What is IR35?
What is known as IR35 is legislation, first passed nearly twenty years ago that seeks to ensure that a ‘freelancer’ pays the right amount of tax. It was created to try to stop people who were really working like employees, from ‘pretending’ to set up their own businesses via their own limited company (known as a personal service company, or PSC), to take advantage of the lower tax rates that structure can sometimes offer.
This doesn’t mean that if you chose to work for yourself as a freelancer and use a PSC, you’re doing that just for tax reasons. Many people chose to contract and like the credibility a limited company gives them, along with the protection it can give from the personal liability to which a sole trader is exposed. But as with many other transactions, where the move to a limited company is purely a tax fuelled change, HMRC will always be looking for ways to unpick an arrangement that they feel is artificial, and unfair. That’s what IR35 seeks to do if a PSC is used for the wrong reason.
The new ‘off-payroll’ rules in the public sector, which are scheduled to be rolled out to the private sector in April 2020 are similar, but not the same – there’s more later on this.
How does it work?
If IR35 is said to apply to an assignment (a piece of work) then that assignment is described as ‘caught by IR35’ or ‘inside IR35’. Following the original rules, if your situation is ‘caught’ then the income that would be paid to your company for the work done is reduced by 5% to allow for the expenses of running a business, and the remainder is ‘grossed-down’ for employers NIC, and the remaining ‘gross pay’ equivalent suffers PAYE tax and employee’s NIC, just like a normal payslip.
There are other possible deductions (such as an employee pension) in this calculation but you should discuss these with your accountant, who can also help with other aspects of the calculation – it’s not easy. By law these calculations have to be made by the PSC, and the PSC either pays those taxes to HMRC each month like any other payroll, or makes an adjustment at the end of the tax year (around 5 April) to do the same calculation and make the same payment, but on an annual basis.
How do I know if I’m ‘caught’?
In order to decide if an assignment is caught, we effectively do a thought experiment. A typical supply chain will include a worker, their PSC, possibly an agency or other intermediary, and then an end user, who benefits from the work done. What we do, is imagine that only the worker and the end user exist, and we imagine the contract that would exist between them, and each party’s rights. We do this by examining the actual contracts in the supply chain, and, critically, the working practices that occur in reality. What kind of a contract do they suggest?
Then we consider if that imagined contract, supported by the actual working practices, is indicative of an employee / employer relationship (so ‘caught’ by IR35), or of a business to business relationship (so ‘not caught’). Essentially – does the worker look and smell like a member of staff, or like a third party service provider? In order to do this, we consider their situation on a holistic basis, but we concentrate on several things in particular as part of that assessment. These are known as the ‘silver bullets’ and ‘other factors’.
If any one of these ‘silver bullets’ is not present, then an assignment is highly likely to be ‘outside’ IR35 and ‘not caught’ by the legislation:
- Mutuality of obligation (‘MoO’) – the principle that an employer and employee are obligated to each other – to supply continuing opportunity to work, to pay a notice period if no work is available, to serve a notice period if you chose to leave work, and so on. If there are not obligations on both sides, then there is ‘no MoO’.
- Personal service – if the worker can be substituted by their PSC (not by other parts of the supply chain like an agency) then there is not a requirement for personal service. An end user can make only reasonable demands regarding a substitute, such as a particular trade credential or level of experience, and not reject a substitute out of hand.
- Control in HOW the work is done. A worker can be given a very detailed specification for work, but if they are not controlled in how they deliver that, then there is not sufficient control to demonstrate an employment relationship, and the assignment should be seen as outside IR35.
To complete an employment status assessment, which is essentially what the IR35 test is, we also consider other factors – that may or may not indicate that the worker is operating like an employee, such as:
- Financial risk – does the worker and their PSC bear real financial risk? Do they need insurance? If work is not completed satisfactorily, will they have to put it right, without charging or being paid for those corrections? If there is genuine financial risk, that indicates a lack of employment – an ‘outside’ or ‘not caught’ IR35 situation.
- Part and parcel – does the worker look like and behave like an employee? Are they on the holiday rota? Do they use a lot of end user equipment and other resources? This is often a greater risk the longer they work with one end user. If they look like an employee, they are more likely to be ‘inside’ IR35.
What does this mean for me?
If you have a PSC, and your assignment is ‘inside IR35’, then you have to do the calculations and pay over the payroll taxes to HMRC, or you are in breach of the regulations. When a PSC does this, it almost always pays more tax, and so unsurprisingly, some contractors ignore the rules and keep more of the PSC’s income for themselves, taking a mixture of a low salary and dividends. Taking money this way is perfectly legal, unless IR35 applies.
If HMRC look at your situation and decide that you should have applied the rules and didn’t then they will look to collect the tax due, plus interest and penalties. You can challenge this in court or a tribunal, but of course that’s not easy, and expensive. The safest bet is to make sure you know if an assignment is inside or outside IR35 when you agree to do the work, and then you can make sure you know how much of the assignment rate you’ll end up with after tax. A good accountant will be able to help you review your contract and working practices, and provide an illustration.
The off-payroll rules were introduced to the public sector in April 2017. They apply the same kind of employment status test to an assignment through a PSC, but now, the end user is supposed to decide if the assignment is caught, and then whoever pays the PSC (the end user, or any other intermediary, such as an agency) is liable for the payroll taxes, if they don’t process them and they should have (so if the assignment was caught, but they ignored that).
The rules are scheduled to apply in the private sector from April 2020. They are not exactly the same as IR35, but the principles are the same. There will be more consultation with Government before the private sector rules are finalised, so watch this space.
If all the assignments you are carrying out are caught by IR35 or the off-payroll rules, you may choose to stop using a PSC, or not open one in the first place. If so, you can use an umbrella company to get paid instead. If so, it’s vital that you make sure they tax all of your pay and don’t use any tax avoidance schemes (see HMRC’s Spotlight 45 for more details of what’s not allowed).
FCSA accredited members are tested regularly to make sure they are compliant with legislation, and the FCSA’s code of conduct. So, choose a fully accredited FCSA member if you are choosing an umbrella company.