What is IR35?
Navigating the intricate landscape of UK tax legislation is no easy feat, especially for contractors. Amidst the myriad of regulations, one term stands out prominently: IR35. But what is IR35, and why does it matter?
In this comprehensive guide, we delve deep into the heart of IR35. Whether you’re an aspiring contractor or a seasoned veteran seeking clarity, this guide aims to demystify IR35, empowering you with the knowledge to make informed decisions and remain compliant.
Background to IR35
Permanent employees and contractors are treated differently under UK law. If a contractor provides services through their own limited, they may take some of their pay in dividends instead of taxable salary.
They can also offset several business expenses against Corporation Tax and pay less in National Insurance Contributions. This lower tax burden reflects the more significant financial risk of being self-employed.
HMRC introduced IR35 (or the ‘off-payroll working rules’) in 2000 to tackle ‘disguised’ employment. When a contractor is a ‘disguised’ employee, they take advantage of the tax efficiency of working through a limited company despite being treated and working as though they are an employee by the end client.
HMRC views these disguised employees as avoiding tax by taking advantage of the reward with none of the corresponding risks.
The benefit for employers is that they don’t have to pay employers’ National Insurance contributions or give the contractors employee benefits. The benefit for contractors is that they can pay themselves through their limited company to minimise their tax burden.
What is IR35?
IR35 is an employment status test that determines whether a contract points towards employment or self-employment. It combats tax avoidance by closing loopholes, ensuring contractors working the same way as permanent employees pay the same taxes.
If your contract is ‘inside IR35’, it points towards employment. Your working arrangements are similar to those of a permanent employee, so HMRC imposes broadly the same income tax and national insurance liabilities. Working inside IR35 is usually done via an umbrella company that handles the administrative burden of paying the correct taxes. See our guide on umbrella companies for further details.
If your contract is ‘outside IR35’, it points towards self-employment, and you can enjoy the tax efficiency that self-employment brings (as well as all the associated risks). Working outside IR35 is usually done via a personal service company (‘PSC’). A PSC is a limited company set up by a contractor to provide their services; they are usually the sole shareholder and company director. See our guide on limited companies for further details.
'IR35' Meaning
‘IR35’ was the reference given to the press release which first announced the off-payroll working rules legislation in 1999. It was the Inland Revenue’s (IR) 35th (35) press release.
How Does IR35 Work?
IR35 applies on a contract-by-contract basis; it does not apply once to your entire company. For each contract, the relevant ‘decision-maker’ (usually the end client) prepares a Status Determination Assessment (‘SDS’). The SDS looks at the engagement contract’s wording and the contractor’s day-to-day working practices and decides whether IR35 applies.
Three key factors are considered when assessing a contractor’s IR35 status:
i) Supervision, Direction and Control
Does the contractor maintain autonomy over what work has to be done, when it has to be done, and where it has to be done? If not, this points to an employee-employer relationship.
ii) Substitution
Does the contractor have the right to provide a qualified replacement in their place should they be absent for any reason? If not, this is an indicator that the contract is inside IR35.
iii) Mutuality of Obligations
Mutuality of obligations exists when an employer has a legal duty to provide work, and the employee has a legal duty to perform said work. It is a vital part of a traditional employee/employer relationship.
See our guide to The IR35 Rules for further information.
HMRC offer detailed guidance notes and an online tool to help decision-makers determine whether IR35 is relevant. Third parties also specialise in performing these assessments and providing insurance against a potentially incorrect determination.
Who Does IR35 Apply To?
Any contractor that is a UK resident for tax purposes has the potential to be impacted by IR35. Although the party responsible for performing the SDS can vary, if you are a contractor paying tax in the UK, you need to consider IR35.
This is a point that often confuses contractors. They mistakenly believe that if a potential client is overseas, then IR35 doesn’t apply. Instead, they become responsible for the SDS, decide whether they are inside IR35, and hold the liability should this decision be wrong.
If you work outside IR35 through a limited company, HMRC could open an ‘IR35 enquiry’ into your circumstances. An IR35 enquiry reviews your engagement contract, working practices, and other relevant information to decide whether the decision maker is correctly classified as outside IR35.
If HMRC decides the original SDS was incorrect and you are a ‘disguised employee’, a deemed payment must be made. This payment is calculated as the additional Income Tax and National Insurance you would have paid if you were an employee, plus interest and any relevant penalties.