It is important for modern contractors to fully understand IR35 and what it means to them and their contracting business. As a contractor, you will no doubt have heard about IR35, but this can be a very complex issue to fully understand.
In order to simplify this for you, we have compiled the following guide which will help you get to grips with the legislation. If you’d like to discuss something specifically with our team then please feel free to get in touch.
What is IR35?
The full name for IR35 is Intermediary Legislation and it was introduced in April 2000. The legislation was designed to uncover disguised employees. The term disguised employees means any contractor that the government believe are taking advantage of a corporate structure. With the intention of discovering contractors who should in fact be taxable as any other employee.
The IR35 rules apply whenever a relevant engagement occurs, which means whenever an individual provides services to a client via a third party (who is a limited company). Their income should be treated as it would for any other employee, in the same way that it would be had the contractor been working with the client directly.
The intention of the legislation is that all money received by the intermediary should be treated as paid to the contractor when it comes to taxation. Whilst there are specific deductions that apply, this means that payments are subject to Schedule E income tax and class 1 national insurance contributions.
The key differences for most contractors will be their abilities to claim dividend payments or attribute costs as business expenses.
Impact of IR35
Whenever there is IR35 income and it exceeds your salary (after allowable expenses) the excess will be subject to Pay As You Earn (PAYE) and National Insurance (NI) in the tax year to April 5th. A failure to correctly account for PAYE and NI can result in significant penalties for offenders. HMRC are also likely to apply many fines which will also attract additional interest.
The intermediary will be allowed to deduct certain expenses in respect of IR35 income specifically:
- Expenses deductible as an employee
- Company contributions to approved pension schemes
- Employers NI
- A flat rate of 5% of the gross income from relevant engagements
The vast majority of contractors caught by IR35 switched to using an umbrella company because the tax-benefits were of negligible difference. With the additional benefit that the costs and administration of operating their own limited companies were removed.
Note: Recent changes in Employers National Insurance contributions rules will mean that many contractors should review this decision. If you are unsure, then take advice from specialist contractor accountants.
Are you at risk from IR35
For each engagement, there are three key questions which help you to determine the nature of the employment contract. The 3 main tests are:
Control
You will not be an employee unless there is a right to exercise control over you. This includes a right to control what work is done, where or when it is done, or, how it is done. Actual control is not paramount; it is the right of control that is important for IR35.
The right to get a substitute or helper to do the job
Personal service is an essential element of an employment contract. A person who has the freedom to choose whether to do the job himself or hire somebody else to do it for him, is probably self-employed.
Mutuality of obligation
Within a contract there are various mutual obligations. The obligation to perform and be paid for performing would form part of any contract. However the mutual obligations needed for a contract of employment to exist consist of more than this. There needs to be obligation to offer and an obligation to accept future work.
Other considerations for contractors
Provision of equipment
A “self-employed” contractor generally provides whatever equipment is needed to do the job. The provision of significant equipment (and/or materials) which are fundamental to the engagement is of particular importance when considering the employment status of an individual.
For example, an:
An IT consultant is engaged to undertake a specific piece of work. They must work exclusively at home using their own computer. This is a strong indicator that they are self-employed.
Employee is provided with office space, computer and telephone. This is an indication that they are in indeed an employee.
Flexible working benefits for employees should not alter this. Even if they choose to operate using their own computer or work under a bring your own device (BYOD) policy.
Financial Risk
An individual who risks his own money by, for example, buying assets needed for the job and bearing their running costs and paying for overheads and large quantities of materials, is almost certainly self-employed.
Financial risk could also take the form of quoting a fixed price for a job, with the consequent risk of bearing the additional costs if the job overruns. However, this will not necessarily mean that the worker is self-employed unless there is a real risk of financial loss.
Basis of payment
Employees tend to be paid a fixed wage or salary at the end of the month. They will often also qualify for additional payments including overtime, long-service bonuses or profit shares. Independent contractors tend to be paid once a project is completed.
Opportunity to profit from sound management
If your profit or loss depends on your capacity to reduce overheads and organise his work effectively may well be self-employed. People who are paid by the job/project will often be in this position.
Part and parcel of the organisation
Establishing whether a person becomes “part and parcel” of a client’s organisation can be a useful indicator in some situations. If you are taken on to manage a client's staff, the HMRC would label you as an employee.
Right of dismissal
A right to terminate an engagement by giving notice of a specified length is a common feature of employment. It is less common in a contract for services. A contract with a freelancer on the other hand will only finish when a task is completed or the terms have been breached.
Employee benefits
If you are entitled to sick pay and other employee benefits then you are likely to be labelled as an employee. However, the absence of those features does not necessarily mean that the worker is self-employed. Especially in the case of short-term contracts where such payments would not normally feature.
Length of engagement
Long periods working for one engager may be a typical indication of employment but are not conclusive. It is still necessary to consider all the terms and conditions of each engagement. Regular working for the same engager may indicate that there is a single and continuing contract of employment.
Intention
If the terms and conditions of your contract suggest that you are an employee, it is not enough to simply call yourself self-employed. However, if other factors are neutral the intentions of you as the contractor and the client could be a deciding factor.
The legal bit
Given the list of factors mentioned above it is tempting to try to determine a person’s employment status by simply comparing the lists. By adding up the number of factors pointing towards employment and comparing that result with the number pointing towards self-employment. However, the courts have specifically rejected that approach.
When the detailed facts have been established, the right approach is to stand back and look at the picture as a whole. You should then see if the overall effect is that of a person in business on his own account or a person working as an employee. If the evidence is evenly balanced then your intention to position yourself as a contractor can be a decisive factor.
HM Revenue & Customs (HMRC) has looked at several standard agency contracts and has, as expected, suggested that such contracts fail IR35. HMRC will only consider whether specific contracts fail the test and will not give any clearance on standard contracts.
The conclusion of all the above is that if you sign a standardised agency contract you are likely to fail IR35. It is important to review your contract on a case by case basis as HMRC will look at the facts behind the contract.