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Contractors must demonstrate business risk as part of keeping contracts outside IR35

Contractors able to demonstrate that they are in business on their own account can use this evidence to help with their IR35 defence, because taking business and financial risks are key components of being in business and point to contractors not being ‘disguised employees’.

But, as Andy Vessey from Qdos Consulting explains, being in business and taking financial risks are now less important to IR35 cases than they once were. That’s because the IR35 goalposts are constantly changing as tax tribunals and courts take decisions on live investigations.

“Demonstrating financial risk helps establish a contractor is in business on their own account” explains Vessey. ”But it is not currently quite as powerful a determinant of IR35 status as, for example, control and substitution.”

Factors that demonstrate financial risk

According to Vessey, because the overwhelming majority of contractors are knowledge workers, their contractor limited companies don’t incur the same kind of overheads as, say a widget maker or other product-based business.

“Taking business risks requires expenditure on the kind of overheads that help to demonstrate that the contractor is a bona fide business,” continues Vessey. “You would expect a product-based business to incur capital expenditure such as buying plant and machinery and renting premises, as well as having ongoing overheads like rent, rates, light and heat; but few, if any, contractor limited companies will fit this profile.”

Demonstrating financial risk helps establish a contractor is in business on their own account

Andy Vessey, Qdos Consulting

The corresponding items for knowledge-based contracting businesses are capital expenditure on computers and home-office equipment, possibly some tools and ongoing costs for communications, such as a business landline, broadband and mobile, plus ongoing training to maintain professional skills and in work-related areas like health and safety. Marketing, such as creating a website, stationery and business cards, is also a good ongoing expense to demonstrate risk.

“Contractors based at home can also charge their contractor limited company a formal rent for using their house as an office,” says Vessey. “The rent should not be more than market value and all contractors, especially higher-rate taxpayers, should check with their accountant that the numbers stack up.”

In addition, having to invoice the client or agency with no guarantee of payment and having exposure to bad debts is not a condition commensurate with being employed, and is generally viewed by the courts as evidence that contractors are taking risks. A contractor who goes down the path of debt recovery proceedings, such as sending a letter before action or using debt finance, places him or herself squarely in the realms of being in business.

Employees and subcontractors

“Formally employing a worker is a classic demonstration of financial risk, but most contractors would not have a role for a full-time employee, other than the typical exception of a partner or spouse,” says Vessey. “An alternative is to use sub-contractors and substitutes.”

Sub-contractors can be used to help complete projects, or elements of projects, and may point to the contractor bringing on board a specialist. Contractors can also outsource business processes, such as hiring a freelance bookkeeper or researcher.

Although not a ‘silver bullet’, hiring a substitute ticks a number of boxes, as Vessey highlights: “Substitutes who replace a contractor outright for a period of time are not the same as subcontractors, but can play a powerful role in demonstrating that a contractor is not offering a personal service and is not caught by IR35.”

Evolving case law means the IR35 goalposts keep changing

Because employment status is not defined in statute, each contractor’s case must be determined on its individual merits by using legal precedent and case law, which is created each time a judge or tax tribunal rules on a previously unclarified element of the law.

“As IR35 experts have applied precedent and case law in defence of contractors, so HMRC has identified the trends in these defences and changed their strategy accordingly. This results in short periods of stability and then a change when a new ruling is made,” Vessey says.

“Basically, creative and effective contractor defences in IR35 status cases will continue to be victims of their own success. HMRC spots what tactics work and take measures to circumvent them. But,” he concludes, “demonstrating that you are in business and taking financial risk is likely to remain a part of future IR35 defences.”

Published: 28 April 2010

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