What is IR35: A Comprehensive Guide for Contractors and Businesses

Introduced by HM Revenue and Customs (HMRC), IR35 is designed to identify and tax individuals who are working as disguised employees through their own limited companies, also known as personal service companies (PSCs).

The aim is to ensure that individuals who should be taxed as employees cannot avoid paying the appropriate taxes by working through intermediaries.

What is IR35?

Intermediaries legislation typically refers to laws or regulations aimed at determining the employment status of individuals who work through intermediaries, such as personal service companies or agencies. These laws are designed to tackle issues related to tax avoidance and ensure that workers are properly classified for tax and employment rights purposes.

In many countries, including the UK with its “IR35” legislation, intermediaries legislation targets situations where individuals provide their services through a company they control, rather than being directly employed by the client.

The aim is to prevent these individuals from benefiting from tax advantages that might arise from being classified as self-employed contractors when they are, in reality, working in a manner similar to traditional employees.

Under intermediaries legislation, if a worker is deemed to be effectively an employee of the client, despite working through an intermediary, they may be subject to the same tax and National Insurance contributions (NICs) as regular employees. This can have significant implications for both the worker and the client, affecting tax liabilities and potentially leading to disputes over employment rights.

The Purpose of IR35

The core concept of IR35 revolves around determining whether a contractor is genuinely self-employed or if they should be considered an employee for tax purposes. If HMRC determines that a contractor falls within the scope of IR35, the income they receive from their contracting work will be subject to the same tax and National Insurance contributions as if they were directly employed by their client.

Inside IR35 and Outside IR35

The terms “Inside IR35” and “Outside IR35” refer to the classification of employment status for tax purposes, specifically concerning contractors and freelancers who provide their services through an intermediary, such as a personal service company.

Inside IR35

Being “Inside IR35” means that the contractor’s working relationship with their client is considered akin to employment in the eyes of HMRC. Therefore, the contractor must pay income tax and National Insurance Contributions as if they were an employee.

For contracts in the public sector, and since April 2021 in the private sector (for medium and large businesses), the responsibility to determine IR35 status lies with the client or the hiring organisation. If they decide a role falls inside IR35, they must deduct the appropriate taxes and NICs through payroll just as they would for an employee.

Outside IR35

Being “Outside IR35” means that the contractor is considered to be in business on their own account and therefore operates outside the scope of the IR35 rules. This status implies less tax liability, allowing the contractor to pay themselves through a combination of salary and dividends, which can be more tax-efficient. It is generally more favourable financially for a contractor to be classified as outside IR35.

For small companies, the responsibility to determine IR35 status remains with the contractor’s intermediary.

Determining IR35 Status

The determination of whether a contract is inside or outside IR35 depends on several factors relating to the employment relationship. These include:

• Control: If a contractor is classified as inside IR35, the client has significant control over how, when, and where the work is done, similar to an employer-employee relationship. Outside IR35, on the other hand, means the contractor has autonomy over how to carry out their work, choosing the methodology and approach without client-imposed processes.
• Substitution: Under inside IR35, the contractor cannot send a substitute in their place; the client expects personal service. Whereas, being outside IR35 means that the contractor can send someone else to do the work, indicating they are supplying a service rather than their personal labour.
• Mutuality of Obligation: If there is an obligation for the client to provide work and for the contractor to accept it, mirroring an employment relationship, the contractor is classified as inside IR35. However, the client is considered outside IR35 if there is no obligation on either side; the contractor can refuse additional work, and the client is not obliged to offer continual work.

To assess IR35 status accurately, many turn to legal experts or use HMRC’s online tool, the Check Employment Status for Tax (CEST).

Decisions on IR35 status can significantly impact a contractor’s net income, and incorrect assessments can lead to hefty penalties, making it crucial for both contractors and clients to carefully consider IR35 rules in their contractual agreements.

IR35 and Its Impact on Different Business Structures

IR35 impacts different business structures in various ways.

IR35 and Sole Traders

Sole traders are individuals who are self-employed and run their business as a single person. They are not directly targeted by IR35 because they do not operate through an intermediary corporate structure.

Although IR35 does not apply, sole traders must still be cautious about their employment status regarding their clients. If a client relationship too closely resembles employment, HMRC may treat them as employees for tax purposes, under different criteria not related to IR35 but still focusing on employment status.

IR35 and Limited Companies

Limited companies are often the preferred choice for contractors due to the tax efficiency they offer. However, with IR35, things can get complicated.

If a contract is inside IR35, it means the contractor is considered an employee for tax purposes. This can significantly reduce the take-home pay of the contractor as they’ll have to pay income tax and NICs just like regular employees.

On the other hand, if a contract is outside IR35, the limited company can continue to enjoy the tax benefits. The contractor can take a small salary and the rest as dividends, which are taxed at a lower rate than income.

The impact of IR35 on limited companies is therefore largely dependent on the nature of the contract. It’s crucial for contractors to understand their IR35 status to avoid unexpected tax bills and penalties.

IR35 and Umbrella Companies

Umbrella companies act as employers to contractors who work under fixed-term contracts usually at different locations. The contractor becomes an employee of the umbrella company.

Since contractors are employees of the umbrella company, IR35 rules do not apply directly. The umbrella company handles all PAYE (Pay As You Earn) and NICs obligations. This structure reduces the contractor’s administrative burden, as they do not have to conduct IR35 assessments or calculate taxes.

As a result, contractors don’t usually need to worry about IR35. The umbrella company acts as a third-party supplier between the contractor and the client, reducing the risk of being caught ‘inside’ IR35.

However, while the contractor holds no liability for their employment status, they may still experience a deduction in earnings as they will have to be placed on the payroll of the company. So, while umbrella companies offer a level of protection against IR35, they may not be the most financially beneficial option for all contractors.

Who is Liable for IR35?

The general rule of thumb is that the party paying the contractor, often referred to as the ‘fee-payer’, is the one held liable. This could be an agency, an intermediary, or the end client themselves.

The responsibility of determining a contractor’s IR35 status also falls on the fee-payer. This is a crucial role, as incorrect classification can lead to hefty penalties from HMRC.

However, it’s important to note that liability can shift. If there’s a failure in the supply chain, for instance, if the agency doesn’t pay the correct tax, the liability can move up the chain, potentially reaching the end client.

It’s also worth mentioning that from April 2021, changes to the IR35 rules mean that medium and large-sized private sector clients will be responsible for setting the IR35 status of their contractors.

Disputing an IR35 Decision

Here’s a guide on how to dispute an IR35 decision:

Step 1: Understand the Determination

• Review the Status Determination Statement (SDS): The client is required to provide a Status Determination Statement detailing their decision on whether the IR35 rules apply. This statement should include the reasoning behind their conclusion.
• Analyse the Reasons: Understand the factors that led to the determination. Consider aspects such as control, substitution, mutuality of obligation, financial risk, and other relevant criteria that the client used to make their decision.

Step 2: Gather Evidence

• Contract Review: Compare the actual working practices against what’s written in the contract. Look for discrepancies between the contract terms and day-to-day job execution that might suggest a different employment status.
• Document Communication: Keep records of all communications regarding your working arrangements. This can include emails, messages, or notes from meetings that demonstrate your independence in the role.
• Prepare Supporting Documentation: Collect evidence that supports your claims about factors such as the right of substitution, the absence of mutuality of obligation, and control over how the work is done.

Step 3: Engage in Dialogue

• Initiate a Conversation: Contact the client or the agency that made the determination. Outline your concerns clearly and provide the evidence you’ve collected. It’s often beneficial to solve these issues directly if possible, as it may lead to a quicker resolution.
• Client’s Dispute Resolution: Utilise the client’s own dispute resolution process. Engage with this process by formally submitting your dispute and supporting evidence.

Step 4: Use Professional Services

• Consult a Specialist: Consider consulting with an IR35 specialist, such as an employment status expert or a tax advisor, who can provide a professional opinion and possibly strengthen your case.
• Legal Advice: If necessary, seek legal advice to understand the full scope of your options. Legal professionals specialised in tax or employment law can offer crucial insights and representation.

Step 5: Formal Appeals

• HMRC Involvement: If the issue cannot be resolved through dialogue with the client or their dispute process, you may need to prepare for a formal appeal or a review by HMRC. This can be initiated through contacting HMRC directly to discuss the case.
• Tribunal: As a last resort, consider taking the case to a tax tribunal. This formal legal process should only be considered after all other avenues have been exhausted and should be navigated with professional legal assistance.

The Significance of IR35

IR35 legislation plays a critical role in the UK’s tax and employment landscape, aiming to ensure fairness in taxation among contractors and businesses. By distinguishing between genuine contractors and disguised employees, IR35 addresses tax avoidance and secures employment rights for those affected.

Both contractors and the businesses that engage them must navigate these rules carefully to determine the correct employment status, as misclassification can lead to significant financial penalties and legal complications.

As the landscape of work continues to evolve, understanding and compliance with IR35 remain vital for all parties involved, ensuring that everyone pays their fair share while fostering a flexible and compliant workforce.