IR35, officially known as the Intermediaries Legislation, is a set of tax rules in the UK targeting “disguised employment.” This term refers to situations where individuals provide services to clients through their own limited companies or other intermediaries but operate in a manner similar to that of an employee. The aim of IR35 is to ensure that these individuals pay the correct amount of tax and National Insurance contributions (NICs) as they would if they were employed directly by the client company. For UK businesses, understanding IR35 is crucial to avoid penalties and ensure compliance.
What is IR35?
Introduced by HM Revenue & Customs (HMRC) in 2000, IR35 is designed to prevent tax avoidance through disguised employment. Disguised employment occurs when a worker provides services through a limited company, but the nature of their working relationship with the client is more akin to that of an employee than a genuinely self-employed contractor. If caught under IR35, the worker must pay income tax and NICs similar to what they would pay if they were an employee of the client.
Key Points to Understand:
- IR35 is not a tax in itself but a set of rules to determine how you should be taxed.
- The goal of IR35 is to ensure fairness and prevent individuals from paying less tax by setting up a limited company while still working as an employee.
Who Does IR35 Apply To?
IR35 applies to individuals who operate through an intermediary, typically a personal service company (PSC) or an agency, but would otherwise be considered employees if engaged directly by the client. This legislation mainly affects:
- Freelancers and contractors who provide services through a limited company.
- Personal Service Companies (PSCs) set up by individuals to provide their services.
- Agencies that place individuals in roles within other organisations.
Example:
A graphic designer might work exclusively for a marketing agency through their own limited company. If the relationship between the designer and the agency resembles an employer-employee arrangement, IR35 could apply.
How Does IR35 Work?
To determine whether IR35 applies, the client (the business hiring the contractor) must assess the working arrangements and relationship between themselves and the contractor. The assessment focuses on several factors that help determine if the contractor is, in reality, an employee.
Factors to Consider:
- Control: Does the client dictate the contractor’s work schedule, location, and how the work should be performed?
- Substitution: Can the contractor send a substitute to complete the work, or is the work required to be done personally by the contractor?
- Mutuality of Obligation: Is there an obligation for the client to provide work, and is the contractor obliged to accept it?
- Financial Risk: Does the contractor bear any financial risk? For example, are they responsible for rectifying errors at their own cost?
- Integration: Is the contractor integrated into the client’s organisation, such as attending team meetings or receiving employee benefits?
Example:
An IT consultant works through a PSC and is contracted by a large corporation. If the corporation dictates the hours, provides tools, and the consultant is seen as part of the team, IR35 might apply.
Determining IR35 Status
Determining whether a contract falls inside or outside IR35 involves considering various factors related to the nature of the working relationship. These factors are often referred to as the “tests of employment” and help establish whether an individual is an independent contractor or a disguised employee.
Key Considerations:
- Control
- Question to Ask: Does the client have control over what, how, when, and where the work is done?
- Implication: High levels of control by the client suggest employment rather than self-employment.
- Substitution
- Question to Ask: Can the contractor send a substitute, or must they perform the work personally?
- Implication: The genuine right to provide a substitute indicates self-employment.
- Mutuality of Obligation
- Question to Ask: Is there an obligation for the client to offer work and for the contractor to accept it?
- Implication: An ongoing obligation suggests an employment relationship.
- Financial Risk
- Question to Ask: Does the contractor bear financial risk, such as covering the costs of errors?
- Implication: Bearing financial risk is indicative of self-employment.
- Integration
- Question to Ask: Is the contractor integrated into the client’s organisation (e.g., attending meetings, using client tools, etc.)?
- Implication: Integration within the organisation can indicate employment status.
Example:
A contractor providing services for a tech company works on-site, uses the company’s equipment, and adheres to the company’s work policies. Such an arrangement is more likely to be considered “inside IR35.”
Penalties for Non-Compliance
Failing to comply with IR35 can have significant financial consequences for both the contractor and the client. If HMRC determines that a contractor falls within IR35 and has not been paying the appropriate tax and NICs, the following penalties may apply:
- Back Taxes: Payment of all unpaid income tax and NICs.
- Interest Charges: Interest on the amount of back taxes owed.
- Penalties: Penalties for failure to correctly determine IR35 status and make appropriate deductions.
Example:
A consultancy firm hires several contractors through PSCs without assessing their IR35 status. An HMRC investigation finds the contractors should have been classified as employees. The firm may face substantial fines and be required to pay back taxes and NICs.
Recent Changes to IR35
Significant changes to IR35 were implemented in April 2021. The responsibility for determining a contractor’s IR35 status shifted from the contractor to the medium or large-sized private sector clients. This change followed similar rules already applied to the public sector since 2017.
Key Changes:
- Responsibility Shift: Medium and large private sector businesses must now assess the IR35 status of contractors.
- Small Companies Exemption: Companies meeting two or more of the following criteria are exempt from these rules:
- Turnover of £10.2 million or less.
- Balance sheet total of £5.1 million or less.
- 50 employees or fewer.
Example:
A medium-sized engineering firm that hires contractors through PSCs must now assess whether these contractors are genuinely self-employed or should be taxed as employees under IR35.
Steps for Businesses to Ensure Compliance
Ensuring compliance with IR35 is crucial for businesses to avoid penalties and maintain good standing with HMRC. Here are steps businesses should take:
- Review Contracts
- Ensure all contracts with contractors clearly outline the nature of the working relationship.
- Include clauses that reflect a genuine self-employment status, where applicable.
- Conduct Status Assessments
- Regularly review the IR35 status of all contractors.
- Use HMRC’s Check Employment Status for Tax (CEST) tool for guidance, but be aware that it may not cover all scenarios.
- Maintain Clear Communication
- Communicate clearly with contractors about IR35 assessments and any changes to their status.
- Keep records of all assessments and communications.
- Seek Professional Advice
- Consult with tax professionals or legal advisors to ensure full compliance.
- Consider obtaining insurance to cover potential IR35 liabilities.
- Stay Updated on Legislation
- Keep up-to-date with any changes to IR35 legislation and guidelines from HMRC.
- Regularly train internal teams responsible for engaging and managing contractors.
Summing It Up
Understanding IR35 is vital for UK businesses that engage contractors. These rules are designed to ensure that individuals who work like employees are taxed like employees. By carefully assessing each contractor’s status, maintaining accurate records, and seeking professional advice, businesses can stay compliant and avoid costly penalties.
Remember: Ignoring IR35 rules can lead to significant financial penalties and damage to your business’s reputation. Take proactive steps to assess your contracts, seek professional advice, and stay informed about any legislative changes. This approach will help you manage your workforce effectively while staying on the right side of the law.
For further reading and guidance, you can visit HMRC’s official IR35 page.