IR35 is the name of a particular part of the Finance Act 2000 designed to prevent people from avoiding tax by describing themselves as self-employed or freelance when they are, to all intents and purposes, an employee of the company they’re doing contract work for.
If you are found to be operating “within the scope of IR35”, the way you pay tax and the amount of tax you pay changes significantly.
Up until recently, contractors and freelancers have self-certified with HMRC to declare that they do not fall within the scope of IR35.
IR35 changes
From 6th April 2017, contractors in the public sector have no longer able to self-certify – it is now the role of the public sector hirer about whether IR35 applies or not. A similar system will be introduced for contractors working for medium-to-large businesses from April 2020. You will still be able to declare your own IR35 status if the company you’re contracting for meet at least two of the following criteria:
- they have 50 staff or less
- their balance sheet is worth less than £5.1m
- their turnover does not exceed £10.2m
What is IR35?
IR35 is designed to stop situations like these:
• A member of staff’s employment contract is terminated on Friday
• The same member of staff returns to work on Monday as the director of his or her own limited company
Why do HMRC want to stop this?
When someone is a member of staff, they pay income tax and National Insurance on their earnings. Their employer pays 13.8% of their wage above a certain level in National Insurance Employers’ Contributions.
When that person returns as a contractor, National Insurance Employers’ Contributions is no longer payable. The contractor may draw the same earnings from their former employer (perhaps even higher) and they will split their income between salary and dividends. That means a lot less money for the Exchequer.
BusinessCostSaver note – a dividend is a way of paying shareholding company directors out of a company’s profit. There is currently a £2,000 dividend allowance under which dividend tax is not payable. Dividend tax is also much lower than income tax and National Insurance.
If the person is no longer a staff member and is now a contractor, they will have to pass a series of HMRC tests to determine whether they are a “disguised employee” or not.
IR35 rules
In order not to be caught under IR35 rules, the relationship between a contractor and a contracting organisation needs to meet a number of conditions.
Defined provision of services – the contractor should know exactly what work is entailed in the contract with their customer. Each part of the service provided should be described in detail together with some expression of the desired outcome of the provision of the parts of service and the service as a whole.
Control – the contractor should not be told that they will be directed, supervised, or controlled by the customer or a representative of the customer. To avoid IR35, the concentration should be, as much as possible, on the ends and not the means.
Substitution – the contractor should be permitted, as part of the contract, to allow someone else to complete work or parts of work in the contractor’s place.
Mutuality of obligation – any further work in addition to previous work done for the client should be covered by a separate contract and agreement. The contractor must not be obliged to do work for the contracting organisation and the contracting organisation must not feel obliged to offer the contractor any more work past what has been agreed in advance.
Contract termination – the contract should be for a defined project and the contract should end when the defined project has been completed to the contracting organisation’s satisfaction. The contract covering the work should be based around a realistic and estimated timeframe in which the work can be completed.
Financial risk – a contractor should have some sort of professional indemnity insurance at the very minimum, have a service level agreement, and agree to remedial work when needed and when caused by something the contractor has or hasn’t done or has completely wrongly.
Payment – the agreement on how the contractor is paid should look and feel like those that exist between companies and should not look and feel like a succession of pay-days. Clients should be billed by the hour, by the day, or by the project.
Exclusivity – the contracting organisation should in no way impede the contractor from working for other companies when they like, even if a client is a competitor of the contracting organisation.
Equipment and premises – ideally, the contactor should provide the equipment used on a job. The contractor should keep receipts for the equipment and demonstrate that they are in charge of upkeeping and maintaining their equipment
Intention – the contract should show that the contractor and the contracting organisations are separate and that there is no employer-employee relationship.
IR35 investigations
On the one hand, it’s great for you that (outside the public sector) you can declare whether your contractual arrangement is within the scope of IR35 or not. On the other hands, it’s not great for the taxman because, in his mind, the system is open to abuse and manipulation.
From HMRC’s point of view, there is a lack of transparency about the whole situation.
That lack of transparency is made worse by the severe shortage of staff available to them who can go out and find IR35 transgressors. From around 1,000 investigations in tax year 2003/2004, the figure fell to 192 in 2013/2014. No more recent figures are available for us to compare whether this downward trend is continuing however the introduction of the public sector IR35 rule in 2017 and its subsequent extension to private sector contracts suggests strongly that they have given up and are just going to penalise everybody now.
If you are investigated, you will get a letter from HMRC asking you if you have considered your contracting status in the light of IR35 and they will ask you for justification on why you believe you fall outside the scope of IR35.
They will investigate some more after that, normally asking for more paperwork including your contract and they may wish to speak to the companies you provide contracting services for.
If they judge that you fall within IR35, then you are likely to face a demand for the income tax and National Insurance you have not paid plus interest plus penalties of up to 100% of the tax owed.
IR35 and client diversification
Rather than just servicing one client, you can provide further protection for yourself by developing a portfolio of clients each of which you invoice and have separate contracts with.
The more customers you serve under contract, the more that your contracting business looks and feels like a standard business with a variety of turnover sources.
How much worse off will you be if you’re in the scope of IR35?
A significant amount.
If you fall under IR35 rules, you’ll be subject to normal Schedule E taxation and National Insurance – the same as employees pay. You’ll have a 5% allowance subtracted from your tax to cover your administrative expenses. You can claim additional expensive for business travel, subsistence while away of business, professional indemnity and other business insurance, benefits-in-kind, and executive/personal pension payments.
The much-increased tax you pay prevents you from accumulating cash in your business.
Let’s look at how £60,840 worth of fee income would be treated for a contractor using a personal services company against one who had been caught by IR35.
In this example, we’re assuming £10,000 worth of annual costs, covering travel, subsistence, expenses, accounting, and insurance.
| Inside IR35 | Outside IR35 | |
|---|---|---|
| Total Income | £60,840 | £60,840 |
| Income Tax | £8,385 | £2,179 |
| Employees National Insurance | £5,001 | £464 |
| Employers National Insurance | £5,962 | £0 |
| Total National Insurance | £10,963 | £464 |
| Corporation Tax | £578 | £7,285 |
| Total Tax | £19,926 | £9,928 |
| Average Tax | 32.75% | 16.32% |
| Net Income After Tax | £40,914 | £50,912 |
As you can see, the person caught in the scope of IR35 is nearly £10,000 worse off so getting it right does make a big difference.
Are there any other ways to avoid IR35?
• Make sure that all of your contracts are IR35 friendly – a good accountant will help you with that
• Diversifying the services you provide and your customer base
• Go contracting overseas in less complicated tax regimes
• Go back to the world of employment, particularly if you find contracting less stable and you are concerned about IR35
• Use an umbrella company
• Never start work without a contract you (and your accountant) are happy with
• If your client thinks s/he’s your boss and tells you to do something not in your contract, refuse
• Make sure there’s a right of substitution clause in your contract
• Always make sure it’s your company name mentioned in the contract and never you personally
• Never ask for holidays – discuss with your client when taking a holiday works best for you and your them
• Never carry around stationery suggesting you are your client’s employee
• Try not to have a client email address
• Don’t let your client pay for any training
• Always make sure that there is a provision in your contract to allow you to work for others.
And finally, don’t become part of the furniture!