The Background to IR35
Introduced in 2000, IR35 is a piece of legislation which has been designed to handle “disguised employees”, or contractors who are benefiting from corporate structure rather than being taxed like regular employees.
The IR35 rules apply only to a “relevant engagement”, or a contract in which the individual contractor is providing their services via a limited company to a client and, without that intermediary company, their income would have been treated like that received by a standard employee.
The IR35 legislation intends that all of the money paid to the intermediary for their relevant engagement (apart from a number of specified deductions) should be subject to class 1 National Insurance contributions and Schedule E income tax, excluding many business-related expenses and dividend payments.
As a result of legislative changes introduced by HMRC from April 2017, for contractors working wholly within the public sector, the client or agency will determine your IR35 status. This essentially means that the decision is taken out of contractors’ hands.
Contractor Payment Structures
Contractors can operate under a variety of payment structures. Which one is most appropriate depend on the length and nature of your contract, as well as your preferred level of management and will affect your tax liability.
A Limited Company is currently the most tax-efficient option for contractors on long-term contracts, as business tax, rather than personal tax, applies, although this may change with the forthcoming budget. There will be an increased amount of administration, relative to other payment structures and all responsibilities for taxes and other deductions are the worker’s responsibility. Workers also have additional risks and liabilities if their company accounts are not managed correctly. Payments made by clients or agencies are made gross.
Contractors may use the services of an Umbrella Company when they either don’t want to run their own business or they are planning on only contracting in the short-term.
Working under a PAYE Umbrella offers protection to contractors, as the umbrella company becomes the Employer of Record, entirely removing the risk of being caught under IR35. Workers are a PAYE employee of the umbrella company and are paid minus all applicable tax and NI deductions. The payments from client or agencies are made gross to the umbrella company. As well as receiving administrative support, you would be entitled to the employee benefits such as holiday and sick pay, pension contributions and all statutory rights.
Some agencies offer a PAYE temporary payroll for workers who choose not to use an umbrella company. This basic service offers no additional benefits, other than statutory obligations. The agency effectively manages all taxes before paying the worker.
How does IR35 Work?
With the off-payroll tax, there is the concept of a “Fee Payer”: This is the agency if there is one. Otherwise it is the client. The client must assess the IR35 status of the contractor. The Fee Payer must then pay over all the taxes if they are inside IR35 by treating the contractor’s earnings as salary. So, employers NI must be paid on top of the contractor’s earnings (which is called the “Deemed Direct Payment”). Then, just like salary, PAYE and employees NI is deducted from the contractor’s earnings. If the contractor is wrongly processed as outside IR35, then the fee payer is liable for the tax, not the contractor.
If IR35 income exceeds the salary of the worker (after specified expenses are deducted) the excess is regarded as salary which is subject to National Insurance and PAYE. Any failure to account correctly for NI and PAYE could result in interest and significant financial penalties.
The expenses which are permitted to be deducted by the intermediary with regard to IR35 income include:
- Employee deductible expenses
- Any company contribution to an approved pension scheme
- Employers National Insurance
- 5% flat rate of gross income received from a relevant contracting engagement
Determining IR35 status
To determine whether a contractor is a self-employed freelancer or deemed employed for tax purposes there are three tests which must be applied:
- Level of control workers are not considered to be an employee unless the employer has a right to control the worker’s place, time, or scope of work. If the employer can control any element of the way in which the work is carried out, the contractor will be deemed to be inside IR35.
- substitutes If an individual is contracted to only provide their service personally, they are deemed to be inside IR35. Any contractor who can either choose to work on the job in hand personally or hire a third party to complete the task, they are probably self-employed.
- Mutuality of obligations in any contract there are several mutual obligations, but for a contract of employment to be in place, there must exist an obligation for the contractor to offer and the employer to accept any future work.
There are a number of other considerations which must be borne in mind when determining whether a contractor is inside or outside IR35. These include:
- Equipment Provision Self-employed contractors usually provide all of the necessary equipment required to complete the job in hand. Provision of all essential materials and equipment vital for the engagement is particularly important. As an example, if a contractor is engaged to carry out a particular job in their own home using their own equipment, this is a key sign that they are self-employed. On the other hand, if the contractor has been supplied with computer equipment and an office space by their employer, this suggests that they are “deemed employed”. Even if the contractor chooses from time to time to work in their own home or using their own equipment, this is irrelevant.
- Financial risk Individuals who risk their own finances through, for example, the purchase of assets necessary to complete the job, and those who bear their own overheads and running costs are probably self-employed. Contractors who take a financial risk by offering a fixed price quotation for the job in hand, under the understanding that if the job should overrun or go over budget they would be required to bear those additional costs, may be considered to be self-employed – although this will not necessarily be the case unless the risk of losing out financially is real.
- Payment basis Usually, employees are paid monthly or weekly and receive a fixed amount. They also usually qualify for extra payments like bonuses, profit shares and overtime. An independent contractor, conversely, will usually only be paid a set amount for each particular job.
- Potential for Profit An individual whose loss or profit depends solely on their ability to cut their overheads and effectively organise their workload could be considered to be self-employed. Individuals who receive payment per job are often in such a position.
- Part and parcel of an organisation one indicator of whether or not an individual is “part and parcel” of the organisation could help to determine IR35 status.
- Dismissal Rights one primary sign that points to an individual being deemed employed is whether their employer has the right to terminate their employment after giving a specified period of notice. A contractor who is self-employed will usually end their employment only when the task is completed or should the contract terms be breached.
- Employee benefits often, employees are entitled to receive benefits such as expenses, pensions, holiday pay and sick pay. However, just because a worker does not receive any of these benefits, this does not mean that they must automatically be considered to be self-employed. This is especially the case if the engagement is only a short term one, as payments of this nature would not usually be a feature in such cases.
- Engagement Length Although a longer period of time working for a single employer could indicate employment status however this is not conclusive since the conditions and terms of the engagement must also be considered. However, working on a regular basis for one engager could indicate a continuing and single employment contract.
- Intention The relationship’s reality is the most important element when determining IR35 status. Even if an individual is called “self-employed”, this is irrelevant if the conditions of their engagement all indicate that they are actually employed by their engager. If all of the other factors remain neutral, however, the parties’ intentions will be taken as the determining factor when deciding the individual’s employment status.
The Legalities of IR35
As you can see, there is a long list of conditions and factors which make it difficult to determine the employment status of an individual contractor. One of the greatest problems is that contractors can be tempted to work out their employment status by calculating how many of the above factors point towards them being deemed employed and comparing the result with how many factors indicate that they are self-employed. Unfortunately, however, this approach has been rejected by the courts.
Once the facts are established, the accepted approach is to look at the entire picture and to determine whether it indicates a contractor who is self-employed and operating their own business, or an individual who is working in the form an employee for another person’s business. When the evidence appears to balance evenly, the deciding factor will be the parties’ intentions in the matter.
The Cost of Non-Compliance.
If an assignment is inside of IR35 and the entity responsible for paying the worker (either the agency or the end client) does not deduct NI and applicable tax before paying the worker, then that body can be liable for the unpaid tax and NIC payments. It is, therefore, vital that all parties in the supply chain understand the risks and take steps to comply with the new taxation standards.
Find out More
To find out more about IR35 and how iConsult can help you, get in touch to speak to a member of our team.