What is IR35 & What are the Rules & Changes

IR35 is a legislation designed to prevent people from avoiding tax by describing themselves as self-employed or freelance when they are, to all intents and purposes, an employee of the company they’re doing contract work for.

IR35 is designed to combat tax avoidance. The IR35 legislation is targeted at individuals who are providing services through their own limited companies or partnerships and who may not be paying the tax that they should be.

The legislation should be of huge concern to all contractors; the financial ramifications of falling foul of IR35 can be significant so it is vital that everyone understands how it works.

Why was IR35 introduced?

First issued in 2000, IR35 targets those workers considered in the eyes of HMRC to be ‘disguised employees’. Contractors, being technically self-employed, are not taxed in the same way as average employees, taking dividends from their company and paying far less in National Insurance Contributions. Because of this, HMRC are keen to ensure that those working as contractors (and paying less tax) are indeed genuinely in business on their own account, and are not working in the same way they would have been if employed directly by their client.

Why does HMRC want to stop this?

When someone is a member of staff, they pay Income Tax and National Insurance on their earnings. Their employer pays 13.8% of their wage above a certain level in National Insurance Employers’ Contributions.

When that person returns as a contractor, National Insurance Employers’ Contributions is no longer payable. The contractor may draw the same earnings from their former employer (perhaps even higher) and they will split their income between salary and dividends. That means a lot less money for the Exchequer.

How is IR35 determined?

If you act like and are treated like an employee you should be taxed as one. However, there are a lot of grey areas in the legislation and some points which may seem relatively insignificant can have a major impact.

If you choose to work ‘outside’ IR35 and take dividends from your company, you run the risk of being on the receiving end of an IR35 enquiry. This is effectively an investigation where HMRC review your circumstances and ultimately decide whether or not you have been paying tax correctly.

If they decide that you are a ‘disguised employee’, you will be required to make a deemed payment, effectively paying back all tax and NI you would have paid if you were an employee (plus interest and a possible penalty). This can easily run into tens of thousands of pounds, which is why IR35 is such a big issue for contractors.

In an enquiry, HMRC will look at the contract you have with your agency (or end client if direct), so this is the first thing to check when deciding how to trade. They will also delve into the actual relationship between you and your client, commonly referred to as your actual working practices.

If your contract is IR35 compliant but they subsequently find that you are treated like an employee in reality, they will effectively say the written contract is worthless. It is therefore vital to ensure that your contract and working practices mirror each other.

IR35 rules

In order not to be caught under IR35 rules, the relationship between a contractor and a contracting organisation needs to meet a number of conditions.

1. Defined provision of services – the contractor should know exactly what work is entailed in the contract with their customer. Each part of the service provided should be described in detail together with some expression of the desired outcome of the provision of the parts of service and the service as a whole.
2. Control – the contractor should not be told that they will be directed, supervised, or controlled by the customer or a representative of the customer. To avoid IR35, the concentration should be, as much as possible, on the ends and not the means.
3. Substitution – the contractor should be permitted, as part of the contract, to allow someone else to complete work or parts of work in the contractor’s place.
4. Mutuality of obligation – any further work in addition to previous work done for the client should be covered by a separate contract and agreement. The contractor must not be obliged to do work for the contracting organisation and the contracting organisation must not feel obliged to offer the contractor any more work past what has been agreed in advance.
5. Contract termination – the contract should be for a defined project and the contract should end when the defined project has been completed to the contracting organisation’s satisfaction. The contract covering the work should be based around a realistic and estimated timeframe in which the work can be completed.
6. Financial risk – a contractor should have some sort of professional indemnity insurance at the very minimum, have a service level agreement, and agree to remedial work when needed and when caused by something the contractor has or hasn’t done or has completely wrongly.
7. Payment – the agreement on how the contractor is paid should look and feel like those that exist between companies and should not look and feel like a succession of pay-days. Clients should be billed by the hour, by the day, or by the project.
8. Exclusivity – the contracting organisation should in no way impede the contractor from working for other companies when they like, even if a client is a competitor of the contracting organisation.
9. Equipment and premises – ideally, the contactor should provide the equipment used on a job. The contractor should keep receipts for the equipment and demonstrate that they are in charge of up-keeping and maintaining their equipment.
10. Intention – the contract should show that the contractor and the contracting organisations are separate and that there is no employer-employee relationship.

IR35 investigations

On the one hand, it’s great for you that (outside the public sector) you can declare whether your contractual arrangement is within the scope of IR35 or not. On the other hands, it’s not great for the taxman because, in his/her mind, the system is open to abuse and manipulation.

From HMRC’s point of view, there is a lack of transparency about the whole situation.

That lack of transparency is made worse by the severe shortage of staff available to them who can go out and find IR35 transgressors. From around 1,000 investigations in tax year 2003/2004, the figure fell to 192 in 2013/2014. No more recent figures are available for us to compare whether this downward trend is continuing however the introduction of the public sector IR35 rule in 2017 suggests strongly that they have given up and are just going to penalise everybody now.

If you are investigated, you will get a letter from HMRC asking you if you have considered your contracting status in the light of IR35 and they will ask you for justification on why you believe you fall outside the scope of IR35.

They will investigate some more after that, normally asking for more paperwork including your contract and they may wish to speak to the companies you provide contracting services for.

If they judge that you fall within IR35, then you are likely to face a demand for the income tax and National Insurance you have not paid plus interest plus penalties of up to 100% of the tax owed.

IR35 and client diversification

Rather than just servicing one client, you can provide further protection for yourself by developing a portfolio of clients each of which you invoice and have separate contracts with.

The more customers you serve under contract, the more that your contracting business looks and feels like a standard business with a variety of turnover sources.

How much worse off will you be if you’re in the scope of IR35?

A significant amount.

If you fall under IR35 rules, you’ll be subject to normal Schedule E taxation and National Insurance – the same as employees pay. You’ll have a 5% allowance subtracted from your tax to cover your administrative expenses. You can claim additional expensive for business travel, subsistence while away of business, professional indemnity and other business insurance, benefits-in-kind, and executive/personal pension payments.

The much-increased tax you pay prevents you from accumulating cash in your business.

Let’s look at how £60,000 worth of fee income would be treated for a contractor using a personal services company against one who had been caught by IR35.

In this example, the contractor using a personal services company is paying him- or herself £8,164 in salary. There are additional costs for both of £5,708, covering travel, subsistence, expenses, accounting, and insurance.

As you can see, the person caught in the scope of IR35 is nearly £9,000 worse off so getting it right does make a big difference.

Are there any other ways to avoid IR35?

• Always make sure that there is a provision in your contract that allows you to work for others. Make sure that all of your contracts are IR35 friendly.
• Diversifying the services you provide and your customer base.
• Go contracting overseas in less complicated tax regimes.
• Go back to the world of employment, particularly if you find contracting less stable and you are concerned about IR35.
• Use an umbrella company.
• Never start work without a contract you (and your accountant) are happy with.
• If your client thinks he or she is your boss and tells you to do something not in your contract, refuse.
• Make sure there’s a right of substitution clause in your contract.
• Always make sure it’s your company name mentioned in the contract and never you personally.
• Never ask for holidays – discuss with your client when taking a holiday works best for you and them.
• Never carry around stationery suggesting you are your client’s employee.
• Try not to have a client email address.
• Don’t let your client pay for any training.

And finally, don’t become part of the furniture!

For more advice and support contact Mico Edward Accountants today: info@micoedward.com