Determining IR35 status for contractors is not a simple process. It does not, for example, depend upon a contractor’s pay structure. Rather, determining IR35 status rests solely on the specific contract between a contractor’s limited company (or umbrella company) and the end engager. This includes working conditions. Contractors should explore and assess their contracts to make the correct determinations, which are all based on case law.
Following the Budget of April 2017 and the ensuing Managed Service Company (MSC) legislation, only one umbrella option exists: the PAYE umbrella company.
Contractors working via reputable, compliant umbrella companies will have their revenue taxed as an employee would, i.e. under the PAYE system. Effectively, these companies tax contractors as they would be taxed if designated as inside IR35. It’s theoretically possible for contractors to continue using a PAYE umbrella even after an assessment determining a company as outside IR35, but it’s not the wisest choice for high-earning contractors, who will miss out on significant tax advantages. For the more highly remunerated contractors outside IR35, limited companies offer the most tax-efficient option.
Flexible workers contracting through umbrella companies are able to reduce their tax burden by claiming valid expenses, which HMRC takes into consideration before applying tax. Even so, contractors outside the IR35 net will have appreciably higher take-home pay with the limited company option than they would with the PAYE umbrella option, which is most suitable for inside-IR35 determinations.
The short answer is no. The only way that contractors can avoid paying the same income tax and National Insurance Contributions (NICs) as salaried employees is to ensure that their contracts and working practices place them clearly and safely outside IR35.
The MSC legislation expressly ensures that contractors using umbrellas have their tax calculated as though they are inside IR35. It is crucial that contractors who wish to remain outside IR35 and work through a more tax-efficient limited company should, prior to signing any dotted lines, seek professional legal help to ensure that their written contractual obligations and working practices place them safely beyond the reach of the regulations.
IR35 is the title of a piece of legislation designed to tackle tax avoidance (“IR” stands for Inland Revenue – the old name for HMRC). Specifically, it targets workers who offer services to end engagers via an intermediary (e.g. a limited company) but whose classification would be as employees if they didn’t use an intermediary.
These workers fall under the legislation as “disguised employees”. If HMRC determines that they are in fact inside IR35, then they must pay income tax and NICs on all their limited company earnings as though they are employees. The financial impact of IR35 can be enormous, slashing a contractor’s income by up to a quarter and costing thousands of pounds in added income tax and NICs.
Even though this legislation has been enforced since 1999, many tax experts and representatives of the business community remain heavily critical of it. They consider it badly conceived and poorly implemented by revenue officials, saying that it has resulted in needless and unfair extra costs and significant hardship for genuine small businesses.
Genuine freelancers, contractors, consultants and interims who are legitimately in business should not, however, have anything to fear from IR35. What is vital, though, is understanding how these regulations work. You can then utilise best practices to ensure that they do not apply to your contract. This involves making sure that you have prepared a defence if HMRC investigates you.
IR35 made its debut in 1999 as part of the Finance Act and came into effect in April 2000. Officially entitled “Intermediaries Legislation”, it has since become part of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA 2003). The sections governing NICs became part of the Social Security Contributions (Intermediaries) Regulations 2000.
The government introduced IR35 after becoming concerned that some employers were avoiding significant expenses by offering workers statutory employee rights and benefits while engaging them on a self-employed basis (the self-employed are not eligible for these entitlements). This usually occurred via an intermediary instead of an employment contract. The government viewed this as a form of disguised employment designed to avoid tax.
The most often cited example is the “Friday to Monday” phenomenon, whereby workers left their salaried jobs on a Friday but returned to work on Monday for the same employer in the same workplace doing the same work, only this time engaged as a consultant or contractor trading through a limited company and paying considerably less tax.
To be fair, IR35 could have an honourable part to play in protecting workers’ rights from rogue employers and helping the exchequer prevent lost tax yields. Regrettably, in its present form it falls well short on both fronts.
IR35, in practice, aims to transform a legitimate independent freelancer working through a micro-business into an employee. Reinforced by employment legislature and IR35 case law, the tests that it uses for deciding employment status have evolved over decades in the British legal system.
A key instance of IR35 case law dates to 1968, when a crucial employment law tribunal took place in the form of the Ready Mixed Concrete (South East) Ltd v Minister for Pensions case. However, much more recent cases, including those decided after the introduction of IR35, also apply.
HMRC inspectors focus less on the written contract between the worker and the client (they may even disregard it) and much more on the details of the practical working arrangement, which they codify and then take to be a “notional contract”.
If an investigation ensues, then the revenue official or a tribunal judge will refer to this notional contract to decide whether the working agreement is a legitimate, business-to-business contract outside the remit of IR35, or one of employment – in which case IR35 will apply.
Unsurprisingly, given the complexity and scale of the legal issues, interpreting test results requires expert knowledge of employment law. Neither the independent contractors under investigation nor HMRC’s officials will have this knowledge. This is the principal reason for the erroneous application of IR35 in multiple high-profile tax cases. Contractors, meanwhile, remain uncertain about their true tax status.
The best guidance for contractors in this predicament is to obtain expert, professional IR35 advice. IR35 legislation is simply too complex for the layperson.
The Ready Mixed Concrete case of 1968 bequeathed the three core principles for figuring out employment status. These are the principal “tests of employment”. So, what do they mean?
Other factors to keep in mind include the type of contract, whether a contractor takes a financial risk, whether a worker is “part and parcel” of an end client’s organisation, whether a worker supplies his or her own equipment and whether workers are in business on their own account.
Each of these factors will be under consideration for IR35 determinations. For instance, if you have an unambiguous right to send a substitute and your service in person is not mandatory, then IR35 cannot easily apply. However, if the balance of probabilities leans to the “employee” side of the equation, then you are inside IR35.
Legislation requires contractors deemed inside IR35 to pay added income tax and NICs. Disturbingly, it allows for the recognition of all unpaid employee-level tax and NICs for the prior six years. HMRC has the power to investigate earlier contracts extending over this period. It is by no means unprecedented, given the scope of the legislation, for contractors to face tax, NIC bills, penalties and interest amounting to six-figure sums.
Your first task upon finding that IR35 applies to your contract is to calculate what is referred to as the “deemed payment” on income from your limited company. This involves deducting your PAYE salary from that income, an expenses allowance of 5% and any pension contributions. You must treat the rest as though it were a salary that you received from an employer, so the next step is to calculate the added tax due.
If you are convinced that your contract is inside IR35, then the most straightforward next step is to pay yourself a PAYE salary out of your limited company’s fees, subtracting valid expenses and pension contributions. Due to the fact that you are paying yourself as an employee with this solution, IR35 rules will not apply. ContractorCalculator’s free online IR35 calculator will help you work out the sums accurately.
Contractors running a legitimate micro-business and conducting themselves in a way that meets the outside-IR35 criteria for the employment tests outlined above should find that IR35 does not apply. Unfortunately, HMRC can still launch costly, highly stressful and time-consuming IR35 investigations even if you appear to have met these criteria. Getting professional IR35 advice on your contract and working arrangements is the safest choice.