Frequently Asked Questions?
Most people embark on a contracting career because they love the idea of being their own boss. For those that cherish flexible professional arrangements, they may misunderstand the benefits of working with an umbrella company and believe this mode of engagement is not really compatible with a freelancing career. This is a misconception, as umbrella companies have an important role to play in the contracting marketplace. If you understand what an umbrella company is and how it functions, you will be in a better position to decide if this business model is right your independent freelancing work.
An umbrella company gives you an alternative route to contracting work if you are unsure about setting up a limited company. Both business models function as an intermediary between you (the contractor) and the client (an agency or employer), with the umbrella being responsible for ensuring you get paid for the work you perform.
Limited company vs umbrella company
The core difference between running a limited company and working with an umbrella is your employment status in the company.
If you operate a limited company, your designation is that of a director and you have different avenues open to minimise your tax liability, as long as you have the ability to manage your finances. On the other hand, if you operate through an umbrella, you are deemed an employee. Hence, you are eligible for National Insurance and PAYE contributions.
That being said, when you engage through an umbrella company, you still keep the freedom to establish your working conditions based on each contract. But, your paperwork and back office administration is taken care of for you. Convenience does come at a small cost, because you will pay slightly higher taxes and also have to be responsible for National Insurance contributions.
How does an umbrella company function?
The working of an umbrella company is simpler than you think. Once you finalise the contract with your client, you will have to maintain a timesheet. This sheet has to be countersigned by your client, and at the end of the month, it is sent to the umbrella company. Based on the number of hours you have clocked, the umbrella will prepare and send an invoice to your client.
The client checks the invoice and releases your payment to the umbrella, which, in turn, will pay you after deducting fee, taxes and National Insurance, if any. You will also get a payslip that will present the entire calculation process for your final payment.
A word of caution
Of course, this summary of how an umbrella company runs is intended as an overview rather than an exhaustive summary of the finer details regarding how they operate. Invariably, there are different methods of running the company based on the services offered. Remember, you cannot enjoy a huge tax advantage the moment you enter PAYE. So, don’t get taken up by an umbrella that promises to help you minimise tax. Also, you should not be under the impression that you can claim your expenses at will, as this is not the case with the new IR35 legislation in place.
As a contractor working through an umbrella, you cannot claim every expense. Anything you spend should have been spent entirely on your contracting work and you have to keep all receipts to justify those claims.
It is prudent to remember that an umbrella company will deduct its fee before tax. This can help bring down your tax liability marginally. The fee can be a fixed amount or a percentage of your total payment. Find out the payment schedule. Some umbrellas pay as soon as the client releases the funds while others pay on a specific date in the month.
There is a misconception that an umbrella company does away with the advantages of being an independent contractor, or you end up paying a large slice of your profits to the company. Working under an umbrella company has many benefits, but those advantages depend on your business goals and individual circumstances. Nonetheless, if you do choose to work through an umbrella, you may enjoy substantial benefits in the long run.
If you are a contractor, you might have heard of the term “umbrella company” without fully understanding exactly what one of these entities is and how it works. These types of PAYE schemes are becoming more and more popular in the UK and can offer a hassle-free option for contractors who do not wish to sort out every aspect of their pay and tax affairs themselves.
Here, we’ll take a look at how these schemes work, the questions to ask when looking for a scheme, and how to choose the best provider.
What are umbrella companies?
PAYE umbrella companies are a type of standard UK limited company. They act as the contractor’s employer, so your contract is between yourself and the umbrella company. They then have a contract with the recruitment agency or client. You can think of the umbrella company as a middle-man or go-between, linking you and the client or organisation. You are doing the actual work for the end client but are employed by the umbrella company.
The main benefit for you as a contractor is that the umbrella company handles all payroll issues, including processing timesheets and invoices. It then pays you a salary as an employee after allowing for deductions.
Deductions generally include any legitimate business expenses as a contractor, but the precise scope of what you can claim depends on whether your contract is considered to fall under the Supervision, Direction and Control (SDC) of the client. These new rules were brought in from April 2016.
How do umbrella companies work?
This is the typical sequence of events when working as a contractor via a UK PAYE umbrella company:
- You secure a contract role, usually through a recruitment agency. As your “employer”, the umbrella company signs a contract with the client or agency.
- At the same time, you sign a contract of employment with the umbrella company.
- After working onsite for a pre-agreed length of time, you will need to complete a timesheet, which will be checked and signed by a manager.
- The timesheet will show how many hours you worked that week or month. It will be submitted to both the umbrella company and recruitment agency.
- The umbrella company invoices the recruitment agency and they bill the end client.
- Payment goes back from the client through the agency to the umbrella company. The umbrella prepares and processes your salary.
- You are paid through PAYE. Deductions – including income tax and National Insurance, fees for the umbrella company’s services and any pension contributions – will automatically be worked out and deducted. You should also be reimbursed for certain allowable expenses, such as mileage allowance if you have to drive.
- Any remaining expenses can be claimed back against your income tax bill at the end of the financial year.
Finding the right scheme
There are many different providers out there, and it’s important to find the right one for you. Many recruitment agencies have their own preferred umbrella partners and may recommend a company to you. You do not have to go with their recommendation, however, and it’s usually best to conduct your own research and consider the options available.
As with many other areas in life, word of mouth and personal recommendations are important resources when it comes to weighing up a particular umbrella company. If you are only just starting out as a contractor, your professional circle might be limited, but the advice and opinions of any contractor friends or colleagues that you do have can be valuable. You might also find out more first-hand experience on contractor forums and groups online.
The internet is a good place to research these companies, but a word of caution: it can be difficult to filter out the genuine opinion from the marketing copy floating around. Comparison sites can offer a decent level of background information on leading providers, but you should probably view league tables or rankings with cautiousness as these can be manipulated or slanted in certain ways.
If you are a contractor, your first thought may be to set up a limited company so that you can manage your business affairs. However, there are numerous situations where it makes sense to set yourself up with an umbrella company instead. If you understand the benefits of working for an umbrella and then make an effort to synchronise your business goals with the applicable benefits, you will be in a better position to discern which business model is appropriate for you.
Things to consider
Here are a few things that you should contemplate when trying to decide whether an umbrella company is the right choice for your business needs.
- Reasons to become an independent contractor
Think about why you are choosing a contracting career. Is it to enjoy better work-life balance? Do you want to get the most out of your skills and expertise? Do you look forward to being independent and not being answerable to anyone?
- Managing finances
Do you have sufficient knowledge about finance and bookkeeping to handle your own finances?
- Ambition and objectives
Figure out what inspires you to embark on an independent contracting career and what you would like to achieve. It could be something like becoming the CEO of a company or being attracted by the varied working environments you will be exposed to.
Once you have determined honest answers to these questions, you will be able to look more objectively at the benefits of working with an umbrella company.
Benefits of umbrella companies
There are numerous advantages to being employed by an umbrella company. First of all, you will not have to manage your taxes, National Insurance or payroll. This can be challenging if you are new to your contracting career and are not literate in financial affairs. With this out of the way, you can focus on growing your contracting business.
Secondly, you won’t require as much starting capital when working with an umbrella company compared to establishing a limited company. This frees up funds to invest in expanding the business.
Furthermore, an umbrella company gives you the freedom to outsource administration. This way, you can focus on day-to-day work rather than spending time engaged in tedious paperwork. Not only is this monotonous and time-consuming, it does not generate revenue for your business.
The bottom line
Your status as a contractor will have a major influence on your decision on whether or not to work with an umbrella company. If you are going to fall within the remit of IR35, you might not benefit financially with a limited company setup as you will be liable for National Insurance and PAYE. Under such circumstances, it is prudent to opt for an umbrella company.
It is also important to note that signing up with an umbrella company is not a binding decision. If you feel that a limited company business model is more suitable at any time, you can change the status of your company when appropriate.
In conclusion, it can be categorically stated that the main benefit of an umbrella company is that you can take a different path to becoming a contractor. An umbrella company allows you to go ahead with your plans and optimises your time and responsibilities so that you can focus on your business. It is best to educate yourself about the different business models that you can utilise and then select one that best suits your contracting work to maximise your chances of commercial success.
The well-known test case of James v Greenwich London Borough Council was influential in establishing that limited company contractors do not receive the protection of standard employment rights between themselves and their clients. This applies whether they are inside IR35 or not, but the situation is less clear cut for those contractors working through umbrella companies.
While workers in this category might not be able to exercise employment rights directly with their clients, they may well be entitled to certain rights regarding their umbrella companies. If an umbrella company genuinely employs a contractor, this equates to the contractor enjoying the same benefits as any permanent employee.
Umbrella company models
Your employee status with an umbrella company typically depends on the model that it utilises. Those using a “pure” employment model offer the same employment rights as any other employer. These companies are also often members of relevant trade bodies and might have stringent membership requirements.
Some businesses that market themselves as umbrella companies do not offer employee benefits, however agency PAYE providers might treat their contractors as employees for tax purposes, but these workers are not actually employees of the company. This means that the business can deduct tax and NI at source, but the contractor will not receive employee rights and benefits.
The same goes for payment scheme providers that offer offshore payment solutions such as an employee benefit trust (EBT). Companies often sell these as tax-efficient schemes but, again, the contractor will not have employment rights with the business.
Benefits for employees
Many contractors, freelancers and other self-employed people have greater freedom and flexibility as well as higher potential earnings than traditional employees. On the other side of the scale, employees enjoy greater security and a range of benefits.
Contractors who are genuine employees of an umbrella company should receive the same benefits as any other full-time employee, including but not limited to:
- Holiday pay
- Maternity and paternity assistance
- Statutory sick pay
- Minimum wage
- Guaranteed minimum hours
- Redundancy entitlement
Contractors employed by a large, well-structured umbrella company can also benefit from elements of the organisation’s infrastructure. This might mean having access to human resources support for issues such as disciplinary and employee grievance procedures, should there be a problem between you and the client.
Being the official employee of a professional umbrella company can also bring other benefits. If you need a reference for a loan or mortgage application and your lender looks more favourably on employees, then the HR department can offer the necessary paperwork. Umbrella companies with efficient and experienced HR, payroll and finance departments in place can help individual contractor-employees with a wide range of issues and queries.
Length of service
Some umbrella companies scale the benefits they provide depending on the amount of time that contractors stay with them. If a contractor is a genuine employee, then he or she may have some statutory rights that increase over time (such as redundancy entitlement), but others may be down to the umbrella company’s policies. This could mean, for example, a sliding scale of notice periods, with the company setting the length of a notice period according to how long the contractor has worked there.
Umbrella companies can fill a unique role, offering support infrastructures and benefits that are not available through a limited company, while still giving the flexibility and increased earning potential that contractors desire.
Making the jump into contracting is a big decision, but it’s not the only one that you need to make. You also need to decide the structure that you will work under.
Clients typically engage contractors in two basic ways:
- With direct contracts, the contract exists between the client and either the contractor’s own limited company or an umbrella company.
- Contracts can also be made via recruitment agencies. In this case, one contract exists between the agency and the client company. Another is made between the agency and the contractor’s limited or umbrella company.
As you can see, both scenarios can be used with either a contractor’s own limited company or an umbrella company, but what are the differences between these two ways of working?
If you decide to operate as a limited company, you will become your own company director. This is generally considered to be the most tax-efficient way to operate, but it also comes with a number of statutory regulations and obligations that you must fulfil. You will have to submit annual accounts to Companies House, commit to running the company responsibly (though that would be in your best interests anyway) and meet HMRC tax obligations.
While you are responsible for meeting these obligations, however, there are plenty of specialist contractor accountants who will be happy to do the legwork for you. You will have to pay them, of course, but the tax benefits could still outweigh these costs.
The reason why this model is so tax-efficient is because you can choose to pay yourself a relatively low salary and take other remuneration in the form of dividends. You do not have to pay NICs on these dividends, potentially resulting in a tax saving. It’s worth noting that the value of this tax saving has been dramatically reduced since new dividend tax rates were introduced in 2016.
There are some other tax benefits, however as company director, you can choose when to withdraw funds. This can help in tax planning and, where appropriate, you might also be able to transfer shares to a spouse.
While you pay income tax and National Insurance on your wage, the business must pay Corporation Tax on all profits. VAT is also added to your invoices and repaid to HMRC – minus any legitimate VAT that you have already reclaimed on business purchases.
To start a limited company, you can register with Companies House yourself. This is a cheap and quick process nowadays, but many contractors still prefer to let their accountant handle the procedure, alongside other startup tasks such as setting up payroll and registering the new company for VAT and Corporation Tax.
Umbrella companies are becoming an increasingly popular option for UK-based contractors. When you sign up to this type of scheme, you essentially become an employee of the umbrella company. The end client or agency pays the umbrella company based on the weekly or monthly hours that you have worked. The umbrella company then deducts your income tax and National Insurance, any expenses and its own fees, and pays you the rest in the form of a salary.
This tends not to be as tax-efficient as operating under a limited company structure, but many contractors prefer it as it is regarded as more hassle-free. This can make it a good option for people who are only planning to contract for a limited time, who are testing the contracting waters, or who simply want as little paperwork and related obligations as possible.
The effects of IR35
One important piece of legislation that may affect your decision is known as IR35. This was introduced by the government as a means to crack down on so-called “disguised employment”, where a worker might enjoy the tax benefits of being self-employed while actually working in a way that is identical to an employee of the business that he is engaged by.
This legislation was first introduced back in 2000, but it was augmented by “off-payroll” changes introduced last April. This meant that public sector clients are now responsible for determining a worker’s status as regards IR35.
If your contract work is deemed to be subject to IR35, the tax-efficiency value of working as your own limited company is severely reduced. This could be another reason for considering the option of an umbrella company.
When working as a self-employed contractor, the most common and tax-efficient way of operating is to set yourself up as a limited company. This may sound daunting at first, but the process is relatively straightforward and has many advantages. Although you will incur a number of legal and statutory obligations, these can generally be met easily, especially if you use a specialist accountant.
What is a Limited Company
A limited company is a business organisation that is a distinct legal entity, separate from the company directors and its members and/or shareholders. This means that the liability of directors, members and shareholders is limited by law if the company should face legal action, be declared bankrupt or otherwise find itself in serious trouble.
Limited companies are administrated by company law under the Companies Act 2006 as well as associated legislation, and are the most popular form of incorporated business structure in the UK. According to the most recent government statistics, there are currently around 1.8 million limited companies actively trading in the UK, as opposed to 3.3 million sole traders and 421,000 regular partnerships.
This is a significant increase on 2012, when there were just 1.3 million limited companies actively trading. Although sole traders still outnumber limited companies, their number has only increased by 10%, whereas the number of limited companies has grown by a whopping 38%.
Benefits of establishing a limited company
The main benefit of setting up a limited company, as mentioned above, is that your personal liability as a company director is limited. Your assets are distinct from the company’s assets, so not only are you protected should your company go under, but you also enjoy a tax advantage compared to working as a sole trader.
As a shareholder in your own company, you can draw most of your income from the company in the form of dividends. Unlike salary payments, these are not subject to National Insurance Contributions (NIC). They are taxable, but the first £2,000 is tax-free. Although this is a significant reduction from the £5,000 dividend allowance that shareholders enjoyed prior to 6 April 2018, it is still not to be sniffed at.
You can also divide your shares with a spouse and time your dividend declarations (payments) in order to maximise both your tax-free allowances. Different classes of shares can also be created for tax planning purposes – for instance, if other business partners or investors become involved further down the line.
As a company director, you have total control over your own business, unlike if you were working via an umbrella company. Being a company director also gives you a certain professional status, which can be useful in acquiring contracts, entering into negotiations and exploring future business opportunities.
What other options are open to me?
Contractors who don’t want to set up their own limited company generally use an umbrella company. It is rare for contractors to set up as sole traders as there are considerable disadvantages to going down this route. Non-contractors can also set up their own limited companies but can also simply be self-employed or work in partnership with other self-employed individuals.
How do I form a limited company?
In order to incorporate a company, there are several routes that you can take. The most cost-effective and straightforward method is to go directly to the Companies House Web Incorporation Service online. This costs just £12 and can be completed within 24 hours.
You can also register by post using Form IN01, which takes eight to ten days and costs £40. Same-day incorporation via Companies House will cost you £100. You can also go through an intermediary – for example, formations agent or an accountant – but obviously their charges will vary. If you are new to the process or are unsure as to what you need to do, you may want to take this route.
Companies House will ask you to provide the details of your company’s officials and the amount of shares you want to create, amongst other information. You will also need to give your company a name. Avoid words and phrases that suggest you are affiliated with other bodies or organisations if this isn’t the case, and go for something neutral and professional-sounding, which will look good on your letterheads. You can always change it at a later date.
Once your company is registered, you will be given a Certificate of Incorporation. You or your accountant now needs to register the company to be compliant with VAT, Corporation Tax and payroll purposes with HMRC. This may all sound daunting, but it is remarkably easy to do and the basic costs are far lower than in most other countries. However, it is recommended that you use an accountant as there are several further steps that need to be taken, and you want to make sure that you get them right.
What are my responsibilities as a company director?
Under the rules of the Companies Act 2006, a company director has the following responsibilities:
- Produce the company’s annual accounts
- Submit a snapshot of the enterprise at a given moment in time, known as a Confirmation Statement, to Companies House, and to keep them updated as to any changes made to the company, such as changes of address
- To act in the best interests of the business and its shareholders, within the director’s powers as laid out in the company’s constitution
- To demonstrate reasonable judgement and care in the conduct of business
As a company director, you may appoint a company secretary to oversee administrative tasks, but this is not a legal requirement. You are perfectly entitled to be the sole director of your own limited company.
Once you’ve set up your own limited company, you’ll see why it is the most popular structure for IT contractors especially. There are a number of tax advantages over using an umbrella company, and doing your own paperwork and administration is a small price to pay for this. You also remain in complete control of your company, and most of the day-to-day admin can be handed over to a specialist contractor accountant.
You can discover more about the taxes that you will encounter as a limited company director on our website, and take your time to read through our other related guides.
What limited company expenses can you claim against your tax bill?
If you own a limited company, there are some expenses that you incur while running the business that can be set against your tax bill. There are strict rules regarding what counts as allowable expenses, however, and it’s important to understand what you can and can’t claim for.
Important rules regarding limited company expenses
There are a few important ground rules that you should bear in mind when it comes to your expenses. These include the following:
- You can only claim expenses for things that have been incurred “wholly, exclusively and necessarily” in the course of carrying out your business. For contractors operating under the structure of a limited company, this means during the course of your contracting work.
- This also means that you cannot claim for any expenses with “duality of purpose”. Essentially, this means anything that you use both outside and in work.
- Keep all relevant receipts and paperwork in case you are later challenged. You may need to provide proof of the expenses.
- The majority of allowable expenses can be offset against any Corporation Tax liabilities the business has. There are some exceptions, however, such as “business entertainment”.
Some common limited company expenses
The things that could count as expenses can vary depending on your role and what you need in order to carry out your business. They will generally need to meet the rules of thumb given above.
There are also some standard and common expenses for limited company owners, however, which could include:
- Salaries of all employees – for contractors, this will usually just be you but could include a spouse.
- Employers’ National Insurance Contributions (NICs) on any salary that is above the current NIC threshold.
- Business stationary, postage, printing costs, etc.
- Equipment such as computers and hardware.
- The costs of training courses that relate directly to the business.
- Relevant business insurance such as Professional Indemnity insurance.
- Bank account charges in business accounts.
- Executive pension scheme contributions.
- Magazine subscriptions that are directly related to your work.
- HMRC has a list of allowed groups. Subscriptions to these professional organisations are allowable expenses.
- Accommodation costs if working away from home – but only if your contract has run for less than 24 months in the same location.
- Food and drink (subsistence costs) while away from home – subject to the same 24-month rule, as above.
- Telephone and broadband contracts that are in your company’s name. Also, the costs of individual business-related calls, even if they have been made from a landline or mobile that you also use for personal calls.
- A percentage cost of household bills if you work from home. Alternatively, you can claim a flat rate for using your home as an office of £4 per week or £18 per month.
- Costs for travel and parking when travelling to sites that are not your regular place of work. If using your own car, you can claim a mileage rate of 45p per mile for the first 10,000 miles. It drops to 25p per mile for each mile after that.
- Business accountancy fees (not including charges for your own personal tax return) and professional fees such as hiring a solicitor for business purposes.
- Medical checks and eye tests for employees.
- Advertising and marketing costs.
- Company events such as a Christmas party, but there is a £150 limit on how much you can claim for this.
- Gifts to business clients worth up to £50 each.
- Essential administration such as the fee for your annual Confirmation Statement with Companies House.
There are some other things that you may be able to claim but not via your limited company’s Corporation Tax.
These could include the costs of entertaining clients and the initial costs of forming your company, if you paid for it personally. This incorporation will count as a one-off “capital cost”.
Other things to bear in mind
If your contracting is for a private sector client and you are deemed to fall within IR35, you might still be able to claim a fixed amount equal to 5% of the turnover of the contract to help offset the costs of running a limited company. This is not available if your contract is within the public sector.
As well as this allowance, you can still claim certain expenses such as travel, subsistence and pension contributions. These are known as Section 198 expenses.
You may be able to claim for some expenses that you paid for personally before setting up your limited company. These are known as pre-trading expenses.
If your company pays for certain things that you benefit from personally, such as gym memberships, you may have to pay tax on these “benefits in kind”.
The above information is not exhaustive. Tax is a complicated issue, and you might consider consulting an accountant to address any specific concerns.
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.
What choices are available for contractors who use umbrella companies?
Following the Budget of April 2017 and the ensuing Managed Service Company (MSC) legislation, only one umbrella option exists: the PAYE umbrella company.
IR35 status and contractor payment structures
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.
Is it possible to work through umbrella companies to avoid IR35 taxation?
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.
What is IR35 exactly – and does it affect my contract?
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.
Why did the UK Government introduce IR35?
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.
How IR35 operates
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.
Core tests: control, substitution and mutuality of obligation
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?
This refers to the level of control that an end client has over the work itself, how contractors should complete it and where they should complete it. The higher the level of client control, the more likely you are to fall within IR35.
This refers to whether a worker must offer a service in person or whether he or she can send a substitute instead. If you cannot send a substitute in your place, then you are more likely to fall inside IR35.
- Mutuality of obligation
This arises when an employer has an obligation to offer work and the worker has an obligation to accept it. Contractors who are outside IR35 are free to decline work.
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.
IR35 applies – what next?
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.
Can contractors avoid IR35?
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.
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.
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?
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.