IR35 describes two pieces of tax legislation that seek to tackle tax avoidance by contractors and the firms that hire them. These contractors supply services to clients through an intermediary company. However, were it not for the intermediary, the contractor would be an employee of the client.
HMRC calls these workers “deemed employees”. If caught out by IR35, they must pay income tax and National Insurance as if they were contracted employees. IR35 can potentially impact a worker’s net income by up to 25 per cent, equating to thousands in income tax for the average limited company contractor (PSC).
The original IR35 legislation dates from 2000, but was widely criticised for its poor implementation and was replaced with the new Off-Payroll Tax, which was introduced in the public sector in April 2017. This was initially intended to be implemented in the private sector from April 2020, but was delayed until April 2021 due to the impact of COVID-19.
What is IR35 and why was it introduced?
The new IR35 legislation means that firms must now assess the status of their contractors and, crucially, pay employment taxes on top of the fees they pay to the contractor. This is intended to tackle the “deemed employment” problem, through which organisations can make significant savings on things such as National Insurance, by engaging workers on a self-employed basis rather than with an employment contract.
IR35 aims to play a role in both defending workers’ rights from unscrupulous employment practices and in defending HMRC from lost taxes. However, the original form of the legislation fell short of these aims.
How IR35 works
IR35 essentially seeks to turn legitimate one-person businesses into employees. It involves the application of the UK legal systems’ tests of employment.
This means that HMRC will largely disregard the written contract in place between the worker and their client, instead seeking to create a “notional contract” by looking at the actual nature of their working relationship.
This will then be used by an inspector or tribunal judge to determine whether it is an employment contract, for which IR35 applies, or a business to business service, in which case IR35 would not apply.
Determining IR35 status can be complex and contractors are generally advised to seek advice from IR35 experts.
The three main principles of IR35
IR35 basically involves the application of three main principles in order to determine employment status. These principal “tests of employment” are:
Control – what is the degree of control held by the client over what, how and when the contractor completes their work.
Substitution – Is the worker required to deliver personal service, or can they send a substitute to fill in for them.
Mutuality of obligation – This a concept where the employer is obliged to offer work, with the worker obliged to accept.
Beyond these three principles, other factors taken into account include the type of contract, whether a financial risk is being taken, whether the contractor is seen as “part and parcel” of the client’s organisation, whether the contractor is in business on their own account and the provision of equipment.
If, when these things are taken into account, the situation seems to suggest that the worker is an employee of the client, then IR35 will apply.
What to do if IR35 is applicable
Under the new IR35 legislation, fees paid by clients to their contractors will be treated as employment income. Like a salary, payments will be subject to PAYE and National Insurance Contributions. The fee-payer must then pay employment taxes on top of this, as these can’t legally be deducted from the contractor’s fees.
How can firms and contractors avoid IR35?
The only way firms can totally circumvent IR35 is to hire all contractors on fixed-term contracts and pay all extra employment taxes on top. However, this would be an expensive way round the problem and it would be difficult and time-consuming for firms to attempt to negotiate the rate cuts necessary to offset the additional taxes with all their contractors.
For firms hiring genuinely self-employed contractors, IR35 won’t apply, but costly and time consuming HMRC investigations may prove unavoidable.
However, for those wishing to engage contractors outside of IR35, some companies can offer services assessing all contractors. This service is quick and will provide the company with a Status Determination Statement, complete with full reasoning, for each contractor.
