If you are thinking of working as a freelancer or a contractor via your own limited company, you need to very quickly get a basic understanding of the IR35 rules.
The tax avoidance debate in the UK often focuses on the misdeeds of certain wealthy individuals and large multinational companies. But away from the national press, there is another tax avoidance battle going on between HMRC and the UK’s professional contractors.
The crux of the argument is a piece of legislation called IR35. IR35 “protects hundreds of millions in tax revenue”, HMRC claims.
However, the UK’s contracting population contends that IR35 is a millstone around their necks, and which puts disproportionately high compliance costs on one-person businesses.
So what are the IR35 rules that you need to know about if you are new to contracting?
How does IR35 operate in practice?
The Intermediaries Legislation (IR35) became law in 2000.
This tax legislation is designed to determine if a worker is legitimately self-employed – a true freelancer – or a “disguised employee”.
This matters to HMRC because a salaried employee will pay a fixed amount off of Income Tax and National Insurance contributions, whereas a limited company director has more flexibility with how they extract profits from their company, the end result usually being they pay less tax.
Would an IT worker, for example, be classed as a normal ’employee’, if the intermediary (the limited company) didn’t exist?
What about the new ‘Off Payroll’ rules?
Confusingly, convinced that the original IR35 rules weren’t tackling the problem of disguised employment, new Off Payroll Working rules has been drawn up by HM Treasury.
Although this is separate legislation, both the original IR35, plus these new rules, are often referred to as simply – ‘IR35’.
These new rules were rolled out across the public sector in April 2017 and will apply to almost all private sector contracts from April 2021 onwards.
Prior to the creation of these new rules, IR35 status was determined by contractors themselves on a self-certifying basis. Now, it is end-clients who are responsible for determining the employment status of their independent workers.
IR35 was already an administrative burden for professional contractors, and these new rules – albeit temporarily – has had a depressing effect on the market. Many end-clients, worried about their potential liability should they get things wrong, are opting to force contractors into umbrella companies.
This isn’t entirely unexpected, and given time, it is likely that the limited company model will be resurrected, particularly at the more ‘professional’ end of the market.
What happens if you’re caught by IR35?
Put simply, HMRC deems your contract to be caught by IR35, then the entire turnover for that particular contract will be subject to standard ’employee’ taxes – income tax, employees’ and employers’ NICs.
As a limited company contractor, unaffected by IR35, you will draw down money from your company typically in the form of a small salary, and dividends. This is more tax-efficient than working as an employee, mainly because employers’ NICs are not payable on dividends.
This tax differential has diminished in recent years, thanks partially to the 2016 dividend tax hike, and for many company owners, the modest gap in tax is fair enough – and accounts for all the business-related costs contractors have to pay for, that employees take for granted.
What are the key IR35 factors?
There are three key factors which, more than any other, are used to determine whether a contract is caught by IR35 or not.
- Mutuality of Obligation
- Personal Service
If the written terms of a contract work pass these tests, there’s a good chance IR35 won’t apply. At their most basic, these tests examine different aspects of the relationship between you and your client.
1. Mutuality of Obligation
Mutuality of Obligation looks at whether you are free to walk away from an assignment or have an obligation to stay.
2. Personal Service
Personal Service tries to determine if you personally must complete the work (as an employee would have to).
Control examines whether you are able to use your professional discretion to decide how a job should be completed (as an independent contractor would be expected to), or whether your client exerts employer-style control over your day-to-day work.
Two rules of thumb to use
There are two things to keep in mind when applying the three tests.
Firstly, HMRC will look at how you actually do your work, not just what is written in your contract. If HMRC decides to investigate your business they will question your client about these working practices, and if they don’t match what is written in your contract, you could be in hot water.
In essence, all the IR35-busting contract clauses in the world won’t protect you if they don’t reflect the way you actually work.
Secondly, HMRC looks at IR35 on a per-contract basis. This means that you cannot avoid IR35 by having several clients – you have to be demonstrably outside the legislation for each and every contract.
If in doubt, get in touch with an expert
IR35 has become such a big issue for freelancers and contractors that there is now a whole cottage industry offering contract reviews, insurance, and expert advice for those worried about their status.
With such complex and often-changing rules, it’s well worth your time involving a specialist.
Last updated - 5th February, 2020