A Complete Guide to the IR35 Legislation
The ambiguous nature of IR35 makes it easy for ill-informed and underprepared contractors working as limited companies to face charges from HMRC for non-compliance.
Whilst the rules regarding IR35 lack clarity, there are several status tests that can be applied to the relationship between a client and contractor to gain a fair idea about whether the contractor should fall inside or outside of IR35.
Currently, it is the responsibility of the private sector contractor to deem whether they fall inside or outside, but in the public sector the responsibility now lies with the hirer. HMRC are expected to extend the public sector IR35 rules to the private sector soon, so it is in the best interest of both hirers and contractors to have a thorough understanding of how the legislation works and what they must do to comply.
What is IR35?
Inside versus outside IR35: What does it mean?
Benefits and disadvantages of inside and outside
How to tell if you’re inside or outside IR35
How to stay outside IR35
Are there any alternatives?
Corporation tax and IR35
Sole traders and IR35
Get expert help and advice with IR35
IR35 is a tax legislation called the ‘Intermediaries Legislation’ that was introduced in 2000 under the Finance Act. The purpose of IR35 is to tackle tax avoidance by contractors acting as ‘disguised employees’.
IR35 was introduced to stop contractors working under the same or very similar terms as a permanent employee from taking home more money and paying less tax by being paid through a limited company intermediary.
The government offers limited companies tax benefits to encourage entrepreneurship and to offset the risks involved with going it alone. IR35 aims to stop people taking advantage of these benefits.
An update to the legislation in 2017 made it the responsibility of the public sector hirer rather than the contractor to deem whether the contractor is inside or outside of IR35. This change has resulted in an increase in the number of contractors being deemed as inside IR35 as hirers try to eliminate the risk of incurring charges. Private sector contractors are currently still responsible for determining their own IR35 status, but this is set to change soon.
Whether a contractor is inside or outside IR35 can make a big difference on their take home pay and tax contributions, so it’s important for both client and contractor to have a good understanding of the implications of each.
Limited companies outside of IR35 are deemed to be legitimate limited companies and can continue to operate and pay tax accordingly. When operating outside of IR35, contractors receive payment into their limited company and then pay tax at a later date. Limited companies often choose to take a small salary and high dividends to minimise the amount of tax paid, as national insurance contributions are not paid on dividends. After the contractor’s salary has been paid by the limited company, the rest of the money left in the company is profit, which is taxed at 19%. It is the net profit remaining that is then paid as dividends.
If a contract is deemed to be inside IR35 then this can completely negate the tax benefits associated with being a limited company. Limited companies inside IR35 are required to pay tax and national insurance contributions on the entirety of their deemed salary, just like a permanent employee would. Your deemed salary is generally the amount that remains after deducting your 5% allowance for business administrative expenses and any other capital allowances.
You can find detailed information about calculating your deemed salary in the HMRC’s guide here.
Companies caught inside IR35 declare PAYE and national insurance on 95% of their income but retain the 5% allowance for the running of their company.
Being brought inside IR35 from outside can reduce the net income of a contractor by up to 30%, so remaining outside is usually the preferred option.
The image to the side gives an example of what a difference IR35 can make on a contractor’s tax contributions.
There are plenty of websites out there offering free IR35 tax calculators to help contractors and clients get an idea of how much tax and net profit would differ inside or outside of IR35. Different calculator requires different information and so are likely to offer different results.
Although an online calculator may offer a contractor a general idea of their tax liability inside or outside IR35, it should by no means be taken as reliable or accurate, which is why at One Click we pride ourselves on being able to give exact figures to our customers.
HMRC also offer a spreadsheet to help calculate what the deemed employment payment would be for a contractor inside IR35.
To get a true picture of how IR35 could impact your taxes and take home pay it’s best to get advice from an expert limited company accountant like our team here at One Click Group.
When taking on a new contract it’s important that both contractor and client weigh up the benefits and disadvantages of working either inside or outside before deciding whether to continue with the contract and under what terms.
Benefits of inside
- Eliminates the risk of the contractor or client incurring costly bills for back taxes, interest and penalties from HMRC if caught operating outside when they should be inside. HMRC can look at past contracts going back six years to bill for back taxes owed.
- Compatible with the VAT flat rate scheme. Potential flat rate benefits are still available when being taxed under IR35.
Disadvantages of inside
- Contractor pays more tax and takes home less.
- Contractor loses all tax benefits related to being a limited company.
Benefits of outside
- Contractor can choose to pay themselves a low salary and high dividends (dividends aren’t subject to national insurance contributions).
- Contractor can benefit from other tax advantages including adding their spouse as a shareholder, deferring income until a later tax year, and the VAT Flat Rate Scheme which is taxed at less when outside.
- Contractor retains autonomy with the way they work and pay themselves.
Disadvantages of outside
- More administrative work for the contractor.
- Must be vigilant at complying with IR35 rules to remain outside or risk investigation from HMRC.
HM Revenue use a set of rules to determine if a contractor is inside or outside of IR35 and to define whether or not they are ‘self-employed’. They look closely at the client/contractor relationship and written contract to decide this.
To gain a better understanding of whether a contractor/client relationship falls inside or outside of IR35 several status tests can be carried out. Remember that just because a contractor fails a couple of the status tests, this doesn’t necessarily mean that they will be deemed inside IR35 as each status test holds a different weight.
These rules can seem a little ambiguous at best and it’s advised that a limited company accountant is consulted if you’re in any doubt.
This checklist is meant as a very loose guide, as each new working arrangement between a contractor and a client will be complicated and multi-faceted. There are far more points that HMRC take into consideration, but the list below gives an idea of some of the key areas of compliance to consider to ensure a contractor/client agreement falls outside of IR35.
Generally, the more of the points below that are true, the more likely the contract is to fall outside of IR35.
- Contractor is not entitled to employee benefits
Contractors should avoid becoming ‘part and parcel’ of the business. Remember that contractors are not employees and should not be treated as though they are. Contractors should not appear on a business’ list of employees and should not receive any of the same benefits.
- Contractor can work their own hours
In most cases, contractors should be free to work their own hours from a location of their choice and not be restricted to office hours or have their time ‘managed’ in any way.
- Contractor purchases their own equipment
Contractors oversee the way that their business is run, including the equipment that is used. Therefore, it is the responsibility of the contractor to buy their own equipment.
- Client could terminate contractor without any notice
Unlike with permanent employees, there is usually a lack of mutual obligation in the relationship between client and contractor. Either party usually has the right to terminate the contract with immediate effect and without giving any notice.
- Client is not obligated to provide the contractor with work
One of the key risks that contractors take when they go it alone is the unreliable nature of the work. Clients are generally not obligated to provide a contractor with work, just as a contractor is not obligated to accept all work sent their way.
- Contractor has the right to provide the client with a substitute
Limited company contractors provide services, but not a personal service. A contractor should have the right to use someone other than themselves to complete a piece of work. The right of substitution is thought to be one of the strongest tests of self-employment.
- Contractor works for multiple clients
Generally, contractors work concurrently with multiple clients. Working exclusively for one client can make a contractor look more like an employee than a self-employed individual and anyone in this situation should ensure they have proof that they have the right to take on more clients.
- The contract is for services
Getting the wording of the contract right is key to proving that a contractor is outside IR35. One of the most fundamental points to note is that your contract should state that it is a business-to-business contract for services.
Use the beta version of the HMRC’s ‘employment status’ tool to help determine your current IR35 status.
Staying outside of IR35 is usually a contractor’s preference due to the significant financial gains that can be made. To stay outside of IR35 and prove their self-employment the contractor should operate their limited company as a professional business and collect proof of their autonomy.
Conduct yourself as a business – As a limited company a contractor should operate as an autonomous business and not be reliant on any one client. They should provide services to multiple clients and always be marketing themselves to attract further work. Having a professional website and active social media accounts can be a great way of proving this point.
Contracts – HMRC will look at the contract between contractor and client as a key indicator of the contractor’s employment status. Pay careful attention to the wording of the contract, update it when applicable and save copies of all changes and related email correspondence. The contract should be for business-to-business services and a contractor should never name themselves within the contract to avoid it being confused with an employment contract.
Include a substitution clause – Contractors should ensure that every contract includes a substitution clause that states that they can outsource the work to someone else or provide a substitute if necessary. This proves they are not providing a personal service and so cannot be an employee.
Retain control – Contractors should have the right to work autonomously and without ‘management’ from their client. This includes the hours they work, the location from which they work, and the way in which they complete the work.
Collect proof – Whilst all contractors hope to avoid being investigated by HMRC, gathering proof to support your case as you go along can give you peace of mind that you are prepared if it happens. Proof could include email correspondence that shows you being treated differently to employees or acting autonomously, details of tenders (both those won and lost), and correspondence negotiating project-based fees.
Most contractors will aim to stay outside of IR35, but if falling inside of IR35 cannot be helped then a contractor may find themselves with all the administrative work of a limited company and none of the financial benefits. In these instances, an umbrella company may offer an attractive alternative.
When a contractor joins an umbrella company they are paid (and taxed) as though they are an employee. Therefore, if a contractor falls outside IR35 then they will be much better off if they act as a limited company and take advantage of the numerous tax benefits. However, if they fall within IR35 then they will be required to declare PAYE and national insurance anyway, so using an umbrella company may be an attractive option for the sake of simplicity as it eliminates the administrative work related with paying taxes and national insurance.
Contractors should be aware though that when they choose to use an umbrella company they may lose some of the benefits of working as a limited company.
- Generally, when being paid through an umbrella company, tax is paid on 100% of the income rather than 95%.
- Contractors cannot use the Flat Rate VAT Scheme when being paid through an umbrella company.
All limited companies must pay corporation tax on their profits at the standard rate of 19%. Therefore, companies operating outside of IR35 will pay corporation tax at this rate.
Contractors caught inside of IR35 will have to pay PAYE and NI on their deemed salary. The income is not taxed twice so they will not be required to pay corporation tax on the deemed salary. The contractor would only be liable for corporation tax on work completed which didn’t fall under IR35.
Sole traders cannot be caught inside IR35 because the IR35 legislation refers to an intermediary between the client and contractor (the limited company) and a sole trader is legally the same entity as their business.
Even though sole traders don’t need to worry about IR35, most contractors still prefer to set up as a limited company rather than a sole trader as the benefits outweigh the risks.
To understand why this is, it’s important to understand the key differences between a sole trader and a limited company.
Sole Trader vs Limited Company
A sole trader is a self-employed person who operates themselves as a business. A limited company is a separate legal entity which can own assets and incur debts. A limited company can issue shares to its owners, which determines how much of the company that person owns.
Limited companies are usually more tax efficient than sole traders as they pay corporation tax on profits rather than income tax and can benefit from a range of other tax advantages that are not available to sole traders, such as adding spouses as shareholders or delaying when dividends are taken. Sole traders pay tax via the self-assessment system and pay income tax and national insurance on their profits.
At One Click Group our accountants can help you to review your contract and offer advice on working practices to help you stay either outside or inside of IR35. Give us a call on 0345 557 1287 today to find out how we can help you.