only 7%, could be drawn from the company. Add to this corporation tax of 19% and tax-free expenses, and it quickly becomes clear how much the government lost in tax revenue. IR35 gives HMRC the authority to challenge the true relationship between a worker and their employer.
What does this mean for you as a contractor?
It is your responsibility as a contractor to ensure that you do all that you can to ensure you fall outside of IR35. Should you be found to be acting as an employee and therefore be working inside IR35, you risk huge financial loss:
Employees National Insurance
Employers National Insurance
Total National Insurance
Net Income After Tax
Consequences of being inside IR35
At the core of IR35 is the relationship between the employer and the worker. Is the contractor working under a contract for services or a contract of service? As minute as the difference may appear, ramifications of of being found to work under one or the other can be immense. A contract for service, by contrast, is a genuine contract for a contractor who will be performing services for the client. On the other hand, a contract of service is a contract which can be construed as an employment contract and would, therefore, be found to be inside of the IR35 legislation. If the engagement is considered ‘disguised employment’ by HMRC, the contractor may be liable to pay a “deemed employment payment” which is equal to the amount of any tax and national insurance contributions which an employee would have paid throughout that tax year.
What can you do to protect yourself?
Before starting a new contract, or accepting an extension on your current contract, it is therefore essential to review all the terms thoroughly or, ideally, to have your accountant review the contract to ensure it is IR35 compliant. Most accountants offer a free review service, which you should ensue you are utilising. If you do not have an accountant many will offer relatively cheap review services, or you can contact us at The Contract Doctor, and we will be able to assist with your queries.
If you choose to review the agreement yourself be aware that there is no clear definition of what constitutes a contract for services (self-employment) or a contract of service (employed solution). However, the following three elements were identified in the famous ‘Ready Mixed Concrete’ Case from 1968 as being consistent with a contract of service (i.e. being an employee rather than self-employed):
To be a legitimate limited company, there should be the option to provide a substitute to replace a contractor in the role. It is important to remember that the client is contracting with the actual company, not with the individual contractor. Therefore, the company must be able to substitute different contractors even if it only has one employee at the time.
Mutuality of Obligations
The contract should state that the company is under no obligation to accept any work which is offered, and the client should have no obligation to offer or provide any work. It has been argued that this obligation extends to work currently being undertaken, but there are many exceptions to this rule. For example, if a contractor is working on a time-sensitive project within a financial institution, it may be critical that they remain on the project for the entire duration. In this situation, the contract should state that after the project there are no obligations to accept further work, but it should also make it clear that they are an essential part to this project in order to justify the reasons as to why they must remain for the entire duration.
As a contractor, you should have the ability to control how you carry out the work you are being contracted to undertake. In other words, the client should not have the right to exercise control over you. They should not, for instance, impose daily start and end times on you, or dictate when you take your lunch break. The main concern, however, is that they do not micromanage you.
Other factors that the courts have considered when assessing whether a contract falls inside IR35 include, but are not limited to, the following:
Payment at an hourly, weekly or monthly rate is associated with employment, whereas a service company should negotiate a rate for a job, invoice for the work done, and bear the expenses and overheads. It should be remembered that HMRC’s own ‘Schedule E’ Manual states that a self-employed individual can be paid by the hour or day, meaning that this test is inconclusive.
A contractor is responsible for how their business is run. Unlike an employee, they provide their own equipment, hire their own helpers, take a financial risk, are in charge of investment and management, and are able to profit from sound management when carrying out a project. HMRC will therefore look at the risk being taken by the contractor, as it is not usual for an employee to take a financial risk
Provision of Equipment
Equipment and other facilities provided by the service company can be important. An employee will have all of the necessary major items of equipment and facilities provided by their employer. Contractors will generally provide their own equipment.
Where a service company works exclusively for one client, there is a presumption that the contractor providing the services is an employee, as it is usual for a service company to work for more than one client. The important thing here is not that a contractor is actually working for more than one employer, but that they have the option of doing so. It has been stated in a previous tax bulletin that HMRC concedes that ‘long periods working for one client may be typical of an employee but are not conclusive’. Nevertheless, the article does goes on to say that ‘regular working for the same client may indicate that there is a single and continuing contract of employment’.
It is not only the terms of the contract which are scrutinised when determining if there is a contract for service; conduct also plays a vital part in the assessment. Any of the following could lead the courts to rule that, despite a contract being IR35 compliant, the actual role being fulfilled falls inside of the legislation:
- Starting and finishing work at the same time as employees;
- Taking lunch with and sitting with the employees;
- Going on company incentive events; and
- Receiving bonuses.
It is therefore critically important to ensure that your contract for services is wholly compliant with IR35 and so avoid any investigations into conduct whilst on an assignment, as the slightest similarity to employment may be cause for further inspections.
The Future of IR35
From 6th April 2017, contractors in the public sector have no longer been able to self-certify to HMRC that they fall outside of IR35. It is now the duty of the actual public-sector hirer or the agency to establish whether the worker is deemed to be self-employed or working under a contract of service. Due to the level of risk involved in making in this decision, and the often limited knowledge of IR35 rules available to a company, most public-sector bodies will only allow a worker to provide services using a payroll solution. If the agency or public-sector hirer has determined that a worker is a contractor and is subsequently found to be inside of IR35, tax will need to be paid at source and all future income will be charged at a higher employee rate. Strangely, the contractor is not eligible to receive other employment rights such as holiday allowance or sick pay; they simply pay the inside IR35 rate of tax with none of the employment benefits. The risk for private sector contractors is that the same strict rules will soon come into force for them. Rumours of such a change have been circulating for some time, and with other European countries having already implemented stricter rules for contractors it seems sensible to assume the UK will soon be following suite.
HMRC has been accused of pushing for "aggressive" reform of the IR35 rules concerning off-payroll working with Freelance UK even suggesting they are abusing their powers “with certain inspectors pursuing cases without an objective assessment of reasonable prospects of success”. Whilst we cannot predict when any changes will happen, all contractors need to ensure that they understand the basic rules and that all of their contracts are a contract for service as opposed to a perceived employment contract.
In conclusion, it is vital that both contractors and clients are aware of their legal and contractual obligations in the light of IR35, and that they stay abreast of developments.
Sign up to stay on top of the latest articles and blog posts.