What is IR35 (and what does it mean for you?)
Note: Due to the challenges businesses are facing because of COVID-19, the government announced on 17 March that IR35 tax reforms will be delayed by one year. They were supposed to go into effect in April 2020, but will now go into effect on 6 April 2021. Find out more about the IR35 delay in our Coronavirus: Help for businesses hub.
Contract work offers lots of advantages for both businesses and workers. Employers get to hire skilled and specialised staff at a lower cost. And contractors gain flexibility and the ability to retain multiple income streams in tandem.
But there has long been a grey area when it comes to tax rules surrounding contract work. IR35 addresses these issues.
While contractors can often benefit from tax advantages, they must abide by the IR35 rules in order to do so. This is why, if you’re a contractor or a small business that hires contractors, it’s important that you know what IR35 is and how it works.
In this article, we’ll help you understand the basics of IR35, why it’s so important, and how it works for both businesses and contractors.
Table of contents
- What is IR35?
- Who does IR35 apply to?
- Inside IR35 vs outside IR35
- How do businesses determine the IR35 status of workers?
- How to determine your own IR35 status as a contractor
- IR35 and small businesses
- Wrapping up
What is IR35?
IR35 is tax legislation that aims to collect additional payment from employees “disguised” as contractors for tax avoidance purposes.
The legislation was first introduced by the UK government in 2000 but has gone through multiple changes since then. In April 2017, new legislation was introduced under the name of ‘Off-Payroll Reforms’, that was specifically targeted towards the public sector.
Even though this was separate legislation, it was often (confusingly) referred to as IR35.
This new tax legislation introduced a different set of tax treatment, which holds public sector clients responsible for assessing their contractor’s IR35 status and paying employment taxes on top of the fees paid to the contractor.
The off-payroll working rules are designed to ensure that workers who provide services to clients through a limited company or any other intermediary are liable to pay the same amount of tax they would if employed.
According to the new legislation, tax and National Insurance contributions will be deducted from the contractors’ fees and paid to HMRC.
In essence, IR35 is formulated to address an inconsistency in the tax system. It aims to effectively put an end to “deemed employees” operating through a limited company structure and thus avoiding taxes.
Quick-tip: Deemed or disguised employees are a category of contractors that might be granted similar rights and advantages to full-time employees, yet are not paying the correct amount of tax according to their position. Freelance contractors who do not enjoy similar rights and benefits as employees do not fall under this categorisation.
To put an end to this tax avoidance, whether intentional or not, and to protect legal employment rights, HMRC is cracking down on anybody who falls into this category. Once in effect, people who have been using a ‘limited company status’ and have avoided paying taxes and National Insurance will now be obligated to do so.
Who does IR35 apply to?
According to the UK Government, IR35 rules apply to workers who are providing their services through their own limited company, otherwise known as a Personal Service Company (PSC) or an intermediary.
Here’s a complete breakdown of who is affected by IR35:
- Workers providing their services through an intermediary
- Clients who receive worker services through an intermediary
- Agencies providing worker services through an intermediary
IR35 does not apply to:
- Self-employed contractors providing services to clients
- Clients receiving services through self-employed contractors
- Clients located outside the UK or with no UK presence
Who determines IR35 status?
Before 6 April 2021
According to the current IR35 rules, if a worker is providing services to a client in the public sector, the client is responsible for determining their worker’s employment status.
On the other hand, if a worker is providing services to a client in the private sector, the intermediary is responsible for deciding their employment status.
However, this will change with the new off-payroll working rules in April 2021.
After 6 April 2021
According to the new legislation, medium to large-sized private sector clients, along with all public sector authorities, will be held responsible for deciding if the IR35 rules apply to their workers.
And in case of a worker providing services to small businesses in the private sector, the worker’s intermediary will be held responsible for deciding their employment status.
Inside IR35 vs outside IR35
Now that we have identified what IR35 is, and how it affects businesses and workers, it’s time to learn whether you fall inside or outside IR35.
‘Inside IR35’ essentially implies that contractors are subject to Pay As You Earn (PAYE) and are required to pay the tax as well as the National Insurance (NI) contributions as a permanent employee typically would.
It’s important to note that tax and employment legislation are currently separate. So, even if you’re considered an employee for tax reasons, you may not automatically be entitled to employment rights, such as sick days or paid annual leaves.
‘Outside IR35’ essentially implies that a contractor is considered as self-employed for tax reasons. They are free to pay themselves in the most tax-efficient way; typically a mixture of salary and dividends taken from their company.
These contractors are responsible for making sure all their personal and company taxes are calculated correctly and paid on time.
Contractors who are responsible for paying their own taxes must complete a Self-Assessment tax return. This process is relatively straightforward but can be daunting when filing your tax returns for the first time. To learn more about how to file taxes as a self-employed freelancer or contractor, read our comprehensive guide to Self Assessment tax returns.
How do businesses determine the IR35 status of workers?
There are two ways to determine the IR35 status of your workers.
1. Independent IR35 assessment service
An independent IR35 assessment service is a fair and compliant way for businesses to determine the status of their workers.
These services usually ask contractors a series of questions in order to gather all of the necessary details to make an informed decision. Once a decision is made and reviewed by the independent service, it is up to the client to approve or disapprove the judgment.
Independent services also ensure protection of the clients’ liabilities to encourage fair assessment.
2. Check Employment Status for Tax (CEST)
Check Employment Status for Tax (CEST) is HMRC’s tool to help you determine the status of your workers.
Before you begin, you’ll need to know a few things, including details of the employment contract, worker responsibilities, mode of payment, and so on. Once you have that information, you can use this tax tool to see if HMRC will treat the worker as employed or self-employed for tax purposes.
This IR35 tax tool should ideally be used at the time of employment, or in case of a change in an existing contract. Check out this employment status manual for more detail.
You can also check your worker’s employment status for tax purposes using the CEST tool.
How to determine your own IR35 status as a contractor
Just like businesses can determine their workers’ IR35 status, contractors can also go ahead and check their own status using one of the following three methods.
1. IR35 tests
This test requires you to figure out the extent of control that your client has over your work.
If the client/business manages and monitors the contractor’s tasks, or in other words, has ‘control’, it means that the worker falls inside IR35.
To take this test, you need to identify whether the service you’re offering to a client is personal or business-related, and whether or not you can propose a substitute to do your job.
If it’s possible to send a substitute to finish the tasks in the contractor’s absence, it means that the worker is not providing a personal service and falls outside IR35.
Mutuality of obligation
To take this test, you need to know whether the client is obligated to provide you with consistent and paid work. You also need to consider if you’re under any obligation to accept this work.
If either of the two parties is obligated to provide or accept work from the other, the contractor falls inside IR35.
2. Contract review
Contract reviews play an extremely important role in determining your IR35 status. Since contracts cover every condition and clause of your working status with your client, they offer a detailed perspective into the service you offer.
After a thorough review of your contract, you should have enough information to take any of the IR35 tests mentioned above, such as details of what you’re responsible for or if you’re under any sort of obligation.
3. Evidence collection
All too often, evidence is required to support one’s claims of being inside or outside IR35.
This is why it’s so important to keep records and maintain proof of all business-related activity.
For example, if you have your own website, this is an indication that you’re actively running a business of your own.
The absence of requesting time-off is also an indicator of the level of control you have over your work. Time-sheets and invoices could be used as evidence of this.
In the case of remote work scenarios, you must keep a record of proof for the time you spent working. Most contractors make the mistake of not recording the time they spend working from home and eventually fail to prove it. These records can be a huge indicator of how your client has no control over your schedule or your process.
IR35 and small businesses
Fortunately, the UK government has decided that small businesses are exempt from new IR35 rules.
This means that contractual workers can carry on operating through intermediaries, such as Personal Service Companies (PSCs), and may self-assess to account for tax and NI contributions.
In order to qualify as a ‘small’ business, you must meet at least two of these three conditions:
- Have an overall turnover of £10.2m or less
- Have a workforce strength of fewer than 50 employees
- Have £5.1m or less on your balance sheet
If you’re an honest and professional business, contractor, consultant, or freelancer, you shouldn’t have any reason to fear IR35. Nonetheless, it’s still important to know how the legislation works.
Businesses and contractors should regularly assess their contracts and pay due taxes to avoid facing any penalties or getting into legal trouble.
The rule of thumb is to exercise due diligence while defining the ‘client-contractor relationship’ in order to minimise your chances of being taxed heavily.
Photo by Brooke Cagle, published on Unsplash