A Simple Guide to IR35
Whether you’re new to contracting, or you’ve been at it for a while, you may find yourself scratching your head trying to understand the complexities of IR35. The IR35 tax legislation was put into place in April 2000 by HMRC to combat tax avoidance, and has become one of the most commonly spoken about pieces of legislation in the contracting world.
As the Chancellor delivered the budget in October 2018, all eyes and ears were on the most widely anticipated announcement: the extension of IR35 reforms to the private sector.
What is IR35?
IR35 was introduced to stop self-employed individuals from avoiding tax, by working as employees of their own limited companies. By doing this, they benefit from the tax advantages of being a contractor without accepting the increased responsibilities of company ownership. Being a director of a limited company comes with substantial responsibility, control and liability.
What does it mean to be inside or outside IR35?
If your contract and working practices fall inside IR35, this means that you have similar employee benefits, responsibilities and control to those of a permanent employee. Being inside IR35 also means that your relationship with your client is effectively one of disguised employment and you will have to pay employed levels of tax and National Insurance contributions (NIC) on your income.
Disguised employees are contractors who act as full-time employees.
Let’s take an example. Imagine you’re a freelancer for a company called Millie’s Backpacks. You charge Millie’s Backpacks, your client, a day rate. If you go into their offices on a daily basis, and have an assigned desk with your own computer and other equipment, and enjoy similar benefits to permanent Millie’s Backpacks employees (such as holidays and training sessions), your contract with Millie’s Backpacks would likely be considered to fall inside IR35. However, if, when you go into the Millie’s Backpacks office, you sit in the kitchen, use your own laptop and don’t have allocated time off, your contract will likely fall outside of IR35.
If the relationship with the client is in fact a business-to-business arrangement and outside IR35, you are free to pay yourself dividends from your company profit. Whilst dividends do not attract corporation tax relief – as is the case with salary – dividends are not subject to NIC and attract a lower rate of income tax, and are therefore a tax-efficient way of extracting income.
How is your IR35 status determined?
HMRC uses a series of tests to determine if a worker is legitimately in business on their own account, or operating as a disguised employee of the client. When looking at your contract, a number of factors are considered – but the three main factors are:
Direction and control: does your client have control over the methods and equipment that you use to carry out your work?
Substitution: can you provide a replacement to undertake your work in the event that you cannot fulfil your duties?
Mutuality of Obligation: is there any obligation or scope for your client to ask you to perform additional duties?
If you answered yes to any of the above questions, your contract may be deemed as being inside IR35.
Other factors that may determine your IR35 status include financial risk, provision of equipment (sometimes you may have to use client-owned or authorised equipment), right of dismissal and employee benefits. HMRC has compiled a list of factors that they use to determine whether someone is a disguised employee or not.
In April 2017, changes to the legislation meant that public sector contractors were no longer in charge of determining their own IR35 status. Instead, the responsibility fell to the end client. However, for private sector contractors, the responsibility continues to lie with them to determine whether or not they are inside IR35.
So my contract falls inside IR35 – what next?
If you are found to be working inside IR35, there’s no need for alarm. You can still run your own Personal Service Company (PSC) or limited company and you can still continue with the assignment you will just need to ensure you are paying the correct tax. If you have not paid enough, you will have to pay a ‘deemed payment’ at the end of the tax year to account for any tax deductions or national insurance contributions that an employee would have paid; also known as the ‘deemed employment payment’. If you’ve already paid enough national insurance and tax then you might not need to make a deemed employment payment.