Dear Contractor Doctor
When I started contracting last year, I was new to the complexities of IR35. Having read up on the subject on Contractor Calculator I realise that IR35 might apply to my contract.
My client is based outside the UK and unaware of IR35. They drew up a short contract that does not include any substitution clauses but has a two-month notice period on both sides. I have had my written contract assessed and the verdict was that it would probably fail an IR35 review, mostly due to these two factors. However, based on what I have been reading, I’m sure my working practices put me outside.
My written contract therefore puts me inside IR35 but my working practices put me outside – which is correct?
Contractor Doctor says:
Although it is not ideal for a contractor to have an IR35 unfriendly contract, the underpinning legal principles on which the IR35 legislation is applied mean that working practices take precedence over a written contract.
The contract may be missing key IR35 friendly terms, such as a substitution clause, but IR35 case history – like the Datagate Services case – shows that a contractor can still win an IR35 case against HMRC with an IR35 unfriendly contract.
However, the challenge is to collect and present the evidence that working practices put a contractor outside IR35. This means proving that the contractor fails the test of employment, and is in business on their own account.
Be warned: Failing to prove they are outside IR35 could cost a contractor a significant sum of money to pay for back taxes, interest and penalties on past contracts, and a loss of up to 25% of take home pay if they are forced to operate IR35.
Why do working practices take precedence?
When assessing IR35 status, an HMRC inspector or tribunal judge will create what is called a ‘notional contract’. This is a hypothetical contract constructed on the basis of the contractor’s working practices and relationship with the client.
So, for example if a contractor was offered some additional work mid-contract and they turned it down, this would imply that there is no mutuality of obligation in this ‘notional’, hypothetical contract. The client is not obliged to offer work and the contractor is not obliged to accept it. The opposite is true in the case of employment.
Similarly, there may be no substitution clause in the contract. But there have been cases in the past that have been won by IR35 consultancies where there was no substitution clause but the contractor sent in a colleague to cover a period of holiday.
This implies an unfettered right of substitution in the notional contract. That means there cannot possibly be an employment relationship as personal service is not required.
The HMRC inspector or tribunal judge will work systematically through all the evidence provided about the contractor’s working practices and build the notional contract. This may point clearly towards there being no employment relationship, and therefore IR35 does not apply.
If the contract can’t be changed, build an IR35 life raft
Despite the working practices taking precedence, the contract is often the first place HMRC will start when opening an IR35 investigation. They may be targeting contractors via a large client, which may have hundreds of contractor agency and contractor contracts, so will be looking for ‘low hanging fruit’.
But it may be impractical or simply impossible for a contractor to get their contract changed after it has been signed, particularly if the client is based overseas and not familiar with the UK’s tax system and IR35.
If a contractor knows that their contract is likely to attract unwelcome attention, then they should start creating an IR35 life raft.
The first step is to consider taking out investigation insurance, or joining an organisation such as PCG where investigation insurance comes with membership. An IR35 enquiry should never be tackled without expert help, but without insurance to pay for professional support, this will be costly. Then some proactive planning should be conducted to collect key evidence to support an outside IR35 postion.
Despite the working practices taking precedence, the contract is often the first place HMRC will start when opening an IR35 investigation
IR35 working practices review, best practice and dossiers
An IR35 consultancy that completes contract reviews is also likely to conduct working practices reviews. If a contractor is confident that their working practices put them outside IR35, then it is well worth investing in this more in-depth assessment.
The consultancy may even work with the client to secure a signed statement of working practices, in which the client will confirm in writing that the contractor is not controlled, that there is no mutuality of obligation and that it is possible to substitute, even though the contract may say differently.
And at all times contractors should keep to IR35 best practice, which means creating and maintaining a dossier on every contract. This should include emails, records of meetings, evidence of substitutions, and other evidence that could be handed to HMRC at the outset of an enquiry. This can kill the investigation before it gets off the ground.
In conclusion, contractors should not simply roll over and operate IR35 just because they have a poorly worded contract. Working practices take precedence, and investigation insurance, which can cost as little as £10 per month, is essential.