IR35 is a word used to describe two sets of tax legislation that are designed to combat tax avoidance by workers, and the firms hiring them, who are supplying their services to clients via an intermediary, such as a limited company, but who would be an employee if the intermediary was not used.
Such workers are called ‘deemed employees’ by Her Majesty’s Revenue and Customs (HMRC). If caught by IR35, they have to pay income tax and National Insurance Contributions (NICs) as if they were employed. The financial impact of IR35 is significant. It can reduce the worker’s net income by up to 25%, costing the typical limited company contractor thousands of pounds in additional income tax and NICs.
Despite having been in force since April 2000, IR35 is heavily criticised by tax experts and the business community as being poorly conceived, badly implemented by HMRC and causing unnecessary costs and hardships for genuine small businesses. This is why Government is replacing the original IR35 legislation with the new Off-Payroll Tax, which was initially introduced into the public sector in April 2017, and will be extended to the private sector from April 2021.
If you are a genuine contractor, freelancer, interim or consultant who is in business on your own account, you should have nothing to fear from IR35. This is so long as you take the time to understand how the legislation works and apply best practice to ensure it does not apply to you, and have a defence prepared if investigated by HMRC.
For firms that hire contractors, where the new Off-Payroll Tax needs to be considered, they should also not fear the new legislation, provided they take the correct steps when hiring and engaging their contractors.
What is IR35 and the new Off-Payroll Tax?
IR35 is a set of tax laws which form part of the Finance Act. The first piece of legislation came into force in April 2000 and is properly known as the Intermediaries Legislation. IR35 takes its name from the original press released published by the then Inland Revenue (now HMRC) announcing its creation.
The income tax element of the Intermediaries Legislation has subsequently been integrated into the Income Tax (Earnings and Pensions) Act 2003 (ITEPA 2003), and the NICs element into the Social Security Contributions (Intermediaries) Regulations 2000.
In April 2017 the Government introduced the "Off-Payroll Reforms", which is a separate piece of new tax legislation that applies to the public sector, but which is also, albeit confusingly, referred to as "IR35."
The new Off-Payroll rules were an admission by HMRC that the original rules were unenforceable. Whilst they both contain the common theme of "deemed employment", the newer rules introduce a different set of tax treatment, meaning that firms will now have to assess the contractors status, but, more importantly, pay employment taxes on top of the fees paid to the contractor. This new tax is now widely referred to as the "Off-Payroll Tax".
Why was IR35 introduced by the government?
IR35 was introduced to tackle the problem of ‘deemed employment’. This is where organisations engage workers on a self-employed basis and usually through an intermediary, rather than on an employment contract, so they become deemed, or "disguised", employees.
This can save the engaging organisation a significant amount of cash as they no longer have to pay employers’ NICs of 13.8% or the Apprenticeship Levy of 0.5%, and it also means they do not have to offer any employment rights or benefits.
A common example was the ‘Friday to Monday’ phenomenon. That is when an employee leaves employment with their employer on a Friday only to return to the same role in the same office on the Monday, only engaged as a contractor or consultant trading through a personal services company and paying much less tax.
IR35 should have a genuine role to play in defending both workers’ rights from unscrupulous employers and the Exchequer from lost tax yield. Unfortunately, the legislation in its original current form fell well short of those aims.
How IR35 works – the tests of employment
Because IR35 essentially seeks to turn a legitimate one person small business into being an employee, it is underpinned by employment legislation and IR35 case law. As a result, the tests of employment evolved over decades by the UK legal system are applied,
The key IR35 case law dates back to a seminal employment law case tribunal, Ready Mixed Concrete (South East) Ltd v Minister of Pensions from 1968. More recent cases, particularly those ruled on since IR35 was introduced, can also apply.
Essentially, an HMRC inspector will attempt to disregard the written contract in force between the worker and their client, and use the actual nature of the working relationship to create a ‘notional contract’.
An inspector, or a tribunal judge, will use this notional/hypothetical contract to determine whether the contract is one of employment, when IR35 applies, or one for business to business services where IR35 does not apply.
Not surprisingly, an expert knowledge of employment law is required to fully interpret these tests. Neither those independent professionals being investigated nor HMRC’s tax inspectors, and nor hiring clients can possibly be expected to become experts in decades of employment status case law.
Determining whether you are caught by IR35 is complex, and ideally you should seek expert IR35 advice. However, you can use on IR35 Shield to provide you with guidance about your IR35 status.
Control, substitution and mutuality of obligation
In short, IR35 involves applying three main principles to determine employment status from the Ready Mixed Concrete case. These are known as the principal ‘tests of employment’:
- Control: what degree of control does the client have over what, how, when and where the worker completes the work
- Substitution: is personal service by the worker required, or can the worker send a substitute in their place?
- Mutuality of obligation: mutuality of obligation is a concept where the employer is obliged to offer work, and the worker is obligated to accept it.
Other factors are then taken into account to determine whether you are caught by IR35 include the contract type, whether you are taking a financial risk, if you are ‘part and parcel’ of the engager’s organisation, being in business on your own account and provision of equipment.
All of this evidence is taken into account, and if the balance of probabilities is that the worker is an employee then IR35 applies. So, for example, if a worker genuinely has an unfettered right to send a substitute in their place, personal service is not required and IR35 cannot possibly apply. But, relying on that alone can be fraught with danger.
What to do if IR35 applies – how to calculate the deemed payment
If IR35 does apply, then each piece of legislation (both Chapter 8 and Chapter 10) makes provision for how to pay the extra income tax and NICs. But, pay special attention to the different tax treatments, because under the new rules (Chapter 10), the employment taxes cannot be deducted from the contractors fees and are paid on top.
Under the original rules, when IR35 has been found to apply to an IR35 contract, then you need to calculate what is known as the deemed payment on your limited company income. This means that you deduct your Pay As You Earn (PAYE) salary, a 5% expenses allowance, plus any pension contributions.
What is left must be treated as if it were the gross cost to the employer, including all employment taxes, before calculating all the additional tax due. In practice, if you are certain your contract is caught by IR35, then the simplest solution is to pay out all of your limited company’s fees less legitimate expenses and pension contributions as a PAYE salary. Because you are paying yourself like an employee, then IR35 won’t apply.
Under the new rules, the calculation is much simpler. The fees paid to the contractor, called the "direct deemed payment" are to be treated as employment income - which means just like a salary. This means PAYE and employees NI is deducted from that deemed salary. Then the fee-payer, which could be the agency or hirer, has to pay their employment taxes on top - these cannot lawfully be deducted from the contractors fees.
For the original legislation, Chapter 8 IR35, you can you ContractorCalculator’s online interactive IR35 calculator to help work this out.
For the more recent Off-Payroll Tax legislation, you can use the new interactive calculator: Off-Payroll Tax Calculator.
How can IR35 be avoided by firms and contractors?
There is no way that IR35 can be circumvented by firms, other than to make the choice to hire all contractors on fixed term employment contracts - which basically means hiring them as if the IR35 applies, and paying over all the extra employment taxes. This would however be an expensive way of eliminating the problem, and it's extremely unlikely a firm could renegotiate with all their existing contractors the kind of rate cut necessary to offset all the new taxes.
But for firms that are hiring self-employed contractors, IR35 will not apply. That does not prevent HMRC from launching an investigation at a later date, which can be time consuming, costly and highly stressful.
For firms that wish to engage contractors outside IR35, and mitigating any IR35 risk they can use IR35 Shield for Business, which can assess all contractors in a single day. Each assessment takes 15 minutes and gives an instant result, including the necessary Status Determination Statement and full reasons for the determination.