If you’re a self-employed contractor, you may have heard of the term ‘IR35’, particularly if you work via your own limited company.
IR35 has had a lot of negative coverage in the press, and has seen pushback from contractors and companies in the private sector.
But what is IR35, and how does it affect you?
A brief history of IR35
Though IR35 has been hitting the headlines recently, it has actually been law in the UK since 2000.
Many self-employed people operate as businesses and provide their services through a limited company such as “Joe Bloggs Limited”, often known as a personal services company or PSC.
By virtue of operating through a limited company, or PSC, the profits of that company are subject to business tax (such as VAT and corporation tax), compared to personal tax (such as PAYE and NICs) of income paid directly to the individual.
Legislation was passed in 2000 designed specifically to target individuals that provide their services through PSCs.
At the time IR35 was instigated business tax rates were more favourable than personal tax rates, which meant that HMRC received less in revenue in respect of a PSC Worker than it did in respect of an employee. In addition, as the PSC did not pass on all of the fees to the PSC Worker as wages, HMRC also lost out on payment of employer’s national insurance contributions too. An increasing number of people were working in this way so HMRC was concerned to ensure that those operating through PSCs were genuinely in business on their own account and not in fact disguised employees.
So IR35 was launched.
In short, IR35 aims to ensure that the fees paid to a PSC for work carried out by a PSC Worker are genuinely entitled to be taxed as a business profit, or whether those fees are actually disguised employees pay and so should be subject to PAYE and NICs and other applicable charges.
What does IR35 do?
Essentially, it considers several factors to assess whether someone operating through their PSC is actually more akin to an employee than someone genuinely self-employed and providing B2B services.
If the working practices of an assignment is found to be similar to that of employment, this is known as “inside IR35” and simply means that the PSC must make a deemed IR35 payment to HMRC of approximately the same value of tax and NICs as would have been the case if it had been employment.
IR35 was originally introduced to tackle and clarify the muddy waters of ‘deemed employment’.
The onus of determining whether an assignment undertaken via a PSC fell under IR35 or not has always been up to the PSC to determine. In reality, this often means the PSC Worker making the decision.
However, by declaring an assignment “inside IR35”, the PSC is required to deduct tax, NICs (including employer’s NIC) and other applicable charges and make a deemed payment to HMRC. Given this extra cost, there is little incentive for an “inside IR35” determination to be decided by the PSC. Despite having sufficient powers to enforce IR35 legislation, HMRC has been unable to do so effectively.
Is IR35 the same as off-payroll working?
Almost but not quite. IR35 is the legislation and case law that determines whether a working arrangement is more akin to employment than B2B, whereas off-payroll working refers to rules that govern how to pay individuals who are not on payroll.
New Off-Payroll Reforms for the public sector were introduced in April 2017. The confusion arises because this ‘Off-Payroll Tax’ is also widely referred to as ‘IR35’.
By the Finance Act 2017, Parliament introduced rules applicable to services provided to public sector clients by PSC Workers. These became known as the ‘Off Payroll Rules’. Whereas under the original IR35 Legislation, the PSC determines whether a working arrangement is inside IR35, the Off Payroll Rules flip that on its head for public sector clients. In the public sector it is now down to the PSC’s end client to determine whether or not the PSC Worker in relation to that assignment is inside IR35, and therefore must be paid via payroll. If the assignment is assessed to be outside IR35, the PSC will continue to deal with the income as it currently does.
Off-payroll rules were introduced because it is, essentially, an admission by HMRC that 2000’s IR35 legislation was effectively unenforceable.
Click here to find out more about Off-Payroll Reforms.
The off-payroll changes are therefore seen as a mechanism for HMRC to ensure that all “inside IR35” working arrangements are taxed as employment income so that the Exchequer receives PAYE and NICs due.
These off-payroll changes were introduced to the public sector in April 2017, and were supposed to be introduced to the private sector in April 2020.
However, because of the global Coronavirus Pandemic, IR35 changes to the private sector have been delayed until 6 April 2021.
So how do you know if you’re “inside IR35”?
It is important to understand that working practices are far more important than contractual arrangements when determining IR35 status.
There are three main factors to consider:
- Personal service
- Mutuality of obligation
Plus two additional factors:
- Financial risk
- Part and parcel
All factors are considered to build a view of the whole picture. Factors 1 to 3 are generally viewed as the most important, but in reality they all count towards the overall IR35 determination.
Is there a right of substitution, or are you personally required to provide the service? If it must be you personally then this can be an indicator towards an employment relationship (i.e. “inside IR35”) rather than a B2B arrangement.
If the contract permits you to arrange for an equally-qualified substitute to provide the service, does your client still pay your business for the service?
Given that your relationship with your client should be on a B2B basis, then your client ought to pay your business for the service received, even if you send a substitute. Your PSC should then pay the substitute accordingly.
If your client pays your substitute directly this potentially undermines the B2B relationship and will indicate towards the arrangement being inside IR35.
If you can provide examples of when you have substituted (and your client has paid your PSC for that substitute) during an assignment, this is often seen as “magic bullet” evidence that the assignment is outside IR35.
How the work is done should not be controlled.
The PSC worker should have autonomy to do the work and apply their expertise as necessary, without being supervised or told how to do it.
The client should plan the assignment or project according to their required outcomes, and the brief should not give a “recipe” of how to get there – the client of paying for the PSC’s expertise, so the methodology should be the PSC’s decision.
Contracts that are based on periods of time at agreed hourly/daily/weekly pay rates are suggestive of an employment relationship, whereas contracts with specific deliverables and outcomes are much more akin to a B2B relationship.
Mutuality of Obligation
In an employment relationship there is mutuality of obligation: the employer is obliged to provide work, and the employee is obliged to do that work.
By comparison, to be outside IR35 there should be no mutuality of obligation. For contracting to be genuine there should be no obligation for the client to provide additional work beyond the original project, and if further projects are offered then the PSC worker should not be obliged to accept them.
This does not prevent you undertaking additional work for your client, but it must not be obliged and any additional work should be subject to a separate contract, scoped separately with it’s own project plan and agreed deliverables.
The above 3 factors – personal service, control, and mutuality of obligation are the three main factors that are considered when determining IR35 status.
There are two additional factors, financial risk and part & parcel, which are also considered to form the whole picture, but generally these carry less weight than the above.
In assessing whether a contract has slipped into looking like employment, the level of financial risk that the PSC undertakes is considered, i.e. whether it is genuinely in business on it’s own account.
For example, if you make a mistake do you have to correct it yourself at the PSC’s own cost? If a builder constructs a wall that later falls down, that builder would usually be expected to return and correct the error without charging an additional fee.
The reason for your client engaging your services will be considered, and if it is covering for a normally permanent employee (e.g. maternity cover) then it is likely that the assignment will be inside IR35. If you have been engaged to fulfil the same role as permanent employees but flexed to increase volume of output, again this is likely to be inside IR35.
Other examples include whether the PSC has things like business insurance, a website to advertise business services, marketing activities etc.
Part and parcel
Sometimes it is all too easy to slip into looking like an employee, and therefore seeming “part and parcel” of the client business. Considerations might include:
- Are contractors readily identifiable as separate to employees?
- Could an outsider tell the difference between contractors and employees?
- Do contractors have access to the same benefits and perks as employees?
- How is the performance of contractors measured? (Ideally should be on achieved outcomes, nothing else)
- Are they on the staff holiday planner? Are they included in Xmas parties? Are they included in “employee of the month” competitions?
Whilst from a team / HR perspective it can seem only natural to fully integrate contractors into the wider workforce, this could inadvertently endanger their IR35 status. The fact is that contractors are not employees and should not be treated as such.
Assessing IR35 status
HMRC has an online tool, Check Employment Status for Tax (CEST) to help clients (and contractors) ascertain if their assignments are inside IR35 or not.
The online tool considers most of the employment indicators (personal service, control, financial risk, being part and parcel) but the tool explicitly omits mutuality of obligation.
We have already outlined that mutuality of obligation is a key factor in considering employment status, and many employment experts have argued against this glaring omission by HMRC.
However, HMRC consider that sufficient mutuality of obligation exists by virtue of the contractual arrangements, i.e. tasks being completed in exchange for payment.
This position is not always borne out by employment tribunals and the courts when they consider employment status.
There are a number of other IR35 status determination tools available which do consider mutuality of obligation as well as the other factors.
By comparison, HMRC say that they will only stand by the result generated by their tool, providing that accurate information was entered in order to generate the status determination.
Notwithstanding, many IR35 experts believe that HMRC’s CEST tool is so flawed by virtue of not considering mutuality of obligation that they would not recommend using it.
From April 2021 all end-clients will be responsible for determining IR35 status, so it will be their decision regarding which tool to use.