What is IR35?

What is IR35?

IR35 is legislation designed to prevent the practice of ‘disguised employees’. That is when workers supply their services to end clients as a contractor via an intermediary, such as an agency or limited company. It is possible that they could pay a lot less tax and National Insurance when working in that way, compared to the sums they would owe if they were on the client’s books as a regular employee.

IR35 applies to those contractors who would be considered an employee were it not for the intermediary vehicle. If they fall within IR35 rules, the contractor deemed to be a disguised employee would have to pay the same income tax and NICs as any other employee. The costs can be significant, potentially cutting an individual worker’s earnings by 25% and costing the average limited company contractor thousands of pounds in extra taxes.

The legislation was introduced in 1999, but despite having a commendable goal – that of reducing tax avoidance – it is generally seen by contractors, tax experts and the wider business community as being poorly drafted and badly implemented by HMRC. It is felt that it can cause hardships and unnecessary costs for genuine small businesses.

Small businesses and individual contractors who are genuinely working for themselves should not, in theory, have anything to fear from the IR35 legislation. However, it can be all too easy to fall under the purview of IR35 if you do not have a clear idea of how it works and what it all means. Being investigated by HMRC can be intimidating, so it helps to follow best practices in all your contracts and to be prepared if your business affairs do come under scrutiny.

What exactly is IR35?

‘IR35’ is the name commonly used to refer to the UK’s anti-avoidance tax legislation. Introduced as part of the wider Finance Act, it was designed to tax ‘disguised employment’ at a rate similar to normal employment. Its official designation is the Intermediaries Legislation, with the name IR35 stemming from a press release issued by the Inland Revenue, now known as HMRC, at the time of the legislation’s creation.

The National Insurance element of IR35 has since been integrated into the Social Security Contributions (Intermediaries) Regulations 2000. The income tax element of the legislation has been integrated into the Income Tax (Earnings and Pensions) Act 2003 (ITEPA 2003).

Why was it introduced?

As previously mentioned, IR35 was introduced with the intention of tackling ‘disguised employment’. That is where workers are engaged and paid on a self-employed basis, generally through an intermediary entity such their own limited company. Rather than being genuinely self-employed their relationship with their client is such that they would be classed as a regular employee if not for the intermediary.

This can save the client company a considerable amount in employer NICs, as well as in benefits and rights such as sick pay and leave that they would have to provide to regular employees. One notorious example of disguised employment is known as the ‘Monday to Friday’ arrangement. Under this approach, an employee leaves official employment with their employer on Friday and returns on Monday to carry out exactly the same duties. However, under the new arrangement, they are now engaged as self-employed contractors or consultants, resulting in a lower level of tax.

Most agree that IR35 should have a role to play in bringing in legitimate tax revenues and clamping down on unscrupulous employers looking to save on providing employees with the benefits they are due. Unfortunately, as it stands, the legislation often does not live up to its lofty aims.

IR35 in action – the tests of employment

When determining whether a contractor should actually be classed as an employee under IR35 rules, an HMRC investigator will look closely at their contract as part of the process. More importantly, they will look at the actual working relationship between the contractor and client. If the reality of their working relationship does not match the contents of the contract, they will consider the ‘notional contract’ that reflects the reality.

This hypothetical or notional contract will be used to determine whether the contractor is genuinely self-employed or whether they should be treated as an employee for tax purposes under IR35.

Decisions made under IR35 legislation rely on IR35 case law, underpinned by wider employment legislation. Important IR35 case law can be traced back to a key employment law case tribunal dating back to 1968 – that of Ready Mixed Concrete (South East) Ltd v Minister of Pensions. More recent cases are also relevant, particularly those that have taken place since IR35 was introduced nearly two decades ago. IR35 case law has evolved over a long period and is still continuing to do so.

As such, it requires people with an extensive knowledge of this legal framework to properly interpret and apply the legal principles. HMRC’s inspectors do not generally have this level of expertise and those being investigated almost certainly do not. This is one of the reasons why IR35 decisions have often been incorrectly applied, including some high-profile cases.

Contractors often face uncertainty when it comes to issues involving IR35 and it is often wise to seek expert professional guidance on these matters.

Control, substitution and mutuality of obligation (‘MOO’)

Three principles used in the Ready Mixed Concrete case of 1968 are still used today as cornerstones when determining employment status. These are control, substitution and mutuality of obligation.

  • Control - This seeks to determine how much control the client has over the worker’s actual work processes. Does the client stipulate and supervise what they must do, when they must do it and how tasks should be completed?
  • Substitution - This aspect looks at whether the worker must complete work and tasks themselves or are able to use substitutes to deliver contracted outcomes.
  • Mutuality of obligation - Mutuality of obligation (or MOO) refers to a working relationship where the client or employer is obliged to offer work, while the worker is obliged to accept it.

There are some other factors that will be considered, including whether you are ‘part and parcel’ of the client’s business, whether you are obliged to use the client’s equipment, whether you are taking a financial risk in undertaking the work, and the actual contents of your contract.

All these factors will be taken into account when deciding whether a contractor should fall under IR35 and should be treated as an employee. Not every point has to be proven, but the balance of probabilities must show that the worker is acting as an employee for IR35 to apply.

Calculating the deemed payment if IR35 applies

Worryingly for many contractors, if it is deemed that IR35 applies to a contractor, HMRC can go back to look at six years’ worth of prior contracts to see if the legislation should also be applied to them. The taxman could demand back payment of income tax and NICs, not to mention interest and penalties, going back several years. This could result in a very large sum having to be paid.

When IR35 has been applied, you need to work out a sum that is known as the ‘deemed payment’ on your limited company income. To do that, you should deduct your PAYE salary, pension contributions and a 5% expenses allowance.

The remaining sum is treated like an employee’s salary, so you can use it to calculate the additional tax and NICs owed. If you pay all of your limited company’s fees, minus legitimate expenses and pension contributions, as a PAYE salary, IR35 should not apply. That is because you are essentially paying yourself in the same way as an employee anyway.

If you are operating as a legitimate, independent small business then IR35 should not apply, however, that does not always prevent HMRC from investigating your working practices and business affairs, which can in itself be stressful, costly and time-consuming.

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