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The Contracting sector in the UK contributes more than £300bn to the economy each year. Contractors are used by both the private and public sectors and the professions that might fall into the contracting sector are wide ranging.
They include but are not limited to:
- Construction, such as bricklayers, plumbers, electricians, architects, surveyors etc.
- Business services such as accountants, bookkeepers, HR and training, legal etc.
- Engineering services such as consultants, engineers, designers etc.
- IT services such as developers, technicians, designers etc.
- Transport services such as drivers, hauliers etc.
The introduction of and amendments to IR35 has had a profound effect on the Contracting sector. Research by the Association of Independent Professionals and the Self-Employed (IPSE) shows that over a third of contractors (35%) have left self-employment since the changes to IR35.
The research also found that of those who remain, more than a third (34%) are now working through unregulated umbrella companies and another third (36%) are working through engagements deemed “inside IR35”.
What is IR35?
Self-employed IR35 rules are designed to work out whether a contractor is someone who is genuinely self-employed rather than a “disguised” employee, for the purposes of paying tax. IR35, also known as the “intermediaries’ legislation” applies where an individual provides their services to a client via an intermediary such as a personal service company – this arrangement is known as “off-payroll working” – but the relationship with the client would otherwise suggest employment status.
A personal service company (PSC) is a limited company set up by a contractor to provide their services to clients. Contractors who set up and work through a limited company enjoy some tax efficiency and, whilst they don’t usually get employee benefits such as holiday and sick pay, they have flexibility and control over their work.
Being inside IR35 means your contract falls in the “off-payroll” working rules and HM Revenue and Customs (HMRC) sees you as an employee for tax purposes. Being outside IR35 means your contract points towards self-employment, so you can operate under self-employed tax regulations.
Some contractors try to take advantage of this tax efficiency by appearing self-employed on the surface, when they would actually be an employee, were they not providing their services through their limited company.
HMRC says that when working out whether IR35 applies to a contract or engagement, “you must work out the employment status of the person providing their services”. HMRC goes on to say that the off-payroll rules apply if the contractor “would be an employee if there was no intermediary”.
Why was IR35 introduced?
The term IR35 refers to the press release that originally announced the legislation in 1999. IR35 was introduced in 2000 and the IR35 rules became law via the Finance Act 2000 (Schedule 12) to challenge tax and National Insurance Contribution (NIC) avoidance schemes that were using intermediaries, for example limited companies, personal services companies and partnerships, to minimise tax and NIC obligations. A large number of “contractors” were posing as limited companies even though the majority of them were technically “employees”.
An example of this happening was at organisations who terminated the direct employment of some often highly paid employees, only to re-contract the same people as self-employed workers doing the same job, saving the organisation employer’s NIC and other employee benefits, and saving the now self-employed workers both tax and NICs.
This was a large-scale problem at the time, due mostly to the lax system regarding this area of tax. This meant that professional employees could convert their status from a PAYE employee to that of a limited company or partnership very easily and pretty much in an instant to gain tax benefits, considerably decreasing the amount of tax they paid, avoiding NICs – as no NICs are payable on company dividends – and thereby increasing their take home pay.
This tax “loophole” presented the tax office with issues regarding what to do about it. There appeared to be a large number of professionals posing as contractors when they were still employees, but the problem was how to identify those named as “disguised employees”. The Inland Revenue decided something needed to be done about those that were able to become contractors and avoid a significant amount of tax.
This is what led to the IR35 being introduced as a way for the Treasury and tax office to be able to identify the contractors that were still employees and paying lower rates of tax than they should have been.
In 2016 the Government announced that there would be a clampdown on “so-called off-payroll working” within public sector organisations. From April 2017, public sector bodies became responsible for working out whether or not their workers are IR35 or not.
From April 2020 an extension of the existing “off-payroll” working rules was to become effective to the private sector; however, as a result of the COVID-19 outbreak, the Government deferred the implementation date of the private sector IR35 changes until April 2021.
Who does IR35 apply to?
When referring to IR35 status, the common terms used are “inside” and “outside” IR35. Outside IR35 status applies to those who are genuine contractors, whilst inside IR35 applies to those who are employees for tax purposes. These terms indicate the contractor’s status of being either inside or outside of the scope of IR35 legislation.
There are three main criteria used to evaluate a contractor’s IR35 status:
- Supervision, direction, and control – This relates to how much say the client has over how the contractor completes the work. A contract that specifies things like the time a contractor can start and finish work, or the days they are required to work, points towards employment. A contract might also point towards employment if a client oversees a contractor’s work excessively and gives guidance on how to complete it. In addition, if the contractor is not only providing their services for the agreed job but also working on different tasks as the client sees fit, the contract is likely to be inside IR35.
- Substitution – Can the contractor bring someone else in to complete the contract, or does the contractor need to do the work themselves? If the contractor cannot send someone else, they are likely to be inside IR35. For a contract to fall outside IR35, the contractor should be able to send a substitute to complete the work instead, if and when required. An outside IR35 contract can’t be so restrictive that it applies only to the contractor; it should have a genuine clause that states that someone else can provide their services to complete the work if necessary.
- Mutuality of obligation – Is there an obligation on the client to offer work, and does the contractor have to accept it? This is called mutuality of obligation, and if an element of it exists, the contract may fall inside IR35. This is an important clause in a contract, as it is a key test when working out self-employed status. If the client is obliged to offer work and pay the contractor, and the contractor is obliged to take it, this demonstrates a Contract of Employment. In practice, this means a self-employed contract involves working on a project-by-project basis. Once a contractor has completed a project, they are under no obligation to work on further tasks and the client is under no obligation to offer them further work.
Other criteria come into play as well. These are less important but are still used to help decide if a person is inside or outside IR35.
- Equipment – HMRC often tries to argue that if equipment is provided by the client, and the contractor doesn’t use their own, they are a disguised employee.
- Financial risk – Self-employed contractors usually take a degree of financial risk, like any other business. Is the contractor responsible for errors made during the contract, and would they need to rectify them in their own time? There is also usually a requirement to have professional indemnity insurance.
- The way the contractor is paid – Self-employed people are paid on a project basis, which might mean when the work is completed or at particular project milestones.
- “Part and parcel” of the organisation – If contractors become so ingrained that they become part of an organisation’s structure, with people reporting to them for example, this points to employment rather than self-employment.
- Exclusivity – Does the contractor work for other clients? Typically, the self-employed can work for multiple clients at once.
- Intentions of the parties – The contract should make sure the relationship between the contractor and the client is one of supplier and customer, but this should be genuine. If HMRC found the actual intended relationship is more like an employee and employer, it will ignore the contract.
- Business “on your own account” – Essentially this determines whether the contractor is actually running their business as a business. If the contractor has things like a business website, a dedicated office space, and even employees, the contractor will be seen as operating a business and not offering their services in the same way as an employee.
If the contractor is a sole trader, then they are not affected by IR35 as the legislation only applies to incorporated companies for tax purposes. However, the above designation of employment status rules affects everyone who provides a service to clients, including sole traders.
What is IR35 compliance?
Historically, determining IR35 status was the responsibility of the contractor. In April 2017, legislative changes took effect in the public sector which shifted the responsibility for determination away from the contractor to the relevant end-client. The April 2021 IR35 reforms are now expected to be implemented in the private sector too.
These private sector reforms only apply to medium and large businesses, whilst small businesses will be exempt.
According to the Government, a business qualifies as small if the following conditions are met:
- The turnover is not more than £10.2 million.
- The balance sheet total is not more than £5.1 million.
- The number of employees total no more than 50 (Companies Act 2006).
The responsibility for IR35 lies with the contractor if they are providing services to a client in the private sector which is classed as a small company under the Companies Act 2006. The responsibility for IR35 lies with the end-client / fee-payer if the contractor is providing services to a client in the public sector or is providing services to a client in the private sector which is classed as a medium or large company under the Companies Act 2006 from 6th April 2021.
When it comes to complying with the IR35 legislation, contractors and/or clients should consider the following steps:
- Review each contract for IR35 status. This includes assessing both the written terms and also the working practices, i.e. the reality of the appointment against the key factors above.
- Check that working practices reflect what is detailed within the contract. The reality of the appointment holds more weight than the written terms so it is important to ensure the contract is a true reflection of the appointment.
- Keep a record of the due diligence. This could include copies of third-party contract reviews, a Confirmation of Arrangements and/or relevant correspondence which may help evidence the position.
- Ensure the relevant tax and National Insurance is paid for the IR35 status. Being compliant with IR35 is often confused with being outside IR35, but compliance really just means paying the correct tax for the employment status.
- Maintain up-to-date assessments of the contract, ensuring reassessments throughout the contract or if there are any material changes to the contract.
- Keep an eye on relevant news for any changes or updates to how IR35 status is determined.
It is important to remember that whilst it might no longer always be the contractor’s responsibility to determine their IR35 status, contractors should still be focusing on ensuring compliance within their contracts.
Non-compliance with IR35 could leave the contractor and/or client with not only the weighty cost of defending themselves against an enquiry from HMRC but also the potential burden of being saddled with the cost of any unpaid taxes should they be caught by the legislation.
It is not only the private sector that falls foul of the IR35 regulations and compliance. There are a few notable cases of high-profile public sector non-compliance.
According to its annual report for 2020-21, HM Courts & Tribunal Service, a part of the Ministry of Justice (MoJ), paid £12.5m to HM Revenue & Customs in relation to IR35 liabilities arising from incorrect assessments of the employment status of its workers. In 2019, HMRC challenged the MoJ to revisit employment status determinations for off-payroll workers engaged between 6 April 2017 and 5 April 2020, where they had previously concluded workers were operating outside of the off-payroll working rules.
The MoJ is not the only Government department that has had to pay out to HMRC over IR35. The Department for Work and Pensions (DWP) paid £87.9m to HMRC after a review of its IR35 implementation, according to DWP’s accounts.
In March 2020 DWP received a Letter of Offer from HMRC that formally concluded their review of IR35 implementation in DWP. The result was agreement on historic errors and acceptance by DWP of a liability for missing tax/NIC plus interest for the financial years 2017-18 (£21.1m), 2018-19 (£36.7m) and 2019-20 (£29.7m). A liability for 2020-21 (£0.4m) was also subsequently agreed.
The Home Office received a bill of £29.5m after HMRC launched an enquiry into the Home Office’s compliance with IR35 rules and found there had been instances where contractors were incorrectly assessed as out of scope of IR35. In addition, HMRC found the Home Office had been careless in its application of the off-payroll working rules and imposed a penalty of £4m.
What to do if IR35 applies to you
If you work as a contractor through your limited company you can pay corporation tax at 20 per cent on your profits, claim business costs against your tax bill and avoid making National Insurance Contributions (NIC) by paying yourself through dividends.
However, if your contract is deemed inside IR35, you have a number of options:
- You can revert to being a sole trader for the length of the contract; however, many public sector organisations will not contract with sole traders, only with limited companies.
- You can move into direct employment (and PAYE) with the client, either on a permanent or fixed term contract basis.
- You can work through an umbrella company, that is a limited company that employs contractors and acts as a third-party supplier between the contractor and the client. You then don’t need to worry about IR35 as you are already paid through the PAYE system and work under a contract of employment with the umbrella company.
How does IR35 work?
To be operating inside IR35 means that, under the IR35 legislation, you must pay the same tax as an employee. This could also mean that you are entitled to additional rights as an employee or worker, e.g. minimum wage, maternity pay, protection from discrimination etc.
If you’re found to be working inside IR35, you will usually have to pay a “deemed payment” of income tax at the end of the tax year to account for any tax deductions or NIC that an employee would have paid.
If a contractor is working outside of IR35 and HMRC have reason to question this, they may open an IR35 enquiry. In this case, they will begin by sending a letter asking for evidence that the contractor is working outside of the legislation. HMRC can investigate your arrangements at any time, which has the potential to be time consuming, costly and stressful. They can also go back up to six years and evaluate past contracts to see if the legislation should have been applied.
How can IR35 be avoided?
IR35 is something that applies to a role, rather than an individual. For every assignment that you take on as a contractor, the most important thing is to be able to show that you are “in business on your own account” and therefore not an employee of the client.
Here are some suggestions to avoid being caught inside IR35:
- Ensure that your contract with the client is a service contract and not a contract of employment.
- Highlight the ways that your work situation differs from employees’ situations. Employees will have certain set working conditions, such as minimum hours, pension arrangements and other benefits; you need to be able to show that little if any of this applies to you.
- Keep client correspondence – If you have emails that clearly state that you are not under the control of a manager at the business, but are simply contracted to provide a service, this can be useful too.
- When you establish a limited company, don’t name it after yourself, give it a business name. HMRC knows that a company named after a person may well be just that person, and this fits their profile of a personal service company (PSC) established to avoid tax. A business name emphasises the fact that your company is distinct from you, and that you could delegate the work to another person if necessary. Employees cannot delegate in this way, so it marks you out as different from an employee. You should be able to demonstrate that you market your contracting services actively to a variety of clients to indicate that you are in business on your own account.
- Take out your own business insurance. Having your own business insurance, such as professional indemnity insurance, is a great way of demonstrating that you are not just an employee.
- Try to have multiple clients – It’s much harder for HMRC to claim that you are an employee if you are working for more than one client.
- Maintain a CPD log – Employees don’t usually pay for their own training, so if you pay for yours this will be another useful point of difference. Some professions may require you to take continued professional development (CPD) to remain qualified, so by paying for this you are also reasserting your contractor status.
If your business hires contractors, either from time to time or on an ongoing basis, then you should review your relationships with them to ensure they don’t fall inside IR35. Make sure that your terms of engagement are clear and accurate and provide contractors with their Status Determination Statement. If you are at all concerned, you may want to consider changing some contractors into employees if they fall within IR35 and if this is a more practical solution for you both.
If you currently work as a contractor or freelancer or are considering becoming a contractor or own a business that hires contractors, IR35 is something that you should become familiar with.