Understanding IR35 – Everything you need to know
What is IR35?
IR35, also known as the ‘Intermediaries Legislation’, was introduced in 2000 to target tax avoidance in ‘disguised employment’. ‘Disguised employment’ can described as any working arrangement where a contractor or a freelancer carries out work for a business in a way that’s indistinguishable from a normal employer/employee relationship.
IR35 applies to arrangements where a contractor provides their services to a client through a limited company. If you’re engaged through an umbrella company, then you’re not affected by IR35 because you’ll be taxed as if you were an employee.
The potential impact of falling foul of IR35 can be significant in terms back taxes payable and fines. However, there’s considerable uncertainty when it comes to understanding how you may or may not be affected by the legislation.
Why was IR35 introduced?
There are significant cost savings businesses can make if they substitute employees with contractors:
- Businesses save national insurance – a tax on employment up to 13.8% of an employee’s salary.
- Businesses do not have to provide contractors with the employment benefits to which their employees are entitled. This includes legal rights as well those benefits provided by employers over and above the legal requirement.
And contractors who trade through a limited company can also benefit by saving substantial tax and national insurance on their earnings.
These factors conspired to encourage employers and employees to enter into mutually beneficial contractor arrangements. In response, the government created IR35 legislation to discourage ‘disguised employment’ arrangements which have the sole purpose of saving tax.
How does IR35 affect me?
The key objective of IR35 is to establish if you’re operating sufficiently independently from the client. If you can’t demonstrate that you’re sufficiently independent then you are considered to be ‘inside IR35’.
Being inside IR35 means that you will be deemed to be an employee and you’ll be taxed as an employee (i.e. you will pay income tax and national insurance). If you fall ‘outside IR35’, then you will be treated as an independent contractor and you can benefit from tax savings that are available to you.
It’s important to understand that IR35 is applied on a contract by contract basis. It’s therefore theoretically possible that some of your contracts could be inside IR35, while others could be outside IR35.
To determine if you’re operating sufficiently independently from the client you’ll need to demonstrate that you have provable autonomy in how you execute the assignment. Some of the key questions that you will need to consider to prove autonomy include:
- Substitution – this is arguably the most important test: does the contract allow you to substitute or to engage other suitable qualified individuals to provide all or part of the service?
- Control – do you have control in the way you deliver the services?
- Mutuality of obligation – is there a clearly defined end point for the service contract, or is there an expectation by the client that you will continue to work as and when it’s required?
- Working practices – are you effectively an integral part of the client team? Do you receive any employment benefits?
- Provision of equipment – do you provide your own equipment to perform the services?
- Financial risk – do you bear the risk in the assignment for damages, remediation, collection of debt, cost overruns etc?
- Features of a business – does your business look like a commercial business? Examples include having your own business premises, website, stationery & marketing expenditure etc.
What are the IR35 risks to me?
If you fall inside IR35 for a particular contract you’ll be liable for the following taxes on your income after making deductions for allowable expenses:
- Income tax (starting at 20%)
- Employee’s national insurance (up to 12%)
- Employer’s national insurance (up to 13.8%) – Had you been employed directly by the client, then the client would have paid employer’s national insurance.
In total, your income could be taxed at 45% and more if you are a higher rate tax payer.
If you’re outside IR35 for a particular contract, then you have no employment taxes to pay on your client income. You will only pay taxes on the company’s net profits of 20%.
Clearly there are major tax advantages to falling outside IR35. But, you must be sure that your assignments are IR35 compliant. An HMRC investigation into your IR35 status can last up to 4 years and will be a huge drain your time and energy. HMRC can look back 5 years. Win or lose, you’ll be liable for any professional fees to fight your case. And if you’re found to have traded inside IR35 you’ll be required to pay the tax you should have paid, plus interest, plus fines.
What’s the risk that I could face a tax enquiry?
That’s hard to say as HMRC have not been forthcoming in explaining how they select personal service companies for enquiry. What can be said is that HMRC is committed to making a few hundred enquiries a year and that a proportion of these will be randomly selected. On these numbers you would have to be unlucky to be selected. But HMRC also believe in the deterrence effect of IR35 investigations and are therefore likely to pursue the enquiries they do undertake with vigour.
What can I do to manage my IR35 risk?
The strategy to manage your IR35 risk is to take the appropriate level of action to mitigate that risk which in turn depends on your own personal attitude to risk. If you’re uncomfortable about having any IR35 risk then your best option is to treat all your contracts as if they fall inside IR35. However that comes at a great cost and there are strategies available that could reduce your IR35 risk to a manageable level. If you follow these steps then then you will be in a much better position to avoid and to defend HMRC enquiries:
- Before you consider contracting: speak to an accountant who’s a specialist in contractor accounting. Well, we would say that, wouldn’t we? But, there is a serious reason for this: an accountant should be able give you a broad outline of your options, your likely IR35 risk and the next steps that you need to take. It’ll save you a lot of time and guesswork; and your first meeting with an accountant is often free.
- Before you sign your contract: you should get your contract reviewed professionally for IR35 compliance. That applies to all subsequent contracts. This requires a specialist in employment law, such as our partner,Qdos. There are other firms who provide a similar service. The important point is that the IR35 review isn’t just ‘nice to have’, but a critical component in your IR35 defence. And it’s not particularly expensive. A proper IR35 review will explain to you where you have weaknesses in your contract from IR35 perspective and how these can be addressed. But it won’t be enough just to write IR35 out of your contract as HMRC will see through that. The contract needs to be supported by compliant daily working practices. This could be supported by a document known as a “Confirmation of Arrangements” which sets out the true facts of the engagement. For this reason a comprehensive contract review should also include a working practices review. It follows that the best time to do this is when you are negotiating your contract and not after the contract has been signed when it will be far more difficult to make changes.
- After you sign the contract: after your IR35 review you will know if your contract falls inside our outside IR35. If it falls within IR35, then your income will be taxed as if you were an employee. You can still do this within a limited company as there are some other tax benefits of trading within a limited company. Even if your contract is deemed to be IR35 compliant, it won’t stop an HMRC enquiry – it just means that you have a much stronger defence and you could stop an enquiry from progressing. There are insurance products on the market that can help to reduce the risk further:
- Tax enquiry insurance: to cover the professional fees of defending an enquiry, which could amount to thousands of pounds.
- Tax liability cover: to cover the taxes and penalties that may arise out of an IR35 enquiry.
There are several providers, but please refer to a Qdos accountant if you wish to learn more.
- If HMRC launch an enquiry: this could start as a harmless sounding request (e.g. Employer Compliance Review) which could become a fishing trip. Before you respond to any request from HMRC, you should inform your accountant at once. If you’ve taken the measures as described above, then there’s a good chance that the accountant could stop the enquiry from progressing.
IR35 has become a hazard of the trade for contractors. But it doesn’t need to be a worry that keeps you awake at night. If you take the time to understand the risks and take necessary measures you can reduce the risk significantly. Fortunately, there are well established service providers to help contractors manage the risk IR35 legislation presents.
At Beans we’ve built up years of knowledge and experience to help you navigate through the challenges of being a contractor. If you intend to contract or you’re a contractor and wish to discuss something, give us a call or drop in to one of our shops in Crewe and Warrington for a chat, a biscuit and a brew.
There are plenty of sources of information to help contractors. If you want to view the full list of rules relating to when HMRC considers you to be an employee, it’s available on the HMRC website.
We also find Contractor UK has huge amounts of information for contractors on IR35 and other matters.