IR35 is a daunting piece of legislation for many people. If you're currently self-employed and working as a contractor or a business owner that hires contractors, you'll be no stranger to IR35, but it's still a complex and often confusing subject to wrap your head around.
It was introduced to stop businesses and employees from engaging in tax avoidance. Employees would set up a limited company and then work as self-employed contractors with the same business they were previously employed under so that both parties would benefit from not paying tax. HM Revenue & Customs (HMRC) saw this as 'disguised employment,' hence IR35 to tackle this issue.
If you are genuinely a freelancer, contractor, or self-employed worker, you have nothing to fear. But even still, there is uncertainty regarding what IR35 is and who it applies to, mainly because the legislation can be a little vague and lack clarity.
Therefore, this article will explore everything related to IR35 from what it is, how it works, who it applies to, and what to be aware of. Let's jump in.
IR35 legislation is relevant to all self-employed contractors who work through a limited company. But IR35 applies to contractors who work for their own limited company but are, in fact, employees 'disguised' as self-employed. That would include those who receive employment benefits from their client's business, are obligated to be offered work and obliged to accept, have no control over how the work is completed, are paid on a time basis, carry out all contracted work personally, work for only one client long-term, do not have a separate business identity, or are supplied with equipment by the client and work at their premises.
Whilst that is not an exhaustive list, far more factors affect whether IR35 applies to contractors. Those listed are the main points considered if HMRC decides to investigate your employment status. Essentially, IR35 will apply to those who would be seen as an employee of the client's business if not for being contracted through a limited company. Read on for a more extensive list on who IR35 applies to.
What is IR35?
IR35, also known as Intermediaries Legislation, is a term that relates to the off-payroll working legislation. The IR35 legislation is in place to determine if businesses are hiring contractors, or soliciting workers on a self-employed basis but are, in fact, employees in 'disguise', thus hiding their actual employment status and engaging in tax avoidance.
The IR35 legislation came into effect in April 2000 and takes its name from the original press release by Inland Revenue (now called HM Revenue & Customs). Since then, the UK Government has experienced many issues with enforcing the rules, so much so that in April 2017, they established the off-payroll working rules.
These off-payroll working rules are new tax legislation that is entirely separate from the original IR35 legislation but tackle the same issues and are more enforceable. As such, it is also now referred to as 'IR35', which can be pretty confusing. However, from now on, when mentioning IR35, we will be talking about the off-payroll working rules, not the original legislation.
Why was IR35 introduced?
IR35 off-payroll working rules were introduced to tackle tax avoidance and deemed employment. This is where businesses were hiring contractors or workers on a self-employed basis, becoming deemed employees in 'disguise'. Both parties benefitted from this with tax efficiencies.
For a business, they would save a good chunk of money from not having to pay the employer's National Insurance contributions, and would also save money on not having to offer employee benefits or rights to the workers.
For contractors, they would have to open a limited company and, as such, benefit from tax advantages associated with working through a limited company. Although the contractors would be ineligible for employee benefits such as maternity and holiday pay, their take-home pay would increase, and they would have increased flexibility over their work.
The most common form of this in working practices is the 'Friday to Monday' phenomenon. This is where an employee would quit their job with their employer on Friday but return to the same role at the same company back on Monday. The only difference is that this time, they are hired as a contractor working through a limited company, as opposed to an employee, with both parties benefiting greatly from tax efficiencies.
The IR35 off-payroll working rules were designed to address that exact scenario. However, they aren't without their problems. Many people find the IR35 legislation challenging to understand, and it seems that even HMRC struggles with this. There is quite a bit of vagueness regarding employment status guidelines, and it can lack clarity, something which is proven by HMRC's patchy record of wins in IR35 cases. At the time of writing this article, since 2010, HMRC has only won 29% of cases outright, with the rest either being awarded to the contractor or resulting in a split case.
How do IR35 tests generally work?
IR35 is underpinned by case law, and a deep understanding of employment legislation is necessary. Employment status case law has significantly evolved over the last few decades and is a very nuanced and complex field.
But in essence, an inspector from HMRC will try to use the actual working relationship of the business and contractor to establish a 'notional contract'. This is done so that the existing written contract between both parties can be ignored and to highlight the differences. The inspector, or a tribunal judge, then uses the notional contract to assess whether the working relationship and contract are one of business to business where IR35 does not apply – being classified as 'outside IR35' – or one of employment where IR35 would apply – being classified as 'inside IR35'.
What does inside IR35 mean?
If your contract is considered to be inside IR35, this means that under IR35 legislation, HMRC would see you as an employee. As such, you would have to pay Income Tax and employee National Insurance contributions as any other employee would, but you would also have to pay what is called 'deemed payment'. This is to account for Income Tax or National Insurance contributions payments that an employee would have made during that tax year, which they did not.
What does outside IR35 mean?
If your contract is considered to be outside IR35, this means that under IR35 legislation, HMRC would see you as self-employed. As such, you can enjoy the tax efficiencies associated with self-employment, such as paying yourself a salary, withdrawing additional income as dividends that are not eligible for National Insurance contributions, and paying 20% Corporation Tax for profits your limited company has made.
How do IR35 rules work in practice?
According to HMRC, IR35 would apply to a contract or working relationship when in the absence of an intermediary, the contractor would be seen as an employee. The intermediary, in most cases, is the limited company through which the contractor is working and providing their services.
An intermediary can be more than just a limited company, though. It also includes:
- Personal Service Company
- An individual
- A partnership
When does IR35 apply?
As a general heuristic, IR35 will not apply if the working relationship is contracted for services and not employment. But, there are three main principles that are used to assess the employment status of a contract – the mutuality of obligation, control, and substitution.
- Mutuality of Obligation: Is the client obligated to offer work, and is the worker obligated to accept it? If this is the case, then the contract would be considered to fall inside IR35. This is perhaps the most important of the three in determining employment status.
- Control: Does the worker have control and autonomy over what, how, when, and where the work gets completed? If not, then the contract would be considered to fall inside IR35
- Substitution: Does the work have to be completed by the contractor themselves, or can they send a substitute worker in their place? If it must be done by the worker, then your contract would be considered to fall inside IR35
Of course, other factors are evaluated when determining the contractor's employment status as well. Although there are many more factors than the ones listed below, these can include the following:
- 'Part and parcel': Contractors that become deeply rooted in a company's structure and are viewed as part and parcel of the business would point to employment, and IR35 would apply
- Equipment: If the business provides equipment and the contractor does not have their own, this would be viewed as employment, and inside IR35 would apply
- Business ‘on your own account’: Are you running your business as a business? Do you have a business website, office space, or employees? If not, this may point towards employment, and IR35 would apply
- How you're paid: Contractors are often paid per project when the work is completed. If you are paid per hour, this could point towards employment, and thus IR35 would apply
- Exclusivity: Does the contractor work for other clients? If not, this may point towards employment, and IR35 would apply
- Working relationship: HMRC can disregard the contract if it deems it not representative of the working relationship between the contractor and business. If the relationship is more of an employer and employee, IR35 will apply
- Risk: As with all businesses, contractors tend to undertake some financial risk. Is the contractor responsible for mishaps during the contract? If not, this may point towards employment, and IR35 would apply
Who is responsible for assessing a contractor's IR35 status?
Initially, each contractor was responsible for assessing whether they fell inside or outside of IR35. The limited company they were working through was responsible for National Insurance and tax accounting.
In 2017, these rules were changed. While responsibility remained with the contractor in the private sector, the responsibility shifted to the client engaging the contractor in the public sector.
In April 2021, again, there were changes to the IR35 off-payroll working rules. In the public sector, the client engaging with the contractor is responsible for determining whether they fall outside or inside IR35. If the contractor is deemed to fall inside IR35, the party paying them is responsible for deducting Income Tax and NIC and reporting to HMRC.
The changes to the private sector were slightly more drastic. Large businesses are responsible for assessing the IR35 status of their contractors, and as above, the party paying them would be responsible for deducting Income Tax and NIC.
However, a small business would be exempt from this rule, meaning that all responsibility remains with the contractor. Small businesses are defined as such if they satisfy two of the following criteria for two consecutive fiscal years:
- 50 or fewer employees
- Annual Turnover of £10.2 million or less
- Balance Sheet total of £5.1 million or less
As you can see, IR35 and off-payroll working rules are far from straightforward. Most self-employed workers shouldn't have to worry too much since they will naturally fall outside of IR35. Nevertheless, it's good to know what IR35 is and what it entails.
As long as contractors and businesses who hire contractors do not blur the lines between a contracted working relationship with an employer and employee relationship, IR35 should not apply.