If you are thinking of starting out as a freelancer or a contractor, you will very quickly need to 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 freelancers and 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 freelancing and 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?
IR35 – Genuine Contractor or Disguised Employee?
IR35 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 of 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.
As you approach higher day rates commanded by City consultants, this tax shortfall can be many thousands of pounds per year.
Although IR rules and case law are constantly changing, there are a few basics that can help you figure out if you’re affected.
Three Tests Form Basis of All IR35 Decisions
There are three tests that form the basis of all IR35 decisions;
- Mutuality of Obligation
- Personal Service
If you pass one of these tests there’s a good chance IR35 won’t apply to you. 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 decide to investigate your business they will question your client about your working practices, and if they don’t match what is written in your contract you could be in hot water.
Basically, 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, ask 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.
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