What is IR35 and Off-Payroll Tax?
IR35, also known as the Off-Payroll tax rules, was created to both protect worker’s rights and reduce tax avoidance. HMRC have done this by targeting limited company contractors and those that hire them.
Being ‘inside’ IR35 means that you would be considered an employee of the company rather than a self-employed contractor. Under the legislation, this has serious tax implications for both the firm and contractor – you’ll both end up paying more. As such it’s important that you understand the legislation so that you remain a genuine contractor and can maximise your earnings.
Why was IR35 introduced by the Government?
With tax avoidance being a major issue in the UK, it is unsurprising that the government is looking for ways to cut down on it. One way the government decided to tackle the problem was by introducing the IR35 legislation back in 2000.
Prior to IR35, we saw the rise of two bad practices:
- Disguised Employees: people who work in a similar way to full-time employees but bill for their services via their limited companies to make their business as tax efficient as possible.
- The Monday to Friday phenomenon: contractors who worked at the same desk in the same job 40-hours a week using company equipment and were employees in all but name yet could not access employee benefits.
The majority of contractor/firm relationships are genuine, and there are plenty of sole trader limited companies operating in the UK. However, it’s not uncommon for some organisations to take advantage of the rules in these ways so that they can avoid paying employers’ National Insurance contributions or providing employment benefits.
To combat this, IR35 rules are designed to ensure that contractors working via their limited companies, deemed to be doing the same work of an employee, pay broadly the same tax. An HMRC inspector will determine this by applying an employment test to each case, which is based on the actual working practices, rather than any contract.
What does inside and outside IR35 mean?
Being inside IR35 means paying taxes like an employee would but with none of the employment rights that you’d benefit from as an employee such as sick pay or holiday pay. This means you have been deemed to be a disguised employee of a company and any of the small tax advantages you may normally enjoy as a limited company contractor will no longer apply. However, the company is still not required to provide any employee benefits to you. Being inside IR35 can significantly cut into your earnings and leave you unprotected from any workers’ rights, so it’s important that you remain outside IR35.
Being outside IR35 means that you are considered to be a genuine contractor and not a disguised employee. This means both the firm who hired you and HMRC consider you to be self-employed and you can continue to operate as tax efficiently as possible.
If you’ve taken the time to set up your own limited company and become a contractor, you’d likely want to remain outside of IR35 and continue to benefit from a self-employed status. So next let’s review the IR35 rules and look at how you can ensure your contracts point to self-employment and not disguised employment.
IR35 rules
To show that there is no employment relationship, certain relationship criteria is used to determine whether a contractor is 'inside' or 'outside' IR35. As a rule of thumb, IR35 won’t apply if the contract is for the services you provide instead of employment. It’s a good idea to keep the following three things in mind when deciding if your business falls inside or outside of IR35:
- Mutuality of obligation
Working as a self-employed contractor means you can work in a project-by-project basis without any obligation to continue working for that client once the contract comes to an end. Equally, clients are under no obligation to continue offering you contracts once the project you’re working on is complete. If a client is obliged to offer you paid work and you’re obliged to take it, this is an example of a contract of employment, meaning you fall within IR35. Also, if a contract states that you can’t take on other clients while working for them, this also places you within IR35.
- Substitution
If a contract states that the client wants you, and only you, to see a job through from start to finish, then this working relationship will fall within IR35 rules. For a contract to fall outside of IR35 it should highlight that the substitute workers you put forward can complete the contract work on your behalf instead.
- Supervision, direction, control
Contractors must have control over how they complete their work for a contract to fall outside of IR35. If a contract sets working patterns and the client provides excessive input over how work is completed, then it’s likely that this will fall under employment rather than contract work. Keep in mind that if you’re also completing tasks for a client in addition to the contract services you’re already providing, the contract is likely to fall within IR35 too.
If the contractor passes the test as ‘outside’ of IR35 rules, they can continue to invoice and pay themselves through their own limited company. If the work is deemed 'inside' IR35 and HMRC declares that it’s an employment relationship, then tax and National Insurance will be deducted from their earnings and the liability for any tax shortfall lies with the contractor who has been identified as a disguised employee.
Changes to IR35 in the public sector
Originally, IR35 employment status was declared by the contractor and not the hiring organisation. But in 2017, the rules changed significantly for the public sector, with the onus to prove self-employed status shifting from the contractors themselves to the hirer. It could be viewed as the worst of both worlds for the contractor: if found to be 'inside’ IR35, they will be taxed and pay NI as employees, but still won’t receive employee benefits.
These changes made hiring contractors a riskier business, as the hirer is fined if they incorrectly identify an IR35 contractor as an 'outsider'. In a bid to avoid this, some public bodies, including HMRC, NHS and the MOD, have ceased using any limited company contractors.
Changes to IR35 in the private sector
The IR35 reforms already implemented in the public sector have now been extended to private sector contracts. As of April 2021, private sector employers hiring contractors are now responsible for determining their IR35 status.
There are concerns that organisations will be wary about contracting out work, or that contractors will need to work and operate through PAYE umbrella companies.
IR35 insurance for contractors
HMRC is able to open an inquiry into contracts from a contractor up to 6 years in the past and if there’s evidence of deliberate tax avoidance they may be able to go back even further. While it is hopefully unlikely to happen, it’s understandable that you may be curious about protection against an IR35 enquiry. While an IR35-specific policy may not be necessary, contractors may want to explore other insurance options.
If you think you’re being wrongly investigated, it is possible that a legal expenses insurance policy could help the cover you for expenses incurred in representing you at an HMRC Investigation, including disputes about IR35. Policies like this would not cover you for the actual tax but could cover the costs of defending your status.
If you’re looking at legal expenses policies with the intent of it covering you for IR35, be sure to discuss that concern with your insurance company and understand any processes that are needed to properly cover you. If you don’t involve your insurer from the outset and follow all of their processes, you may not be fully covered.
It has also been suggested that having professional indemnity insurance could help towards proving that you are genuinely self-employed if it came to an HMRC investigation. The reasoning behind this is that it may be able to demonstrate that there’s genuine financial risk associated with your work that an employee would not face and that you’ve taken steps to insure against this risk. Usually, as a contractor, you’re required to have this kind of cover so not having it may point to you not being considered a genuine contractor.
IR35 checklist: test your employment status
Trying figure out how to remain outside IR35 or if it applies to contracts you’re working on? Below are some of the factors that HMRC will take into consideration when running an IR35 test, so it’s a good idea to ensure your relationship with your hirer is crystal clear before you begin work.
How you’re paid
To stay outside of IR35, self-employed contract workers tend to be paid on a project-by-project basis, which is usually when work reaches a specific milestone or comes to an end.
Running a business of your own accord
Having a website, dedicated office space and employees all goes in your favour of showing that you’re running your business of your own accord. This reinforces that you’re operating as a self-employed contractor and not offering the services you provide as an employee.
Contractors must have control over how they complete their work for a contract to fall outside of IR35. If a contract sets working patterns and the client provides excessive input over how work is completed, then it’s likely that this will fall under employment rather than contract work. Keep in mind that if you’re also completing tasks for a client in addition to the contract services you’re already providing, the contract is likely to fall within IR35 too.
The equipment you use
If a client provides you with equipment to complete a contract, and you don’t use your own, this could result in HMRC viewing you as a disguised employee. Whenever you’re at the pre-agreement stages of a contract, always make it clear that you’ll be using your own equipment while working to remain outside of IR35, otherwise it could make working out your employment status more difficult.
Contractor remains separate from client business
If a contractor becomes an integral part of a business’s structure, such as having managing employees who report into them, this indicates an employee status as opposed to self-employment.
Exclusivity
One of the major perks of being a self-employed contractor is that you can work for more than one client at once. However, if you’re deemed to be working exclusively for one client only over a prolonged period of time, HMRC could view this as an employee-employer relationship, meaning you fall within IR35.
Financial risk
Self-employed contractors are likelier to experience a higher level of financial risk than an employee would as they have to invest their money into the everyday running of their business. If a client deems work faulty or substandard, putting things to right is a simple way for contractors to demonstrate their exposure to financial risk and a strong indication that they’re in business of their own account.
How to calculate IR35 payment
If it’s deemed that IR35 does apply to your contract, you’ll be responsible for paying the outstanding extra income tax and National Insurance contributions. In fact, HMRC can go back at least six years to determine whether or not IR35 applies to any previous work you’ve carried out and can request you to pay any necessary additional penalties and interest.
You’ll need to calculate the deemed payment on your limited company income for the year. This means that you deduct your Pay As You Earn (PAYE) salary, (a 5% expenses allowance if you’re a private sector contractor) and any pension contributions. Certain allowable expenses, such as travel and subsistence, can also be deducted from your turnover too.
Once all of these costs are calculated, you’ll be left with the deemed payment. Whatever’s left over must be treated like a salary from an employer, meaning you’ll also need to calculate the additional tax due too.
How to prepare for IR35
It might be tricky to determine your employment status, but thankfully there are easy ways you can make sure you’re adhering to IR35 rules accordingly when taking on a contract:
Take the IR35 test
To find out if you are ‘inside’ or ‘outside’ IR35, take the HMRC IR35 test to assess your current work practices.
Review your current practices
Audit your current working practices based on the results of the HMRC test. Think about how IR35 could affect how you do business – and what you can do to help solve potential problems.
Seek expert advice
Before making any changes to how you conduct business, get advice from legal experts to make sure any changes you make are still compliant with IR35 and other laws and regulations.
Not only could being clued up on IR35 rules help keep your business as tax efficient as possible, it could aid you greatly in establishing a strategy to work as effectively as possible – whether you’re a contractor yourself or rely on their services.
