Q: How is an IR35 case decided?
It’s easiest to use an analogy to show this works, for example a builder. If you ask a builder to come and build a fence for you agree with him what the end result will be but it’s entirely up to him how he does it, you don’t tell him how to build the fence. He is subject to certain constraints such as where you want it built, and he might need to work certain hours as you wouldn’t want him to turn up at 2am, but you don’t control how he does what he does. It’s also entirely possible that on day 2 his building partner turns up and takes over, which you don’t care about as long as the work gets done and the replacement person is equally as good. You also don’t care if he brings in someone to help him, as long as he’s not charging you extra. Once the fence is built the builder has no expectation that you’re going to find him something else to do, he can turn down further work if you do offer it, and you have no responsibility to find him anything to do ever again. If he does a bad job you can ask him to correct it free of charge or take legal action, and he will no doubt have insurance in place for just that reason. You may delay paying him, or refuse to pay until he provides an invoice.
An employee turns up at work each day and you can tell them what to do, how to do it, when to do it and where to do it. They cannot send a replacement person. They expect that when they finish one task you’ll find them something else to do, and in turn you expect them to carry on working on a new task when they finish the old one. They have performance reviews, sick pay, holiday pay and potentially pension or bonus schemes. They go to staff events, staff training, park in the staff car park and their name is on the internal contact list. They are very much ‘part and parcel’ of the company. If they make a mistake, they correct it in the employer’s time, and there’s rarely any suggestion that they could be sued (unless they are guilty of fraud).
This is obviously quite simplistic, but it’s how IR35 cases are decided. HMRC (or the Courts) will look at where you fit in between those two extreme examples, and if you’re deemed to be an employee then you’ll have tax and NI to pay on what you should have taken as wages (which is 95% of your income).
Q: How will I know if my contract is within IR35?
IR35 itself depends on several factors, and this isn’t just the written contract itself but the theoretical contract that exists between you and the end client. It’s therefore not possible to avoid IR35 purely by having a well written contract, as it would simply be dismissed as a sham if it’s not realistic.
1. Personal Service – if the contract requires you specifically then it is a contract of service and therefore a pointer toward employment. If you can send a substitute then it is a contract for services which cannot then be seen as employment. This is often deemed the strongest argument against IR35, providing it is a genuine right and not merely an ability to offer a substitute.
2. Control – this covers how, when and where the work is carried out. If you have reasonable autonomy over the work to be done then you would be more likely to be seen as a contractor. If you are told what to do and how to do it, and are expected to work set times for a set fee, it is more indicative of employment.
3. Lack of Mutuality of Obligation (MOO) – this relates to whether you are obliged to carry out the work and whether the client is obliged to offer you work, and also whether you are obliged to carry out work outside the scope of the contract. This applies not only after the current contract finishes, but within the current contract itself. MOO is the most difficult one of the three factors to prove, although the MBF Design case in January 2011 was won by the taxpayer with heavy emphasis on this point.
Q: What is the MSC legislation?
Managed Service Companies (MSC) were developed out of attempts to avoid the IR35 rules. There are many different types of MSC and HMRC have found it difficult to draft legislation to catch all of the variations. Even where HMRC are able to successfully argue that IR35 should apply and additional taxation liabilities arise many MSC have no assets from which the additional tax can be paid or they are deliberately wound up.
Recovery of PAYE and NIC from specified persons
Consequently HMRC introduced far reaching, and quite scary legislation allowing the recovery of unpaid PAYE and NIC to be sought from “specified persons” if recovery of the tax cannot be obtained from the MSC.
The list of “specified persons” is drawn very widely and can include directors of the MSC, the intermediaries who formed the MSC, or those who were deemed to have encouraged the individuals to use the MSC route for the provision of their services, being personally liable.
Q: What is a personal service company?
The term personal service company first arose in the IR35 legislation introduced by HMRC in 2000. Unfortunately for the tax payer it suits HMRC to not define the term.
Since 2000 it has been commonly assumed that a personal service company is a Limited Company that typically has a sole director, who is the contractor, and he/she own most or all of the shares. The personal service company then provides professional services to an end user by engaging the skills and experience of the contractor.
Q: What are the IR35 rules?
The following rules are used by HMRC when they assess your IR35 position:
Direction and Control
Understand if there exists any intention between the contractor and the client to enter an employment relationship. Does the level of direction and control in the relationship support freedom for the contractor to operate independently and determine exactly what, where, when and in what order tasks are completed?
Where the contractor has the ability or right to substitute himself with the services of another there is a strong presumption of being self-employed.
A genuinely self-employed contractor is more likely to provide his own equipment than to have it provided by the client.
Mutuality of Obligation
In Contractor terms there is a test to establish whether the arrangements establish future mutual obligations. If no future obligation exists for the client to provide further work and if the contractor can choose to accept or reject work (if offered) there would appear to be no mutual obligations.
If jobs overrun but fees are fixed, then financial risk rests with the contractor. If they also bear the risks of providing equipment and incurring overheads such as insurance, they are also exposed to financial risk. Both are indicators of being outside the scope of the IR35 rules.
Basis of Payment
Contractors tend to be paid based on a rate for a task rather than for specific periods of time such as weeks or months.
Working practices and Benefits
Acting as or being treated similar to members of staff is a factor in HMRC’s assessment. Use of canteens, staff car parks, using expenses reclaim forms, being paid for sickness or holiday, all indicate employment. An absence of these items indicates self-employment.
Q: What is the effect of being taxed under IR35 on deemed salary?
At the end of the tax year (5th April) if the total salary and benefits paid to you from your company under normal PAYE, are less than 95% of the total income earned under that contract, then the remaining balance (less some allowable expenses) is called “deemed salary” and taxed as if it had been paid as salary.
Where these rules are applied there are further adjustments to Corporation tax calculations and the tax effects of any dividends taken are also adjusted for but the result is always the same…. Your tax bills increase.
Q: How does IR35 affect self employment and personal service companies?
Contractors who are self-employed, or use Limited Companies (also referred to as Personal Service Companies) or other special purpose vehicles designed to reward them in ways other than under PAYE, fall within the intended remit of IR35.
In order to benefit from the tax advantages of using a personal service company or sole trader then it is necessary to fall outside the scope of IR35. If based on the facts you fall inside the scope of IR35 you will be taxed according to its provisions.
Q: How does IR35 affect Umbrella companies?
For individuals under employment contracts or contractors using Umbrella arrangements (where they are taxed under PAYE) IR35 legislation does not apply. No taxation advantage is being sought so no risks of challenge arise.
Q: How do you interpret the IR35 legislation?
The problem with the relatively new IR35 legislation is that it is drafted in general terms, with its rules open to different interpretations. These interpretations remain vague or unclear until such time as case law and precedent determine exactly how the Act’s provisions are to be applied.
It has been very difficult to identify genuine independent contractors from other individuals who seem to have set up their business only in order to get a tax advantage. The legislation is drafted to stop abuses of the tax system and not to prevent people operating as self-employed persons or via their own Limited Companies. Each of these alternatives remains perfectly legitimate. If however the contractor’s services are provided on terms equating to an employment arrangement then special tax rules apply in calculating the amount of tax due.
Q: What are IR35 issues?
IR35 imposes a punitive tax liability where a person is thought to deliberately use a company, sole trader or partnership to disguise the real nature of their engagement with a client. Resulting in them taking their earnings in a manner other than as wages of an employee having paid PAYE and National Insurance.
IR35 can also apply where the genuine day-to-day circumstances in which a contractor provides his services are deemed by HMRC to be similar to employment. The basic rules are easy to understand yet applying those rules and determining employment status can be far more complex. Contractors must also be aware that IR35 legislation can be extended to expose earnings from earlier years to similar tax liabilities, long after those earnings have been spent.
Q: What do I need to do to be IR35 safe?
Talk to a specialist adviser about how you deliver your services as a contractor; get them to review and comment upon your contract for free. Make sure you follow their “tips” on how to demonstrate that you are genuinely in business on your own account. Keep full and proper records, claim all expenses you are legally entitled to claim, and enjoy being your own boss!
Q: Can I insure myself against any costs or taxes?
Yes, insurance is available against any historical tax liability assessed at a future point on a contractor who originally paid tax as if he were outside of IR35 and is subsequently determined to be inside its scope and has to pay tax on a “deemed salary”. You can also insure against professional fees in defending these challenges.
Q: How do I get this right from the beginning?
Speak to a specialist adviser. Make yourself aware of the risks and pitfalls and get some “top tips” in setting up your business properly. Take care with the structure and ensure you behave in accordance with the business practices and working conditions that support your independent status.
Q: Are Limited Companies legal ways of trading?
They are totally legal and very common. Any business person who wants to keep control of their affairs, in a separate “pot”, or to minimise commercial risk and organize their tax affairs in an efficient manner, has the right to trade how they think best. Indeed many government initiatives actively encourage the setting up of new businesses and promote entrepreneurship. If you want to be independent and flexible, you should explore the many benefits of being a Limited Company.
Q: What happens if I thought I was outside IR35 but was wrong?
When contractors start out they are generally an Umbrella worker or use a Limited Company to provide their services to the end hirer. By working through an Umbrella, the temporary worker is an employee of the Umbrella and will benefit by claiming some of the benefits and expenses not always available to permanent staff. Because they are not seeking tax advantage as an “independent worker” IR35 does not affect them. For almost all purposes they are employees of the Umbrella.
As a Limited Company, contractors generally adopt the position that they are outside of IR35 and operate as independently as possible. They consider their contract and working conditions and take full, legitimate advantage of the tax benefits and other flexibilities. If HMRC challenges this stance the contractor has the following choices: (1) To agree with the Taxman, with hindsight, and pay the taxes and interest due. (2) To disagree with the Taxman and argue the case via advisers or in person.
If the Taxman wins the argument he will raise tax bills that treat all your income from contracting as if you were permanently employed throughout. (Back to square one). If tax has been paid late there could also be an interest charge and some professional fees to sort it all out. It’s OK to be wrong and have a different opinion to the Taxman. However, the cost of being wrong can be expensive so get specialist advice early on, and periodically thereafter.
Q: Are all contractors (temporary workers) included under IR35?
IR35 is essentially one of the taxman’s tests to determine if a temporary worker is an independent or “self-employed person”, or in fact a “disguised employee”. The purpose of IR35 is to not allow contractors who are not “genuinely in business on their own account” to benefit from taxation and other flexibilities which are not available to permanent employees.